Ricardian Equivalence Reconsidered

Ricardian equivalence is an old and fascinating theory of economics. One writer summarizes it this way:

In [David] Ricardo‘s view, it does not matter whether [government] choose[s] debt financing or tax financing, because the outcome will be the same in either case. Flip a coin if you like, because in terms of the final results, raising taxes by $1,000 is equivalent to the government borrowing $1,000. This concept, appropriately called “Ricardian equivalence,” may be unfamiliar and counterintuitive. The key to understanding it is recognizing that debt financing is essentially just future taxation. If a government issues a bond today to avoid raising taxes, it will need to raise taxes tomorrow to pay off the bond when it comes due. According to Ricardo’s argument, it makes no difference to the public whether those increased taxes will come sooner (tax financing) or later (debt financing).

… Assume [government] can either impose $1,000 in taxes now to pay for [a government program], or … issue $1,000 of government debt, payable in one year for, let’s say, 10% interest. If  [government chooses] taxes, [taxypayers] have $1,000 less to spend today. That’s straightforward enough.

If, on the other hand, [government chooses] debt, then [taxpayers], being a savvy bunch who’ve seen this debt financing in action before, realize that in one year, it will be time…to pay back the people who buy the government debt. [Taxpayers] will owe those people $1,000 plus $100 in interest, for a total of $1,100. [Taxpayers] know that money must come from somewhere, so they expect that in one year, their taxes will go up by $1,100. In order to be ready for that one year from now, they put $1,000 into saving today, earning 10% interest, so that they will have the $1,100 they will need. This is $1,000 dollars today that they cannot spend today or save for reasons other than paying future taxes, so the outcome is that [taxpayers] have $1,000 less to spend today, just like they do if you raise taxes today.

But there are some standard objections to Ricardian equivalence, which the writer summarizes:

1. [T]here must be complete access to perfect capital markets so that all of the required saving and borrowing can be accomplished without friction, and people must be able to borrow at the same interest rate at which the government borrows, or the equivalence breaks down.

2. Additionally, people must care about what happens in the future, when the government debt will be repaid. If the future taxes only will apply so far in the future that the person will be dead, why save now? But if people refuse to offer to save more now, then offered savings in the economy are reduced, so interest rates would have to be higher if the government tried to borrow than if it taxed people directly today. Thus, it is assumed that either all people live long enough to see the debt be repaid, or they have children (that the parents care about and to whom they leave sufficient bequests) who will live to see that day.

3. Even if these requirements are satisfied, people must also recognize the equivalence between tax finance and debt finance in order to act accordingly. This may be the most tenuous assumption required—regardless of how fine the … educational system is, it is unlikely that public debt theory and present value calculations are included in basic, compulsory schooling.

The first two objections do not negate Ricardian equivalence, they merely make it a tendency. That is, instead of perfect equivalence, there may be approximate equivalence. In the example of a $1,000 government expenditure, taxpayers (as a group)  might save less than $1,000 if the interest rate they pay is more than the interest rate government pays, or they might save less than $1,000 if not all of them have descendants or care about them as much as they care about themselves. But, some amount will be saved, and it may be as much as $1,000.

The third objection overlooks the sophistication of the institutions and persons who have the greatest interest in government’s actions: large corporations and persons in high-income brackets. They will react to government borrowing as if it would affect them and their heirs (corporate and individual). This objection, like the first two, simply makes Ricardian equivalence a tendency.

That is as far as I will defend Ricardian equivalence, for it is unnecessarily complex and counterintuitive. It may be true that taxation and borrowing have the same (first-order) effect on the private sector. But that effect arises simply because it is government spending — not the method of financing it — which extracts resources from the private sector.

If government happens to raise taxes by an amount equal to its additional spending, then the burden of that spending falls, to a first approximation, on the persons who happen to pay the additional taxes imposed by government. Their disposable income is reduced by as much as it would be if government had inflated the prices of  the goods and services they buy. Similarly, if additional government spending happens to coincide with additional government borrowing; the real value of private saving is reduced by the inflationary effect of the additional government spending. In fact, both phenomena occur at the same time, regardless of the mix of additional taxation and/or borrowing; that is, government spending inflates the prices of goods and services and thereby erodes the value private wealth.

Related posts:
The Commandeered Economy
The Price of Government
The Mega-Depression
Does the CPI Understate Inflation?