Consumers in a given economy are forward-looking and they value the welfare of t

Question

Consumers in a given economy are forward-looking and they value the welfare of their descendants. The government chooses to spend G in period t and considers three options to finance G. Option #1 amounts to taxing present generations workers to finance G. Option #2 involves debt issue at time t to finance expenditure at time t. The debt in this case is to be redeemed in the future by taxing retired individuals in the future. Option #3 again involves debt issue at time t, but, now, debt is to be retired in the future by taxing future workers. Which of the three options leads to the highest welfare? (a) First (b) Second (c) Third (d) All three lead to the same level of welfare as Ricardian Equivalence is likely to hold in this economy

Explanation / Answer

d) All the three lead to the same level of welfare as Ricardian Equivalence is likely to hold in this economy.

Ricardian Equivalence

The economic hypothesis holding that consumers are forward looking and so internalise the government's budget constraint when making their consumption decisions is Ricardian equivalence.
David Ricardo developed this theory in the 19th century and it was revised by Harvard professor Robert Barro into more elaborate version.

The demand remains unchanged even if the government tries to stimulate the economy by increasing debt financed government spending is what the Ricardian Equivalence is. The fact is that the amount of money saved today will be used to pay tax in the future and that amount saved will be used to pay off the debt.

This theory also says that the consumption of a person is determined by the lifetime present value of his after tax income. Therefore, this theory comes to an conclusion that whatever be the government's way to increase spending with debt financing or tax financing but the outcome will be the same and the demand will remain unchanged. The debt levels or tax burdens do not have any effect on the consumer spending as per this theory. Because as the government increases spending to stimulate economy it takes out more debt, and people put aside money expecting high future taxes to offset the debt. Thus if this theory holds a position and it is true then countries with high level of debt should also have comparitively higher levels of household savings.

In the example given in this qusetion also all the three option hold an equal position as per the Ricardian Equivalence because taxing present workers, or future workers all comes as same because money saved today by present workers will be used tommorrow as taxes and same with the future workers too, thus the demand here remians unchaged.

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