Recently, some economists have argued that government spending will not stimulate aggregate by invoking a concept called Ricardian Equivalence. Here we explain the idea of Ricardian Equivalence, discuss why it is controversial among economists, and present our view about how the ideas and criticisms that arise from Ricardian Equivalence apply to current debates about fiscal policy.
Modern governments typically finance their spending in two ways: taxing or borrowing. If the government taxes, then current taxpayers fund government activities. If the government funds its activities by borrowing, and if the government does not default on the bonds it issues when it borrows (a condition economists call “the government budget constraint”) the interest on government debt must be paid by future taxpayers. So while deficits avoid the need for the government to impose taxes when it spends, the borrowing really just shifts taxation to future taxpayers. The key question raised by Ricardian Equivalence for our purposes is whether this shift in the timing of taxation affects the ability of government spending to stimulate (or constrain) aggregate demand.
Simple analysis usually assumes that if government spending rises today and taxes are held constant, total demand will increase. The government buys more, and there is no reason for higher government demand to reduce private demand directly because taxes have not changed. According to Ricardian Equivalence, however, rational, forward-looking taxpayers will anticipate paying for government spending at some time in the future. If the government defers taxation, taxpayers will save enough of their current income to pay the higher taxes in the future necessary to meet the bond obligations. This higher saving causes private demand to decline when government demand rises, which reduces, if not totally eliminates, the demand stimulus created by higher government spending.
This outcome relies on some strong assumptions, and there is substantial debate among economists about whether or not taxpayers actually behave in the ways that the Ricardian Equivalence model requires. The theory requires taxpayers to understand how changes in government taxation and spending will affect them throughout their lives, and to change their spending habits to reflect this knowledge. The basic theory assumes that current taxpayers value the consumption of future taxpayers (perhaps their children) the same as they value their own consumption. Most problematic from our point of view, the Ricardian Equivalence idea ignores two important features of the Keynesian theory presented in these pages. First, higher spending creates new incomes when resources are unemployed. Second, to the extent that the government issues bonds now that will be paid off in the future, there is more than just a liability for future taxpayers; there is also a new asset created for the holders of government bonds. We explore the relevance of these ideas in detail in what follows.
Let us begin by taking the strong assumptions of the Ricardian Equivalence theory at face value. Assume that everyone has full information about the future and that taxpayers take current and future taxes into account when they decide how much to spend. For simplicity, we will divide up time into just two periods: “today” and “the future.” The bonds issued as the result of a government deficit incurred today will be paid off in the future, with interest. We will also assume that all taxpayers are the same in the sense that they spend the same share of the after-tax income that they earn both today and in the future. That is, taxpayers will smooth any after-tax income fluctuations across the two periods of time. We will start with a closed economy in which the government borrows from domestic citizens only. These are strong assumptions, but they establish a useful baseline. We will relax some of these assumptions later on this page.
Suppose government spending rises today and that taxes are constant. The government issues bonds as the result of the consequent deficit. The rise in government spending is a direct increase in demand. But the forward-looking taxpayers in our simple model recognize that the government will raise taxes in the future to pay off the bonds that they issue today. If we just look at the anticipation of these future taxes in isolation, it seems that taxpayers would reduce what they spend today (because they smooth the effect of future taxes by reducing both current and future consumption). But we should not look just at the taxes in isolation; we must also consider what the higher taxes will be used for in the future. When higher taxes retire the government bonds in the future, the payments do not disappear down some black hole. Indeed, we can think of future taxes to pay off the government debt as a transfer from taxpayers to government bond holders. Because of our assumptions that everyone is the same and that all the bond holders are domestic citizens, there should be no net effect of this transfer. It is as if the representative taxpayer pays principal and interest on the government bonds to himself as a representative bondholder, and the whole thing is a wash in the future.
In this case, higher government spending today creates demand. This demand mobilizes unemployed resources and increases output, employment, and income. The higher income is a net gain for our citizen taxpayer / bondholders, and they may raise demand even further by spending some share of that net gain in income (appropriately smoothed across today and the future), so there will likely be a multiplier greater than one that magnifies the effect of government spending on today’s output and income. This result is Keynesian, but it allows for forward-looking taxpayers and a government that pays its debts.
