Barro Challenges

People are myopic: Most skeptics argue that even though
the proposition predicts that consumers will not increase
consumption when taxes are cut, in reality lower taxes
are likely to increase consumption and decrease saving
as it is likely that most consumers do not understand
that the increase in government borrowing today is
likely to lead to higher taxes in the future. Hence,
consumers may respond to the current tax cut as they
would respond to any increase in current income by
increasing consumption.

Presence of a liquidity constraint: An underlying
assumption of the Ricardian theory is the existence of
perfect capital markets i.e. the ability for individuals to
borrow and save whenever they want.
Advocates of the traditional view argue that many
people cannot borrow. They would like to consume
more today, but because of liquidity constraints, they
are constrained to consuming less than they would want
according to their permanent income. Therefore a tax
cut for these people eases their liquidity constraint and
allows them to consume more.

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Barro assumptions

Barro assumptions

For it to work, this needs several conditions, most commonly:
A perfect capital market where any household can
borrow or save as much as is required at a fixed rate
which is the same for all persons at a given date.

The path of government spending is fixed
Intergenerational concern. Ricardian equivalence only
happens when the current generation has some concern
for all future generations, even if not a perfect concern.


These assumptions are widely challenged.

Barro-Ricardian argument

Barro-Ricardian argument:

As the government has not changed its spending, the cut in
taxes today means that the government must have increased its
current borrowing (by selling bonds). As the government debt
has to be repaid with interest in the future, future taxes will be
higher which implies lower future disposable income.
Therefore although taxpayers would have more money now,
they realize that they would have to pay higher taxes in the
future. Therefore instead of spending more now they will save
the extra money in order to pay the future tax. The extra
saving by consumers would exactly offset the extra spending
by the government, so overall demand would remain
unchanged.

The idea that tax cuts do not affect desired consumption and
therefore also do not affect ational saving is called the
Ricardian Equivalence proposition

Barro-Ricardo Equivalence

Barro-Ricardo Equivalence - “Are Government Bonds
Net Wealth?”

Basic Idea behind the Barro-Ricardian Equivalence:

An economic theory that suggests that a debt-financed tax cut
(government budget deficits) aimed at stimulating demand do
not affect the total level of demand in the country even in the
short run.

Traditional view on Government Debt:
Traditionally it is believed that a debt-financed tax cut will
stimulate consumption as the reduction in tax raises disposable
income. (unless the economy is already operating at full
employment).

APC

APC therefore depends on the ratio of Yp to current income.

In the short run, if high current income temporarily rises above
permanent income, APC will fall as consumption increases only
with YP. Vice versa when current income temporarily falls
below permanent income, APC will be high.

APC is high when income is low and APC is low when income is high.
However, over a long period of time, changes in income
come from the permanent income component as transitory
income will tend to zero. Hence, in long run time series data,
APC will be stable.

Milton Friedman’s Permanent Income Hypothesis

Milton Friedman’s Permanent Income Hypothesis

Like Modigliani, Friedman argued that consumption is related
not to current income but to a longer term estimate of income,
which Friedman terms as “permanent income”. But the PIH is
different from the LCH in that while income follows a regular
pattern over a person’s lifetime in the LCH, the PIH
emphasizes that people experience temporary and random
changes in their income year after year.

Friedman argued that a person’s current income (Y) can be
decomposed into two parts (i) permanent income (Yp) and (ii)
transitory income (Yt). Yp is the income that people expect to
persist into their future (long term income). Yt is unexpected
income/windfall.

Although income fluctuates, people generally rather have a
constant standard of living though time. For people to avoid
fluctuations in their consumption, Friedman argued that
consumption should mainly depend on Yp rather than Yt
because in the latter people will have to borrow and save to
smooth their consumption over time.