Robust effects of a debt-financed tax cut in an economy with incomplete markets

Abstract

We propose a two-period pure-exchange economy with spot and nominal security markets and a government that enacts a debt-financed tax cut in the first period and decrees a tax increase in the second one. We offer a counter-example to show that such fiscal policy affects the individual’s decisions through the Walrasian demand. The change in consumption allocation invalidates the Ricardian equivalence theorem in this economy even when the risk-free payoff belongs to the asset span. Moreover, this effect on real allocations is robust to small perturbations in the cost of public debt. The result is driven not by the incompleteness of the security markets, but by the no-matching between the risk-free return and the cost of the public debt.