Liquidity Constraints

The first possibility is that households may face limits on their ability to borrow-that is, they may face liquidity constraints. When the government issues a bond to a household to be repaid by higher taxes on that household at some later date, it is in effect borrowing on the households behalf. If, as we have been assuming, the household already had the option of borrowing at the same interest rate as the government, the policy has no effect on its opportunities and thus no effect on its behavior. But if it cannot borrow and lend freely at the governments interest rate, the bond issue may matter. In particular, suppose the household faces a higher interest rate for borrowing than the government does. If the household would borrow at the government interest rate and increase its current consumption if that were possible, it will respond to the governments borrowing on its behalf by increasing its consumption (see, for example, Tobin, 1980, and Hubbard and Judd, 1986).

Again, there are two difficulties with this potential source of failure of Ricardian equivalence. First, empirically, although surely households do not face the same terms for borrowing as the government does, the evidence IS not clear concerning how much these constraints matter for aggregate consumption.

Second, liquidity constraints are not exogenously given. Instead-as a huge literature on credit markets emphasizes-they reflect calculations by potential lenders of borrowers likelihood of repaying their loans. When the government issues bonds today to be repaid by future taxes, households future habilities are increased. If lenders do not change the amounts and terms on which they are willing to lend, the chances that their loans will

This of course is not exactly what an optimizing individual would do; see, for example. Problem 2.4.

Some examples of studies of liquidity constraints are Hall and Mishkin (1982); Zeldes (1989); Runkle (1991); Flavin (1992); and Shea (1995).

and they find that similar results hold for other wartime debt issues. Second, the fact that lifetimes are long means that an increase in wealth has only a modest impact on current consumption. For example, if individuals spread out the spending of an unexpected wealth increase equally over the remainder of their lives, an individual with 30 years left to live increases consumption spending in response to a one-dollar increase in wealth only by about three cents.

Thus it appears that if Ricardian equivalence fails in a quantitatively important way, it must be for some reason other than an absence of in-tergenerational links. Three possibilities have received the most attention: liquidity constraints, non-lump-sum taxes, and rule-of-thumb consumption behavior.

Non-Lump-Sum Taxes

The second potentially important reason for failure of Ricardian equivalence is that taxes are not lump-sum; instead, they are a function of income. Consider our standard example of a bond issue today to be paid off by a tax increase in the future. Even when taxes are a function of income, this policy has no effect on the expected present value of the households lifetime after-tax income. But, since the tax liability is large if future Income is high and low if future income is low, the policy reduces the households uncertainty about its lifetime resources. Under plausible conditions, the household responds to this change by increasing its current consumption, and the response maybe quantitatively important (Barsky, Mankiw, and Zeldes, 1986; see also Problem 2.12 and Section 7.6).

In addition, the fact that taxes are not lump-sum may interact with hquidity constraints. When a borrower fails to repay a loan, it is usually because his or her income has turned out to be low. But, if taxes are a function of income, this is precisely the case when the borrowers share of the tax liability associated with a bond issue is small. Thus a bond issue is likely to have a much smaller effect on the borrowers probability ot repaying a loan when taxes are a function of income than when they are lump-sum. As a result, bond issues may have relatively little impact on the amounts that households can borrow. Thus non-lump-sum taxes and liquidity constraints together may cause large departures from Ricardian equivalence (Bernheim, 1987b).24

•The fact that taxes are not lump-sum may also affect Ricardian equivalence through its impact on govemment policy. A bond issue accompanied by a tax cut increases the revenue that the government must raise in the future, and therefore implies that future tax rates must be higher. Since non-lump-sum taxes involve distortions and since those distortions are greater at higher tax rates, this means that the marginal cost of obtaining revenue has increased. As a result, the optimal response by the government to a bond-financed tax cut generally involves a mix of higher taxes and lower government spending. The lower government spending increases households lifetime resources, and therefore increases current consumption. (Bohn, 1992.)

be repaid therefore faU. Rational lenders therefore respond to the bond issue by reducing the amounts they lend. This mitigates the impact of the bond issue on current consumption. In fact, there are natural cases in which the amount that households can borrow falls one-for-one with government bond issues, so that Ricardian equivalence holds even in the presence of liquidity constraints (Hayashi, 1985; Yotsuzuka, 1987). Thus, determining the implications of liquidity constraints for Ricardian equivalence requires not only investigating the extent of those constraints, but also understanding their sources and how they are affected by bond issues.

Conclusion

What, in the end, should one make of the Ricardian equivalence debate? Economists take a wide range of positions on the issue. At one extreme is the \iew that Ricardian equivalence is a theoretical abstraction so unrelated to reality that it is of httle interest. At the other extreme is the position that despite the many reasons for it not to hold exactly, it is nonetheless a good first approximation. A reasonable middle ground is that Ricardian equivalence is a useful theoretical baseline bul not a useful empirical one. It is valuable as a theoretical baseline because it is so simple and logical. Specifically, any candidate explanation of why governments choices between bonds and taxes affect consumption must spell out precisely how the assumptions underlying Ricardian equivalence fail and why those failures matter. Other models are more difficult to use as building blocks for more detailed anal-> ses. For example, models of liquidity constraints are generally so complex

-""See, for example, Campbell and Mankiw (1989a); Carroll and Summers (1991); and ihefnn and Thaler (1988). Of course, these findings could reflect features of individuals optimization that are not yet fully understood.

Rule-of-Thumb Consumption Behavior

The thhd major reason that Ricardian equivalence may fail significantly is that individuals may not optimize fully over long horizons. The assumption of full rationality is a powerful modeling device, and it provides a good first approximation to how individuals respond to many changes. At the same time, it does not provide a perfect description of how people behave. There are well-documented cases in which individuals appear to depart consistently and systematically from the predictions of standard models of utility maximization, and in which those departures are quantitatively important (see, for example, Tversky and Kahneman, 1974, and Loewenstein and Thaler, 1989). This may be the case with choices between consumption and saving. The calculations involved are complex, the time periods are long, and there is a great deal of uncertainty that is difficult to quantify. So instead of attempting to be completely optimizing, individuals may follow "rules of thumb" in choosing their consumption that put a great deal of weight on current after-tax income. Both the macroeconomic and the microeconomic evidence offer some support for the view that individuals do in fact follow such rules of thumb. If people do follow such rules, they increase their current consumption in response to a bond-financed tax cut even if their lifetime budget constraints are not affected. Thus rule-of-thumb consumption behavior provides an additional possible reason that Ricardian equivalence may fail.