Intermediate
Macroeconomics
Tutorial 7
Chapter 6: Government Budget Constraint
- Household Planning
,T7 6.1, 6.4, 6.5
Ricardian Equivalence
For a given path of government spending the particular method used to finance these expenditures
does not matter. In the sense that real consumption, investment, and output are unaffected.
Specifically, whether the expenditures are financed by means of taxation or debt, the real
consumption and investment plans of the private sector are not influenced. In that sense government
debt and taxes are equivalent. In other words, government debt is simply viewed as delayed taxation:
if the government decides to finance its deficit by issuing debt today, private agents will save more in
order to be able to redeem this debt in the future through higher taxation levels.
Consequently, the Blinder Solow model (chapter 3) is seriously flawed. Here real private
consumption depends on net wealth, which includes government debt (𝐶 = 𝐶(𝑌 + 𝐵 − 𝑇, 𝐴). Under
Ricardian equivalence, government debt in the hands of the public should not be counted as net
wealth since it is exactly matched by the equal-sized liability in the form of future taxation.
The Simple Model
1
𝑉 = 𝑈(𝐶! ) + 𝑈(𝐶" )
1+𝜌
The model presents a straightforward way to understand how households make consumption and
saving decisions over time. A household's lifetime utility depends on consumption in both the current
period and future period, with future consumption being discounted according to their time
preference. Importantly, the model assumes that non-interest income is fixed (exogenous), meaning
the household cannot change its earnings through work decisions. Additionally, the household can
freely borrow or lend at the market interest rate, and there's no taxation on interest income. These
assumptions create a clean framework where the household's budget constraint depends only on
their total lifetime resources, not on when taxes are collected.
Ricardian equivalence emerges in this setup. When the government finances its spending through
either taxes or debt, the household recognizes that government debt today simply means higher taxes
tomorrow. The key insight is that the method of financing (taxes now versus debt now plus taxes later)
doesn't affect the household's total lifetime resources. If the government cuts taxes in period 1
(financing it with debt), the household understands this means higher taxes in period 2. As a result,
the household saves the entire tax cut by buying government bonds, keeping its consumption plan
unchanged. The only change is that the household's saving increases exactly by the amount of the tax
cut, showing that the timing of taxes doesn't influence real economic decisions.
1
, T7 6.1, 6.4, 6.5
Failure of Ricardian Equivalence after Introducing Distorting Taxes
"Distorting taxes" means taxes that change people's economic decisions in ways that reduce overall
efficiency. Instead of just taking money, these taxes alter behaviour—making people work less, save
less, or invest differently than they normally would. Ricardian equivalence assumes non-distorting
(lump-sum) taxes—like a fixed fee that doesn’t affect behavior.
We have assumed that non-interest income is exogeneous in both periods. This indicates that
individuals cannot adjust their labour supply in response to tax changes. Under this assumption, a tax
cut today is fully saved to pay for higher future taxes, leaving lifetime wealth and consumption
unchanged. However, the equivalence fails when labour supply is endogenous—meaning individuals
adjust their work effort based on after-tax wages. If the government cuts taxes today, workers may
increase labour supply, boosting current income, while future tax hikes could discourage future work,
reducing later earnings.
Unlike the basic model, these behavioural responses alter lifetime net wealth because the income
changes do not perfectly offset each other. For example, a tax cut today might incentivize enough
extra work to raise lifetime earnings, leading households to spend part of the windfall rather than
saving it all. Thus, deficits can influence economic activity by distorting labour decisions.
Failure of Ricardian Equivalence after Introducing Borrowing Restrictions
In the simple model, we assumed households could borrow or save at the same low interest rates as
the government. But in reality, ordinary people—especially young workers or those without assets—
often face higher borrowing costs or can't get loans at all. Since governments are seen as more
reliable, they borrow cheaply, while households pay extra (a "risk premium"). This changes everything:
if the government cuts taxes today (funded by debt), people who want to save more for future taxes
might not be able to borrow enough to do so.
This breaks Ricardian equivalence because the theory relies on households being able to perfectly
adjust their savings to offset government debt. When the government cuts taxes today while
increasing future taxes, rational households should save the entire tax cut to prepare for higher future
bills. However, if households face higher borrowing costs than the government or can't access credit
at all, they can't smoothly move money between periods to maintain their optimal consumption plan.
Instead, they spend part of the tax cut now, breaking Ricardian equivalence. Bottom line: When
borrowing is harder for people than for governments, debt-funded tax cuts can actually boost
spending in the economy.
