The government cuts lump-sum taxes by Rs 100 crore and finances the deficit by borrowing. The marginal propensity to consume is 0.8. In the first round, by how much does consumption rise if consumers are short-sighted, and by how much does private saving rise if Ricardian equivalence holds?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Consumption rises by Rs 80 crore; private saving rises by Rs 100 crore
Given:
Cut in lump-sum taxes, ΔT = Rs 100 crore (financed by borrowing)
MPC, c = 0.8
A tax cut raises disposable income by 100. In the first round, consumption rises by c times the cut.
Short-sighted consumers: rise in consumption = 0.8 × 100 = Rs 80 crore
Under Ricardian equivalence, consumers expect higher taxes later to repay the debt. They save the whole tax cut, so private saving rises by Rs 100 crore and national saving does not change.
Option (3) Consumption rises by Rs 80 crore; private saving rises by Rs 20 crore — Rs 20 crore is what short-sighted consumers save, not Ricardian ones.
Option (4) Consumption rises by Rs 400 crore; private saving does not change — Rs 400 crore is the final rise in income through the tax multiplier, not the first-round rise in consumption.
NCERT (2026-27): “Box 5.1: Fiscal Policy … Thus, with a ΔT reduction in taxes, consumption, and hence total spending, increases in the first instance by cΔT. …” “Perspectives on the Appropriate Amount of Government Debt: … Traditionally, it has been argued that when a government cuts taxes and runs a budget deficit, consumers respond to their after-tax income by spending more. … A counter argument is that consumers are forward-looking and will base their spending not only on their current income but also on their expected future income. They will understand that borrowing today means higher taxes in the future. … They would increase savings now, which will fully offset the increased government dissaving so that national savings do not change. This view is called Ricardian equivalence …” |