In the Ricardian perspective, a
deficit-financed cut in current taxes for a given path of government spending,
leads to higher future taxes that have the same present value as the initial cut.
This result follows from the government budget constrain, which equates total
expenditure for watch period (including interest rates) to revenue from
taxation or other sources and the net issues of interest-bearing public debt. It’s
clear that government spending must be paid for now or later, with the total
present value of receipts fixed but the total present value of spending. Hence,
holding fixed the path of government expenditure and non-tax revenues, a cut in
today’s taxes, must be matched by a corresponding increase in the present value
of future taxes.
Suppose now that household’s demand
for goods depends on the expected present value of taxes that is, each
household subtracts its share of this present value form the expected present
value of income to determine a net wealth position. Then fiscal policy would
affect aggregate consumer demand only if it altered the expected present value of
taxes. But proceeding argument was that the present value of taxes would both
change as long as the present value of spending did not change. Therefore, the
substitution of a budget deficit for current taxes (or any other re-arrangement
of the timing of taxes) has no impact in the aggregate demand for goods. In the
sense, budget deficit and taxation have equivalent effects on the economy
(Ricardian Equivalence Theorem).
To put the equivalence result to another way,
a decrease in the government’s savings (that is, a current budget deficit)
leads to an offsetting increase in desired private saving, and to no change in
desired national saving. Since desired national savings does not change, the
real interest rate does not have a rise in a closed economy to maintain balance
between desired national saving and investment demand. Hence, there is no
effect on investment, and no burden of his public debt. In a setting of an open
economy there would also be no effect on the current-account balance desired
private saving rises by enough to avoid having to borrow from abroad. There
budget deficit would but cause current account deficit.
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