Readers might be curious about where the money comes from to buy today’s issue of new government bonds. The multiplier process that creates new income also creates new saving. In fact, a result of basic mathematical models of the Keynesian multiplier process is that income will continue to rise until there is just enough new saving created to purchase the new issue of government bonds. So incomes rise today, saving rises today by enough to finance the government deficit, and future taxes are offset by future debt payments so that there is no spillover from future financial transfers to today’s spending.
We conclude that even with the rather extreme assumptions of the baseline Ricardian Equivalence model, the basic Keynesian effects of direct demand stimulus are largely unchanged.
What about the effects of a tax cut? The recipients of the tax cut would likely choose to spend it less than dollar for dollar, so a tax cut will create less demand stimulus than direct spending, which by definition raises demand dollar for dollar. Thus the standard result, ignoring the question of Ricardian equivalence, is that the tax cut would not raise output and employment to the same extent as higher spending.
With the Ricardian Equivalence assumptions would there be any increase in spending at all as the result of the tax cut? The answer is somewhat subtle. Suppose that when the tax cut takes place, our representative household recognizes that it will soon be buying government bonds so it just leaves the entire tax cut in the bank and does not raise spending at all. In this case, the tax cut would not raise demand at all and it would create no Keynesian stimulus.
In contrast, if some households expect other households to spend part of the tax cut, then they expect that demand and income will rise, and it makes sense for such households to spend more even if they fully perceive the coming sale of bonds and future taxes. The additional money injected into the economy as the result of the tax cut need not idle in bank accounts. It can circulate, generating new incomes. When the government issues new bonds the new money will be somewhere in the system, available to purchase the bonds. In this case, it is rational for forward-looking taxpayers to spend part of their tax cut. Yes, they anticipate higher taxes in the future, but they also anticipate receipt of payments on the bonds they bought and they recognize how others’ higher spending will raise their income. Again, the assumptions of the Ricardian Equivalence model need not change the basic Keynesian results from a tax cut as long as idle resources allow higher spending to encourage more production and create more income.
This discussion shows that the assumptions of the basic Ricardian Equivalence model do not change the basic Keynesian story: higher demand creates income, saving, output, and employment if the economy has under-utilized resources. Let’s now consider how things change if we relax some of the strict assumptions of the basic Ricardian Equivalence model.
Myopia (or is it Uncertainty?) The key behavioral assumption of Ricardian Equivalence is that households perceive that government spending today that is not funded by today’s taxes implies higher taxes in the future. This foresight causes households to reduce spending today, other things equal, possibly mitigating the demand stimulus that caused the government deficit in the first place. Do households actually look into the future of government finance in this way?
Critics of Ricardian Equivalence often assert that typical households are much more myopic in their consumption behavior than Ricardian Equivalence requires. It seems likely that people do not consider the government deficit when they decide to go to the mall or shop for a new car. This suggests that most taxpayers are short-sighted about the way that current government finance affects future taxes. Many taxpayers may be myopic in this sense. But we believe that something more nuanced than simple short-sightedness is going on. If people knew for certain that today’s government deficit would lead to an increase in future taxes on a well-defined group of taxpayers at a well-defined time, we may well observe some of the behavior predicted by the Ricardian Equivalence model. But the actual fiscal implications for the future of a deficit today for taxes in the future are murky to say the least. If taxes must be raised, whose taxes will be raised? When will the tax increase take place? Perhaps government spending will be cut instead. Perhaps the economy will grow fast enough that the tax base will expand and tax rates will not have to increase. In such a foggy situation, one might expect households to base their behavior on what they actually know, which is their current income after taxes, without much reference to a highly uncertain future of their personal tax circumstances.
If myopia or uncertainty reduce the extent to which households cut consumption today because of a possible tax increase in the future, the demand stimulus created by fiscal expansion (or the demand contraction resulting from fiscal austerity) will be larger than it would be with the restrictive assumptions discussed above. In this case, the multiplier on government spending or the demand effects of a tax cut would be larger.
Distribution of Taxes and Bond Holdings. The simple model assumes all households are the same. They pay the same taxes, they spend the same share of their income, and they buy the same share of government bonds. What is the effect of recognizing realistic differences across households?
