Given a reduction in income tax withheld, but no change in income tax owed, households that act according to Ricardian equivalence would ______ the extra take-home pay, while those facing binding borrowing constraints would ______ the extra-take home pay.
A) spend; spend
B) spend; save
C) save; save
D) save; spend

Question

Quizplus · Accepted Answer

Ricardian equivalence suggests that households, anticipating they will have to pay more taxes in the future to offset the government's reduced tax revenue, will save the extra take-home pay rather than spend it. On the other hand, households facing binding borrowing constraints are more likely to spend the extra take-home pay because they have immediate liquidity needs or cannot borrow easily to finance current consumption.

Given a Reduction in Income Tax Withheld, but No Change