Academic journal article
By Hess, Gregory D.; Orphanides, Athanasios
Journal of Money, Credit & Banking , Vol. 28, No. 2
An important question in macroeconomics and public finance is whether the intertemporal allocation of tax revenue necessary to finance government expenditures affects household decisions. Recent attention has centered around the hypothesis that financing expenditures with current taxes is equivalent to deficit financing - the Ricardian equivalence hypothesis. As presented by Barro (1974), Ricardian equivalence predicts that a representative household should be indifferent between bond and tax financing of a fixed stream of government liabilities.(1) With a homogeneous population, the result implies that aggregate consumption does not respond to a current cut in taxes.
The hypothesis, however, rests on several assumptions that have been challenged both at the theoretical and empirical front. Evidence from aggregate data suggests that tax reductions have a positive impact on aggregate consumption - a Keynesian propensity.(2) At the theoretical front, the hypothesis has been shown to fail in the presence of tax related distortions. inoperative bequest motives, nonaltruistic bequest motives, imperfect loan markets. nondiversifiable income risk, stochastic mortality and fertility heterogeneity in income, wealth or abilities and other conditions.(3)
However, the theoretical failure of tax neutrality at the aggregate level often does not yield a Keynesian propensity to consume. With respect to nondiversifiable income risk, for instance, a Keynesian propensity obtains with proportional income taxation and uncertain income but the converse is true for lump-sum taxation with uncertain incidence (see Chan 1983). With respect to wealth heterogeneity and bequest taxation, a Keynesian propensity is obtained with progressive taxation but neutrality is maintained with a linear tax (Abel 1986). A common argument in support port of the Ricardian equivalence hypothesis is that even if the presence of heterogeneity creates non-neutralities at the household level because of the redistribution of the tax burden. in the aggregate approximate neutrality may, still be obtained.(4)
In this paper, we examine the implications of heterogeneity regarding family size for individual household behavior and for Ricardian equivalence in the aggregate. Using a dynastic model of intergenerational linkages. we show that the expected size of the dynastic family relative to the average family in the economy serves as an index of the strength of its intergenerational link to future generations. Heterogeneity in family size leads to conflicting preferences across households over the intertemporal allocation of taxes, with households with larger expected families in favor of a rise in current taxes. A current increase in the size of the government debt falls disproportionately, on dynasties with stronger intergenerational links. Since the incidence of taxes is per capita, those dynasties with more children pay a disproportionately large share of accumulated debt. Intergenerational differences in the size of the dynasty have intragenerational effects - redistributing wealth at a point in time across families of different size.(5) Notably this result relies only on dynastic intergenerational budget accounting and holds independently of the specifics of household preferences.
Further, aggregation over the heterogeneous responses to a tax cut results in a Keynesian propensity to consume. Importantly, this appears despite the absence of any sources of friction, and despite Ricardian behavior within each individual dynasty. A simple calculation using the frequency distribution of family size for the United States indicates that an increase in consumption of about 20 cents for every $1 in tax cuts can be reasonably expected without introducing any frictions such as distortionary taxes or inoperative bequest motives.
The intuition for this result is as follows. Consider a reduction in current taxes which redistributes resources from large families to small families. …