Monetary and Fiscal Policy
Fall 2014
Jeffrey Parker, Reed College
Essay is due: 10am, Wednesday, December 10

Please write a short (1-2 page) essay responding to the following prompt. Send your essays to parker+341@reed.edu no later than class time on Wednesday, December 10.

Comment on the following statement relating to the Ricardian equivalence hypothesis about taxes and deficits:

"In general, we have to pay our taxes to the government in the year that they come due. Clearly, however, we would be better off if that were loosened up. For example, suppose that I can pay this year’s taxes and next year’s taxes in the corresponding years, or I can pay them both this year having a discount on next year’s taxes equivalent to the rate of interest, or I can pay them next year with an interest payment added on this year’s taxes. Clearly, I have added flexibility and would be better off.

"As a matter of fact, that is the present situation for those members of the population with good credit. I can pay next year’s taxes this year by the simple expedient of buying an adequate quantity of government bonds, and I can borrow money to pay this year’s taxes and then pay it back with interest next year. Clearly, these additional opportunities benefit me: I have greater freedom in making my tax payments.

"But let us suppose that the government decides to benefit me even further. Suppose they notice that the interest rate that they have to pay is lower than the interest rate that I have to pay and, in addition, their credit is good so they can always borrow money. They, thus, borrow money for all of their expenditures this year and permit individuals to purchase an adequate quantity of bonds to cover this year’s tax liability or wait until next year. The interest that the individual pays if he or she waits until next year will be lower although the interest received if he or she pays this year will be the same. Clearly this is a 'super-Pareto' move. Not only is nobody injured, a great many people would be benefited.

"From this line of reasoning, we reach the conclusion that the government should collect no taxes this year, they should borrow money and then should collect this year’s taxes plus interest next year. But note that the same line of reasoning would apply next year, and the next, and the next.... This is [a] fallacy, and I should warn the reader that although it is obviously a fallacy, it is very hard to put your finger on exactly what is wrong with it."