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Econ 208

Econ 208. Marek Kapicka Lecture 11 Redistributive Taxation Ricardian Equivalence. Where are we?. Introduction: A model with no Government The Effects of Government Spending Government Taxation and Government Debt Labor Taxation Taxation and Redistribution Government Debt.

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Econ 208

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  1. Econ 208 MarekKapicka Lecture 11 Redistributive Taxation Ricardian Equivalence

  2. Where are we? • Introduction: A model with no Government • The Effects of Government Spending • Government Taxation and Government Debt • Labor Taxation • Taxation and Redistribution • Government Debt

  3. Taxation and Redistribution • Fiscal policy may aim to change income or consumption inequality • Will have an example when • It is optimal to reduce income inequality even if • A (distorting) flat tax is used • There are costs in terms of production

  4. An example: 2 productivity levels • Two types of people: • Low productivity: wages wL • High productivity: wages wH>wL • ½ of population is of low productivity, ½ is of high productivity • Utility:

  5. Taxes • High productivity people are taxed at rate t • Low productivity people get a transfer v

  6. Low productivity people • Subject to • Solution

  7. High productivity people • Subject to • Solution

  8. Government • Budget constraint: • Express utility as a function of t only: • where k=wH/wL>1

  9. Welfare and Production • Assume that the society’s welfare is given by • Big and controversial assumption! • We have

  10. Welfare and Production • Welfare is maximized at • Production is decreasing in t:

  11. Conclusions • There is a trade-off between efficiency and redistribution • What matters: • How the government weights the utility of different individuals • Distribution of skills in the population

  12. Where are we? • Introduction: A model with no Government • The Effects of Government Spending • Government Taxation and Government Debt • Labor Taxation • Taxation and Redistribution • Government debt

  13. Government Debt • 1) The Data • 2) Ricardian Equivalence Theorem • Gov’t Debt does not matter ! • 3) Ramsey Problem • Find the optimal debt level if taxes are distortionary and RET fails • Read 14.1-14.2 for today, 14.3-14.4 for next week

  14. US Government DebtPrivately held debt

  15. US Government Debt • As of now: • Privately held US gov’t debt is about 70% of GDP • Total US gov’t debt is about 100% of GDP • US Treasury: monthly statement

  16. US Government Deficits

  17. Consumers • Budget constraints • Utility

  18. Lifetime wealth • Define lifetime wealth as present value of a disposable income • Then lifetime budget constraint says that present value of consumption is equal to lifetime wealth

  19. A Consumer Who Is a Lender

  20. A Consumer Who Is a Borrower

  21. Government • Current period budget constraint • Future period budget constraint • Present value budget constraint

  22. Competitive Equilibrium • Consumers choose c,c’,s optimally, given r • Government PVBC holds • Interest rate such that the credit market clears:

  23. Ricardian Equivalence • Suppose the government cuts taxes by $600:

  24. Ricardian Equivalence • You should also get a second letter: • There is no change in your wealth!! Dear Taxpayer: We are sorry to inform you that the present value of your future tax liabilities has increased by the amount of $600.

  25. Ricardian Equivalence Theorem The Ricardian Equivalence Theorem: If all government spending is held constant, then a change in current taxes leaves the equilibrium interest rate and the consumption of individuals unchanged

  26. Ricardian Equivalence with a Cut in Current Taxes for a Borrower

  27. Implications of Ricardian Equivalence • Tax cut is not a free lunch! • Timing of gov’t taxes does not matter • Deficits do not matter!

  28. Failure of Ricardian Equivalence • If people are heterogeneous, they might not be affected equally • Some people may receive larger tax cuts than others and their lifetime wealth may change • That is, there is a redistribution of wealth across people

  29. Failure of Ricardian Equivalence • Debt may not be repaid during the lifetimes of the people who received tax cuts • There is a redistribution of wealth across generations • Example: Social Security

  30. Failure of Ricardian Equivalence • Credit markets are not perfect • People may face borrowing limits. In such case, a tax cut will not be saved • People may face higher interest rate than government. In such case, a tax cut will increase present value of their resources and increase consumption

  31. Failure of Ricardian Equivalence • Taxes are not lump sum • If taxes cause distortions, then timing of taxes does matter • A government may want to spread the distortions across all periods

  32. Example of RI: George Bush, 1992 • George Bush, 1992: change in tax withholding • Taxes were deferred until April 1993 • Total size: $25 billion • Hope: consumers will increase spending • Result: consumption didn't change much • Didn't know Ricardian Equivalence...

  33. Real Consumption of Durables, 1991–1993

  34. Real Consumption of Nondurables, 1991–1993

  35. Real Consumption of Services, 1991–1993

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