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Barro's Neutrality

The Inclusion of Bequests

The reason why the burden of public debt is transferred to a future generation is that the government conducts income redistribution between two generations, as shown in Eqs. (4.12) and (4.13). The government reduces taxes on the parent’s generation and raises taxes on the child’s generation using debt issuance. This is a redistribution policy between two generations.

However, redistribution between two generations could be conducted by the private sector as well as by public policy. This is known as bequest adjustment from parents to children. If we include bequests in the model, public redistribution by public debt issuance could be completely offset and public debt may not affect real economic variables. This argument was first highlighted in Barro’s paper in 1974. The concept is called Barro’s debt neutrality theorem.

Barro argued that when the government borrows, members of the older generation realize that their heirs will be less prosperous because the tax burden will be moved to their heirs. Imagine further that the older generation cares about the welfare of their descendants and does not want their descendants’ consumption levels to reduce. One possibility is simply to increase bequests by an amount that is sufficient to pay the extra taxes that will be due in the future. The result is that nothing really changes. Each generation consumes exactly the same amount before the government borrowed. In effect, private individuals offset the intergenerational effect of government debt policy; thus, tax and debt finance are essentially equivalent.

 
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