Fiscal Policy –

–
Macroeconomics (5QQMN937)
King’s College London

Margaret Davenport

King’s College London

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Aim of this lecture

So far, the consumption savings model abstracted from

Fiscal policy: a choice of government expenditure or
taxation that influences the economy.
...and therefore no role for consumption/saving responses
to policy

Incorporate a role for fiscal policy + examine effect on consumption

Barro-Ricardian Equivalence
Focus on understanding role of model assumptions
Empirical importance of heterogeneity
Tax Smoothing - distortionary taxation

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Suggested readings

Garìn, Lester, & Sims, Intermediate Macroeconomics, Version

3.0.1., May 2021, Chapter 13, pg. 295-3001

Carlin & Soskice, Macroeconomics: institutions, instability, and

the financial system, 2015. Chapter 14, section 14.4.

Additional reading (not required, good background):

Institute of Fiscal Studies, Mini-Budget Response
Romer. 2012 Advanced Macroeconomics: Chapter 12,
Sections 12.3 & 12.4
Kaplan & Violante. 2014. “A model of the consumption
response to fiscal stimulus.”

1
Note: You do not need the general equilibrium model (production
economy).
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Barro-Ricardian Equivalence:2 Taxes versus Debt

Given government expenses {Gt }∞

0
Can the design of the fiscal stance {Tt , Dt } influence the
decisions of the agents of the economy?
E.g. Does a tax cut at time t, financed by government
debt, stimulate demand?

2
Barro, Robert. 1974. “Are Government Bonds Net Wealth?” Journal of
Political Economy. Vol.82 (6): 1095-1117.
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Ricardian Fiscal Policy

Consider a fixed level of government spending financed via a

tax increase...
Future government debt reduced (debt sustainability)
If government debt is held by domestic households...
...anticipate lower future taxes due to reduction in debt
Consumption (aggregate demand) should not change, since
wealth does not! (PIH)
Note: We use endowment economy: consumption –> aggregate
demand

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Ricardian Fiscal Policy: visualisation

1.6 1.6

1.4 1.4

Government Debt
1.2 1.2
Lump Sum Tax

1 1

0.8 0.8

0.6 0.6

0.4 0.4
1 2 3 4 5 6 7 1 2 3 4 5 6 7
time time

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Barro-Ricardian Equivalence

Definition: How an exogenous fiscal path {Gt }∞

0 , is financed is
irrelevant for aggregate demand.

Derive main result:

ct X yt − G t
∞ ∞
r)(s B
X
= (1 + 0 − 0 ) +
(1 + r)t (1 + r)t
0 0

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Barro-Ricardian Equivalence: Government

Government budget constraint (period)

Bt+1 = (1 + rb )Bt + (Gt − Tt )

Bt is government debt
rb is interest rate paid to service debt,
Gt − Tt are primary deficits

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Barro-Ricardian Equivalence: Government

Intertemporal budget constraint:

Tt Gt
"∞ # "∞ #
E = (1 + rb )B0 + E
X X
(1 + rb )t (1 + rb )t
t=0 t=0

Present discounted expenditures equal present discounted

taxes (expectations)
BT
Important terminal condition: lim T → ∞ (1+rb )T
=0
(more later)

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Barro-Ricardian Equivalence: Households

∞
" #
U =E β t u(ct )
X

t=0

subject to

ct yt − tt
∞ ∞
" # " #
E = (1 + r)s0 + E
X X
(1 + r)t (1 + r)t
t=0 t=0

Euler equation:

u 0 (ct ) = (1 + r)βE u 0 (ct+1 )

 

Non-distortionary taxation. Euler equation is not affected

Households anticipate future taxes tt : permanent income
Uncertainty about the timing doesn’t matter!
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Barro-Ricardian Equivalence: Derive Main Result
Rewrite the household’s budget constraint:
ct yt tt
"∞ # "∞ # "∞ #
E = (1 + r)s0 + E −E
X X X
(1 + r)t (1 + r)t (1 + r)t
t=0 t=0 t=0

Combine with the government’s intertemporal budget constraint

Tt Gt
"∞ # "∞ #
E = (1 + rb )B0 + E
X X
(1 + rb )t (1 + rb )t
t=0 t=0

Assume: rb = r and tt = Tt (how?), combine budget

constraints:
ct X yt − Gt
"∞ # "∞ #
E = (1 + r)(s0 − B0 ) + E
X
(1 + r)t (1 + r)t
t=0 t=0

Only pdv of government expenditures! Not fiscal stance

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Barro-Ricardian Equivalence: Model Main Predictions

For a given level of government expenditure...

Households anticipate having to repay any tax cuts such
that the budget constraint holds
This means that the path for taxes and government debt
are irrelevant to households
Aggregating means that private saving should offset public
dissaving (show this)
It also means that unfunded tax cut does not have impact
on consumption –> aggregate demand!
...but empirical evidence tends to find important demand effects
of tax changes and there is an enormous amount of debate and
salience about fiscal stance!

