What is the evidence on the Ricardian theory? Buried in our analysis of the crowding-out effect is a critical assumption. We argued that an increase in the government deficit would reduce national savings at every level of the interest rate. Implicitly, we assumed that the change in government behavior had no direct effect on private savings. Instead, there was an indirect effect: savings increased when the interest rate increased. But at any given level of interest rates, we assumed that private saving was unchanged. Perhaps that is not the most reasonable assumption. Consider the following thought experiment:
The government sends you and everyone else a check for $1,000, representing a tax cut.
The government finances this increase in the deficit by selling government bonds. The government announces that it will increase taxes next year by the amount of the
tax cut plus the interest it owes on the bonds that it issued. What will be your response to this policy? A natural reaction is just to save the entire tax cut. After all, if the government cuts taxes in this fashion, then all it is doing is postponing your tax bill by one year. Your lifetime resources have not increased at all. Hence you can save the entire tax cut, accumulate the interest income, and use this income to pay off your increased tax liability next year. The Household’s Lifetime Budget Constraint The household’s lifetime budget constraint tells us that households must equate the discounted present values of income and expenditures over their lifetimes. We use it here to help us understand how households behave when there are changes in the timing of their income. In general, the budget constraint must be expressed in terms of discounted present values: discounted present value of lifetime consumption = discounted present value of lifetime disposable income.