The question of how public debt affects economies has had a long tradition. In the 19th century David Ricardo set up what nowadays is called the Ricardian equivalence theorem. According to that theorem budget deficits today require higher taxes in the future when a government cuts taxes without changing present or future public spending. Given that households are forward looking they will realize that they have to pay higher taxes in the future so that their total tax burden remains unchanged. As a consequence, households will reduce their consumption and increase savings in order to meet the future tax burden. The Ricardian equivalence theorem is based on the inter-temporal budget constraint of the government and on the permanent income hypothesis. The first principle states that public debt must be sustainable in the sense that outstanding debt today must be equal to the present value of future government surpluses. [download]
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