One concern is that bonds are bought mostly by the rich while taxes are paid by almost everyone. In this case, the future payments to retire government bonds discussed above become a transfer from the broad base of taxpayers to the relatively affluent. If today’s taxpayers recognize this transfer, and taxpayers as a group tend to spend a larger share of their income than relatively wealthy bond holders, then distribution effects could lead to a net reduction in today’s spending, reducing the potency of fiscal policies designed to stimulate demand. In other words, any deficit-financed attempt at fiscal stimulus imposes a future transfer payment from relatively high-spending taxpayers to relatively low-spending bondholders, and if this transfer is anticipated, it reduces today’s demand.
We should recognize, however, that if income taxes are raised to pay off government debt, then the tax burden will fall to a large extent on the relatively affluent who pay a disproportionate share of income taxes. In this case, distributional effects of the future transfer payment from taxpayers to bondholders could be minimal; because the transfer is mostly a reallocation of spending power among the affluent. But if debt is retired by rising payroll taxes that affect a broad swath of taxpayers or by reduced spending on social safety net programs, the distributional effects on demand may be significant..
Borrowing Limits. Suppose that some household would like to spend more than they are able to today because they cannot borrow as much as they would like to. For example, a young person with excellent income prospects may want to borrow against her future income, but may be prevented from doing so because she cannot credibly demonstrate her future earning potential to lenders. A government deficit can be viewed as borrowing on behalf of taxpayers, at a very low interest rate. If borrowing-constrained households have lower taxes today as a result of government borrowing, they would likely spend more even though they understand that their taxes will be higher in the future. This effect bolsters the demand impact of fiscal policy.
Foreign Bond Purchases. The simple model laid out at the beginning of this page assumed that all government bonds are purchased by domestic citizens. But many countries, the U.S. in particular, sell bonds on an international market. If foreigners purchase some portion of government bonds issued to finance a deficit, the principal and interest payments on those bonds are still transfers from taxpayers to bondholders, but some of the transfer goes out of the country. This situation reduces the funds available for consumption by domestic citizens and could reduce the impact of fiscal policy on economic activity.
Ricardian equivalence is not a direct criticism of Keynesian macroeconomics. Ricardian equivalence explores the implications of expected future taxes on today’s decisions to spend or save. Even with Ricardian Equivalence, if government policies can raise demand output will be higher, as long as the economy has under-utilized resources. The key question is: Can higher government spending or lower taxes stimulate demand if taxpayers take into account the implications of today’s spending polices for taxes in the future?
In the final analysis, it is very likely that fiscal policies will affect demand, even if taxpayers anticipate future tax implications. Changes in today’s government spending almost certainly matter for today’s demand. When demand is higher, income will be higher if that demand can mobilize unemployed resources. If income is higher than it would have been without more government spending, it makes sense for people to spend more, even if they fully anticipate the implications of any resulting deficits for future taxes and future bond payments financed by those taxes. Tax cuts that increase disposable income can raise demand either because people expect such changes to matter for the spending of others or because households do not (or perhaps cannot) comprehend the implications of today’s tax cuts for future tax liabilities.
It is appropriate to consider the way that anticipation of future tax liabilities might affect today’s spending. These considerations may affect the size of the demand response induced by any particular policy. But, in our MWM view, it is highly unlikely that the considerations raised by Ricardian Equivalence will change the basic implications of Keynesian fiscal policy at times of substantial unemployment.
- Ricardian Equivalence requires consideration of the way current changes in government spending or taxes affect future taxes. If people anticipate an increase in future taxes due to stimulative fiscal policy today, the effect of that policy on demand today could be reduced.
- Future taxes, however, do not simply disappear. They are paid to bondholders. If these bondholders are domestic citizens, future taxes to pay off bonds issued to fund today’s deficits do not reduce the total spending power of the private sector.
- Higher government spending affects demand even if households believe that future taxes will rise to pay off bonds. Tax cuts can affect demand for households that correctly forecast future taxes if these households believe that others will spend part of their tax cut. To the extent that demand rises with fiscal stimulus, output and income rise as well if the economy’s resources are under utilized. This outcome can occur even with the basic assumptions of the Ricardian Equivalence model.
- The assumptions of the basic Ricardian Equivalence theory are restrictive and likely unrealistic in many situations. Relaxing some of these assumptions, such as the ability to forecast future tax liabilities, implies a greater effect of fiscal policy on output. Relaxing other assumptions, such as the restriction that all bonds are bought by domestic citizens, reduces the effect of fiscal policy.