2
Macroeconomics
Tutorial 7
Chapter 6: Government Budget Constraint
- Household Planning
,T7 6.1, 6.4, 6.5
Ricardian Equivalence
For a given path of government spending the particular method used to finance these expenditures
does not matter. In the sense that real consumption, investment, and output are unaffected.
Specifically, whether the expenditures are financed by means of taxation or debt, the real
consumption and investment plans of the private sector are not influenced. In that sense government
debt and taxes are equivalent. In other words, government debt is simply viewed as delayed taxation:
if the government decides to finance its deficit by issuing debt today, private agents will save more in
order to be able to redeem this debt in the future through higher taxation levels.
Consequently, the Blinder Solow model (chapter 3) is seriously flawed. Here real private
consumption depends on net wealth, which includes government debt (𝐶 = 𝐶(𝑌 + 𝐵 − 𝑇, 𝐴). Under
Ricardian equivalence, government debt in the hands of the public should not be counted as net
wealth since it is exactly matched by the equal-sized liability in the form of future taxation.
The Simple Model
1
𝑉 = 𝑈(𝐶! ) + 𝑈(𝐶" )
1+𝜌
The model presents a straightforward way to understand how households make consumption and
saving decisions over time. A household's lifetime utility depends on consumption in both the current
period and future period, with future consumption being discounted according to their time
preference. Importantly, the model assumes that non-interest income is fixed (exogenous), meaning
the household cannot change its earnings through work decisions. Additionally, the household can
freely borrow or lend at the market interest rate, and there's no taxation on interest income. These
assumptions create a clean framework where the household's budget constraint depends only on
their total lifetime resources, not on when taxes are collected.
Ricardian equivalence emerges in this setup. When the government finances its spending through
either taxes or debt, the household recognizes that government debt today simply means higher taxes
tomorrow. The key insight is that the method of financing (taxes now versus debt now plus taxes later)
doesn't affect the household's total lifetime resources. If the government cuts taxes in period 1
(financing it with debt), the household understands this means higher taxes in period 2. As a result,
the household saves the entire tax cut by buying government bonds, keeping its consumption plan
unchanged. The only change is that the household's saving increases exactly by the amount of the tax
cut, showing that the timing of taxes doesn't influence real economic decisions.
1
, T7 6.1, 6.4, 6.5
Failure of Ricardian Equivalence after Introducing Distorting Taxes
"Distorting taxes" means taxes that change people's economic decisions in ways that reduce overall
efficiency. Instead of just taking money, these taxes alter behaviour—making people work less, save
less, or invest differently than they normally would. Ricardian equivalence assumes non-distorting
(lump-sum) taxes—like a fixed fee that doesn’t affect behavior.
We have assumed that non-interest income is exogeneous in both periods. This indicates that
individuals cannot adjust their labour supply in response to tax changes. Under this assumption, a tax
cut today is fully saved to pay for higher future taxes, leaving lifetime wealth and consumption
unchanged. However, the equivalence fails when labour supply is endogenous—meaning individuals
adjust their work effort based on after-tax wages. If the government cuts taxes today, workers may
increase labour supply, boosting current income, while future tax hikes could discourage future work,
reducing later earnings.
Unlike the basic model, these behavioural responses alter lifetime net wealth because the income
changes do not perfectly offset each other. For example, a tax cut today might incentivize enough
extra work to raise lifetime earnings, leading households to spend part of the windfall rather than
saving it all. Thus, deficits can influence economic activity by distorting labour decisions.
Failure of Ricardian Equivalence after Introducing Borrowing Restrictions
In the simple model, we assumed households could borrow or save at the same low interest rates as
the government. But in reality, ordinary people—especially young workers or those without assets—
often face higher borrowing costs or can't get loans at all. Since governments are seen as more
reliable, they borrow cheaply, while households pay extra (a "risk premium"). This changes everything:
if the government cuts taxes today (funded by debt), people who want to save more for future taxes
might not be able to borrow enough to do so.
This breaks Ricardian equivalence because the theory relies on households being able to perfectly
adjust their savings to offset government debt. When the government cuts taxes today while
increasing future taxes, rational households should save the entire tax cut to prepare for higher future
bills. However, if households face higher borrowing costs than the government or can't access credit
at all, they can't smoothly move money between periods to maintain their optimal consumption plan.
Instead, they spend part of the tax cut now, breaking Ricardian equivalence. Bottom line: When
borrowing is harder for people than for governments, debt-funded tax cuts can actually boost
spending in the economy.
2
