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The Implications of Public Debt Issuance

The rational household is concerned with the present value of the tax burden. As shown in Eq. (4.7), the present value of the tax burden is zero, which is equal to the present value of government spending, independent of debt issuance. When the government issues debt, tax may be reduced in period 1. However, in period 2, tax should be raised by the same amount in terms of present value. As long as government spending is zero (or, in general, is fixed), the current tax reduction can completely offset the future tax increase so that the total tax burden does not change.

Based on the argument in Chap. 3, permanent government spending should be the same as permanent tax revenue. Although public debt issuance can change the combination of the tax burden over time, it cannot change the permanent level of tax revenue or the tax burden. When a consumer behaves optimally, based on permanent disposable income, public debt does not affect real economic variables. This is called Ricard’s debt neutrality theorem.

Imagine that the government increases debt issuance by reducing T1. Since c1 and c2 are independent of b, an increase in debt b does not affect private savings, s, with regard to private capital accumulation. In other words, a household raises the demand for public debt by the same amount of debt issuance. Further, the household spends the same amount on consumption as before by allocating an increase in its disposable income because of a tax reduction on the entire public debt. Thus, the total of b + T1 remains at the original value. The household can then pay a higher amount of tax in period 2 without reducing future consumption. Moreover, a tax reduction caused by issuing public debt leads to an increase in private savings by the same amount, so that consumption is not stimulated in period 1.

This means that the wealth effect of public debt on consumption is zero: Ac1/A b = 0. The wealth effect of public debt on consumption is a key effect in the Keynesian model in order to ensure the efficacy of fiscal policy. If government spending is fixed, an increase in public debt means a decrease in taxes. Thus, the wealth effect of public debt is the same as the multiplier effect of tax reduction. In the Keynesian model of Chap. 2, the multiplier of tax reduction is given as — ДУ/Д T = c/(1 — c) > 0. When Ricardian debt neutrality holds, the efficacy of Keynesian fiscal policy is uncertain and the Keynesian policy loses its efficacy.

 
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