econ 208
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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. - PowerPoint PPT PresentationTRANSCRIPT
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Econ 208
Marek KapickaLecture 11
Redistributive TaxationRicardian Equivalence
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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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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
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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:LCLCU 2),(
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Taxes
High productivity people are taxed at rate t
Low productivity people get a transfer v
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Low productivity people
Subject to
Solution
LLLC
LCLL
2max,
vLwC LLL
LLL
LL
LLL
w
vwU
wC
w
vwL
2
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High productivity people
Subject to
Solution
HHLC
LCHH
2max,
HHH LwtC )1(
HH
HH
HH
wtU
wtC
wtL
)1(
)1(
)1(22
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Government Budget constraint:
Express utility as a function of t only:
where k=wH/wL>1
2)1( H
HH
wtt
Ltwv
HH
HLL
wtU
wtktwU
)1(
)1(
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Welfare and Production Assume that the society’s welfare
is given by
Big and controversial assumption! We have
HL UU
HL
HHLHL
wkttw
wtwtktwUU
)1)(1(
)1()1(
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Welfare and Production Welfare is maximized at
Production is decreasing in t: k
kt
2
1
222
222
22
)1(
)1()1(
)1(
tww
twttww
twvw
LwLwY
HL
HHL
HL
HHLL
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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
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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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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
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US Government DebtPrivately held debt
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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
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US Government Deficits
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Consumers
Budget constraints
Utility
srtyc
tysc
)1('''
)',( ccU
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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
r
tt
r
yywe
1
'
1
'
wer
cc
1
'
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A Consumer Who Is a Lender
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A Consumer Who Is a Borrower
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Government Current period budget constraint
Future period budget constraint
Present value budget constraint
BtG
')1(' tBrG
r
tt
r
GG
1
'
1
'
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Competitive Equilibrium
Consumers choose c,c’,s optimally, given r
Government PVBC holds Interest rate such that the credit
market clears: Bs
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Ricardian Equivalence
Suppose the government cuts taxes by $600:
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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.
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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
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Ricardian Equivalence with a Cut in Current Taxes for a Borrower
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Implications of Ricardian Equivalence
Tax cut is not a free lunch! Timing of gov’t taxes does not
matter Deficits do not matter!
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Failure of Ricardian Equivalence
1. 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
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Failure of Ricardian Equivalence
2. 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
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Failure of Ricardian Equivalence
3. 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
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Failure of Ricardian Equivalence
4. 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
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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...
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Real Consumption of Durables, 1991–
1993
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Real Consumption of Nondurables,
1991–1993
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Real Consumption of Services, 1991–
1993