Endogenous Government Spending & Ricardian Equivalence (Revised: 9-90)

Henning Bohn

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: Many analyses of debt policy assume exogenous government expenditures. Instead, we use an optimizing model in which the government selects values of taxes, spending, and debt to maximize welfare. If demand for publicly provided goods is elastic, a debt-financed tax cut increases consumption, because individuals rationally expect some reduced government spending in future. Even though future taxes rise, they do not offset the expansionary effect of the current tax cut on consumption. Depending on preferences, the marginal propensity to consume out of tax cuts can take any value between zero and the marginal propensity out of ordinary income.

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