Proportional Income Tax and the Ricardian Equivalence in a Non-Expected Utility Maximizing Model

Abstract

A number of papers have examined the issue whether the Ricardian equivalence holds in a world where tax is proportional to future labor income. Barro [2] and Tobin [16] discuss deviations from Ricardian equivalence arising from the interaction between individual uncertainty and tax policy. Following the same line of reasoning as Chan [5], Barsky, Mankiw and Zeldes [3] as well as Kimball and Mankiw [10] make a persuasive argument that in an environment where future labor is uncertain, the marginal propensity to consume out of a deficit financed tax cut is significantly positive if future taxes are proportional to income. Their argument is that future taxes provide insurance to consumers by reducing the variance of after tax future income. Such an insurance which Barsky, Mankiw, and Zeldes [3] call reduces the precautionary saving of the consumer, thus boosting current consumption. The purpose of this paper is to reexamine this risk-sharing hypothesis and the issue of debt non-neutrality using a nonexpected utility maximizing framework. My analysis builds on recent advances in the representation of non-expected utility functionals which enable us to disentangle risk aversion from intertemporal substitution in consumption. I use a hybrid non-expected utility preferences a la Weil [17], which is isoelastic in intertemporal substitution but exponential in risk preference. The benefit of using this class of non-expected utility functionals is that it admits an analytical solution which is difficult to obtain in the existing permanent models [18]. Aside from its analytical tractability, this formulation of the preference also helps us to have a useful decomposition of the effect of a deficit financed tax cut into income and information effects. The risk-sharing effect of a deficit financed tax cut discussed by Barsky, Mankiw, and Zeldes [3] depends on the relative strengths of the aforementioned two effects. Our results show that the above risk-sharing effect is quantitatively small for a plausible range of risk aversion and intertemporal substitution. The marginal propensity to consume out of a deficit financed tax cut is considerably lower than the Keynesian consumption propensity proposed by Barsky, Mankiw, and Zeldes [3]. This means that the Ricardian equivalence may be a reasonable