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Ricardian Equivalence: Empirical evidence

A negative relationship between public and private saving

across developed countries (de Mello et al., 2004)
A strong contractionary response to tax increases (Romer
and Romer, 2012)
Micro-based evidence generally finds a large mpc: ≈ 25%

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Private and Public Savings

Private and public savings negatively correlated

Control for auto-correlation and other macroeconomic
variable fluctuations
Source: De Mello, Kongsrud, and Price, (2004): Saving
Behaviour and the Effectiveness of Fiscal Policy
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Aggregate GDP Response to Tax Rise

Narrative approach cleanly identify exogenous tax changes

Tax increases highly contractionary (U.S. data 1945-2007)
Source: Romer & Romer. 2012. “The Macroeconomic Effects of Tax
Changes: Estimates Based on a New Measure of Fiscal Shocks.” American
Economic Review, 100: 763-801.
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Covid Stimulus: Consumption Response (CARES Act
2020)
Coibion, Gorodnichenko, & Weber. 2020. “How did U.S.
Consumers Use their Stimulus Payments?”
One-time transfer of $1200 per adult, $500 per child
Large-scale survey of U.S. households:

Find somewhat smaller consumption response (during

covid)
Uncover huge amount of heterogeneity:
lower-income/constrained households more likely to spend
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Barro-Ricardian Equivalence: Revisiting Assumptions

The government budget constraint is satisfied (debt

sustainability?)
No uncertainty regarding burden of taxation
(redistribution)
Perfect capital market (borrowing constraints)
Household heterogeneity
Lump-sum taxation (tax-smoothing model in a few slides)

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Barro-Ricardian Equivalence: Sustainability questioned

Mini-budget response:
Today, the Chancellor announced the biggest pack-
age of tax cuts in 50 years without even a semblance
of an effort to make the public finance numbers add
up. Instead, the plan seems to be to borrow large sums
at increasingly expensive rates, put government debt on
an unsustainable rising path, and hope that we get bet-
ter growth. This marks such a dramatic change in the
direction of economic policy-making that some of the
longer-serving cabinet ministers might be worried about
getting whiplash.
- Paul Johnson, IFS Director

Institute of Fiscal Studies, Mini-Budget Response

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Barro-Ricardian Equivalence: Redistribution

Parker, Souleles, Johnson, and McClelland (2013):

Consumer Spending and the Economic Stimulus Payments
of 2008
Economic Stimulus Payments: 100 billion dollar program of
tax rebates
300-600 dollar per tax-filling individual
600-1200 dollar per couple
300 dollar per child
targeted to low-income households
Randomized timing of disbursement (final two digits of the
recipient’s Social Security number)
Households increased their consumption after receiving a
transfer
12-30 percent (depending on specification) of their
payments on nondurable goods
Even more on durable goods, primarily vehicles
Total response of 50-90 percent of the payments

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Barro-Ricardian Equivalence: Borrowing Constraints

Current consumption increases in response to tax cut

Government borrows on household’s behalf
(tutorial: r 6= rb )

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Household Heterogeneity: Beyond Borrowing
Constraints

Can constrained households account for the aggregate evidence

against Ricardian Equivalence?
Kaplan & Violante (2014) measure US data fraction of
constrained households is only around 10%
Find a larger share of “wealthy hand-to-mouth” (illiquid
wealth/housing) ≈ 33%!
Their model can generate the higher marginal propensity
to consume in line with micro evidence with:
1 Two types of assets: liquid and illiquid
2 Heterogeneity consistent with household level asset,
portfolio data in the US
Kaplan & Violante (2014). A Model of the Consumption
Response to Fiscal Stimulus Payments.

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What is the optimal timing of distortionary taxes
So far, we considered lump-sum taxation...the timing of
taxation was irrelevant.

Examine the timing of distortionary taxation

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Tax Smoothing (Barro, 1979)3

Government chooses the path of distortionary taxation {τt }∞

0
to minimize present discounted value of distortions:

X 1 τ2
"∞ #
t
E
2 (1 + r)t
t=0

subject to

Bt+1 = (1 + r)Bt + Gt − τt

Assume the distortion is proportional to τ 2 in each period...

Gt exogenous level of real government expenditure
τt is the optimally chosen tax in t
3
Barro, Robert. 1979.
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Tax Smoothing (Barro, 1979)4
First order condition:
τt = E [τt+1 ]
Taxes should follow a random walk: expected to be smoothed
over time!
Combine Euler equation + intertemporal budget constraint
(lecture)
1 Gt
∞
" #
τ0 = r B0 + E
X
1+r (1 + r)t
0

Analogous to random walk in consumption from PIH!

Large (transitory) expansions in G should be smoothed
over time
Deficits should optimally arise in recessions (finds empirical
support)
4
Barro, Robert. 1979. “On the Determination of Public Debt.”
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Summary
Barro-Ricardian equivalence:
Derived main result: timing of lump-sum taxation is
irrelevant
Challenges, empirically due to constrained households and
heterogeneity
Empirical tests:
A large consumption response out of transitory tax changes
Points to violation of Ricardian equivalence due to
constrained households + heterogeneity
Tax-smoothing model
If taxes are distortionary, optimal to smooth distortions
over time
Analogous to the permanent income hypothesis result with
consumption (last week)

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