Explain Ricardian equivalence, and discuss what implication it might have on the efficacy of expansionary fiscal policy.
Ricardian equivalence states that for a given level of government spending a change in taxes – financed by a deficit – will have no effect on the real economy. It is posited that individuals are forward thinking and rational and realise that a tax break today will have to be paid in the future. Therefore individuals won’t go out and spend this tax cut but will instead save it so that they can smooth consumption.
They will save ΔT.r (tax cut multiplied by real interest rate), acknowledging that the government will have to pay interest on its debt so future taxation will need to incorporate this. Realistically the rate the government has to pay on its bonds will probably be higher than the savings rate of interest – as financial intermediaries get a cut – and thus consumers may need to save even more, potentially reducing consumption.
So far we have taken government spending as constant but we can also think of this by comparing two government spending strategies:
(a) increase in G financed by deficit
(b) increase in G financed by taxation (balanced budgets)
According to Keynesian’s (a) will have a greater multiplier than (b) [fiscal multiplier=1] because consumers won’t reduce consumption to pay off future deficits. yet those who believe Ricardo (note: Ricardo didn’t believe in the theory which would take his own name!) would believe that these two policies are equivalent, and would have the same multiplier. This is because consumers will realise that the deficit will have to be paid off in the future and so will increase savings now. Thus they act as though they receive an increase in taxation now and so the fiscal multiplier in both scenarios is 1.
In reality we can criticise Ricardian Equivalenceon a number of grounds which would lead us to question whether (a) is really equivalent to (b). Firstly, asset markets aren’t perfect and some individuals are liquidity constrained. RE would imply that if taxes rise now, for a given G, then future taxes will fall and hence individuals should borrow from the future to pay these taxes. Yet not every individual will have the option to do this due to credit constraints.
Secondly, we assume that individuals are forward thinking and have the cognitive capacity to understand the logic behind this. Whilst we present no evidence to support this claim, we think it highly likely in reality that a significant number of people are myopic and/or don’t understand the implications of this.
Thirdly, we are assuming either that the change in taxes happens in ones lifetime (i.e. T1 and T2 both fall within my lifespan) or that individuals are benevolent towards their children. If this weren’t the case then a tax break now – financed in the future, which is after I die – will mean I spend more now, as it is not me who has to pay this back. Whilst evidence on inheritance suggests a high degree of benevolence, this is not complete. Additionally, some individuals may not have children/family and therefore are ambivalent about future generations having to pay off their spending spree.
Finally, we note experimental evidence by Meissner and Rotham-Afschar that 62% of participants in an experiment did not have behaviour conforming to RE. In conclusion, RE says that the efficacy of expansionary fiscal policy is the same regardless of the financing method (i.e. taxation or deficit). Yet there are many reasons why this proposition wouldn’t hold and experimental data also refutes it. Thus RE is only likely to be significant for a minority of the population and as a result the Keynesian proposition that deficit financed expansion will have a higher multiplier than a balanced budget, is likely to be true.
NB: RE only holds for non-distortionary taxation.