Ricardian equivalence and political uncertainty

I like teaching Ricardian Equivalence. Ricardian Equivalence is the idea that consumers will respond to a tax cut by saving the full amount, and not spending any of it. (Here we are concerned only with the impact of the tax cut on income, and we ignore any incentive effects.) It is counterintuitive, so it makes students think.  It illustrates the importance of intertemporal budget constraints: that a tax cut financed by borrowing, and holding future spending fixed, must imply higher future taxes to either pay back the borrowing or pay the interest on that borrowing.[1] So a consumer that thinks ahead (and that faces the same interest rate as the government) will have to decide not just how they respond to the tax cut, but how they will pay for future tax increases. Finally it gets across the idea of consumption smoothing in the absence of credit constraints: if a consumer wanted to spend more today and spend less when taxes go up, they will have already done so by borrowing themselves.

Now macroeconomic textbooks will tell you many reasons why Ricardian Equivalence does not hold. Some of these are also interesting for students to explore. However one basic point often does not get the emphasis it deserves, and that is the assumption that the future path of government spending on goods and services remains unchanged. Only by making this assumption can we say that a tax cut today will mean tax increases tomorrow.

In reality consumers who receive tax cuts have very little information about what the implications will be for future taxes or spending. (Things are probably getting better, but as the IMF paper discussed in this post from Carlo Cottarelli makes clear, there is a long way to go.) Even if the current government did say that the tax cut was temporary, and would require higher future taxes to pay back the borrowing, and the consumer believed that government, it is quite possible that a different government might be in power when the time for higher taxes came. If that different government chose to cut its spending rather than raise taxes, then the consumer would be better off in terms of their income as a result of the tax cut.[2] A tax cut today paid for by lower government spending tomorrow will lead to higher consumption today.

The practical importance of this point for temporary tax cuts is probably not great. One of the points I try to get across when teaching is to distinguish between the implications of internalising the government’s budget constraint (which is ‘economics’ for thinking about how the government will eventually pay for a tax cut) and the implications of consumption smoothing. In the standard consumption model, a temporary tax cut, even if it is eventually paid for cutting government spending, will still lead to a quite small immediate increase in consumption, because the consumer will want to spread the benefits over time.[3] If you want to argue that temporary tax cuts will lead to significant changes to consumption, you need to focus on alternative models of consumer behaviour.[4]

The lack of information provided by governments about future fiscal plans, and their inability to commit to such plans in a democracy, is also relevant in trying to distinguish between temporary and permanent tax cuts. Governments often like to pretend tax cuts are permanent even when they cannot be. Those in the US do not need reminding that occasionally governments pretend tax cuts are temporary when they want them to be permanent. Tax cuts could be permanent if they are paid for at some later date by a permanent reduction in government spending. As a result, a tax cut could be a signal that government spending will at some stage be permanently reduced.[5] If that signal is correct, it makes sense to consume all of the tax cut.


So Ricardian Equivalence is a great thought experiment, but never a realistic possibility in a world where governments cannot commit on fiscal plans. Perhaps useful for the macroeconomist as scientist, but never the final answer for the macroeconomist as engineer. The macroeconomist as engineer needs to think about the possibility that a tax cut today implies a change in future plans for government spending, and that consumers might act on that possibility.

---

[1] We also assume no default or printing money.
[2] Whether the consumer’s overall welfare is higher is another matter, but that is beside the point here.
[3] Under certain conditions, a Barro type consumer who cares about their children will just consume the interest their receive on the amount of the tax cut.
[4] In particular, both the existence of credit constraints and precautionary saving really matter here.
[5] A further possibility is that the tax cut represents favourable news about future growth, which also implies that the consumer is permanently better off.