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Government Debt –
Chapter 19, 8th and 9th
THIS CHAPTER COVERS
 about the size of the U.S. government’s debt
and how it compares to that of other countries
 problems measuring the budget deficit [SKIP]
 the traditional and Ricardian views of the
government debt
 other perspectives on the debt [SKIP]
1
Indebtedness of the world’s governments
Country
Gov Debt
(% of GDP)
Country
Gov Debt
(% of GDP)
Japan
142.9
France
70.9
Greece
125.3
U.K.
64.2
Italy
120.4
Germany
42.4
Portugal
99.8
Netherlands
42.3
Belgium
91.6
Canada
40.9
United
States
85.5
Switzerland
6.5
Spain
73.3
Australia
3.5
US debt is large in absolute terms. Moderate compared to other
countries.
https://www.treasurydirect.gov/govt/reports/pd/mspd/2017/opdm042017.p
df
Ratio of U.S. govt debt to GDP
1.2
1.0
WW2
Financial
Crisis
0.8
0.6
Great
Revolutionary
Depression
War
Civil War
WW1
0.4
0.2
0.0
1791 1811 1831 1851 1871 1891 1911 1931 1951 1971 1991 2011
U.S. government spending on Medicare
and Social Security, 1948–2014
9
Percent of GDP
8
7
6
5
4
3
2
1
0
1945
1955
1965
1975
1985
1995
2005
2015
Is the govt debt really a problem?
Consider a tax cut with corresponding increase
in the government debt.
Two viewpoints:
1. Traditional view
2. Ricardian view
The traditional view of Debt
 Cut T and hold G constant:
 In the Short run: Y, u
 Long run (AD-AS model):
 Y and u back at their natural rates
 C , r, I
 Very long run:
 slower growth. Yp is lower than otherwise
because I => K is lower than otherwise.
Ricardian equivalence
 due to David Ricardo (1820),
more recently advanced by Robert Barro
 According to Ricardian equivalence,
a debt-financed tax cut, holding G constant, has
no effect on consumption, national saving, the
real interest rate, investment, or real GDP, even
in the short run.
 This is in section 19.3 and 19.4.
The logic of Ricardian Equivalence
 Consumers are forward-looking, base spending on
current and expected future income
- permanent Income/ Life Cycle Hypothesis
 Implication - Consumers know that a debt-financed
tax cut today (holding G constant) implies an
increase in future taxes that is equal in present value
terms to the tax cut.
 The tax cut today (coupled with a tax hike in the
future) is merely transitory income. Consumption
does not change, Y does not change.
The logic of Ricardian Equivalence
 Consumers save the full tax cut in order to repay
the future tax liability.
 Result: Private saving rises by the amount
public saving falls, leaving national saving
unchanged, r unchanged, I unchanged, Y
unchanged.
 A tax cut financed by government debt does not
reduce the tax burden, it just reschedules the
tax.
 Deficit financed by debt is equivalent to deficit
financed by taxes.
Question:
 Suppose consumers understand that the tax cut
today is to be followed by a decrease in
government spending in the future. Would
consumption increase?
Arguments against Ricardian Equivalence
 Myopia: Not all consumers think so far ahead,
some see the tax cut as a windfall or an increase in
life time income.
 Borrowing constraints: Some consumers cannot
borrow enough to achieve their optimal consumption,
so they spend a tax cut.
 Future generations: If consumers expect that the
burden of repaying a tax cut will fall on future
generations, then a tax cut now makes them feel
better off, so they increase spending.
Bush 1992 withholding
 Lower withholding, but pay up in the following April.
 RE predicts no change in consumption because life
time resource(permanent income) was not changed
– lower withholding was transitory income.
 Survey – 57% said would save and 43% spend.
 Most studies show MPC out of temporary tax
change < MPC out of permanent tax change.
Other examples
 Johnson 1968 tax surcharge. Temporary,
people just reduced savings
 Ford 1974 tax rebate. People just increased
saving