Sunday, 17 February 2013

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.

8 comments:

  1. The problem is imho mainly the following (as far as consumption goes). The welfarestate in the widest sense of the word has come under pressure. And that has become more and more clear to the general public, because of this crisis.
    It is furthermore combined with the facts that because of low interest yields future pensions are partly in doubt and because of the RE bubble people are afraid to go underwater (at least some people). And future income growth is seen more and more as being zero in real terms at best.

    As I see it it is more the combination of these four things than the fact that a present tax reduction might lead to future tax increases or whether it is temporary or permanent that will determine if people save or not. It will be seen by a lot of people as a sort of windfall and because of the uncertainty is used in a safe way(repay extra on mortgage, increase pensions, simple saving etc).

    Where this theory goes wrong imho is that it mainly looks at one part while other parts are considered of less importance.
    Imho one should look at general uncertainty and the way the public looks at that. Which makes it a difficult thing to handle. Say use general consumer confidence as a measure, that will change almost by the month. And with it the part that is saved most likely.
    Very difficult tool to use for longer term planning. Taxes are almost per definition at least medium term, while the data it should be based upon changes say by the month (much shorter term anyway).

    Another issue is the political problems it gives rise to. A tax cut and a lot as temporary stimulus disguished transfers (well from borrowed money) give rise to expectations.
    Not legal ones but clearly social and/or political ones. Simply makes it very difficult, especially in case of transfers as people are actually depending on it, to stop.

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  2. Another problem that I have always had with RE is that it assumes too much intelligence and planning on part of the tax payer. It is the same tax payer who burdened himself/herself with multiple mortgages and assumed that house prices will rise forever. Did anyone seriously think that these people would be so rational so as to make a household spending plan based on govt budgetary constraint?

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    Replies
    1. Funnily enough, that is exactly the same problem that Ricardo had with Ricardian Equivalence. He didn't think that people were that rational either.

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  3. "Perhaps useful for the macro-economist as scientist, but never the final answer for the macro-economist as engineer."

    It is, no doubt, fun to teach Ricardian equivalence. It is also fun to teach Larmarckism. But, please don't leave out the crucial step for the macro-economist as a scientist; empirical testing. Real world testing shows that both R.E. and Lamarckism are inadequate tools for understanding the world. We can do thought experiments all day, but whatever conclusions we draw from them, they are always trumped by what we see in the real world. And we have a lot of natural "experiments" right at our fingertips. S. W.L.very correctly couches Ricardian equivalents in terms of tax cuts, but as you know, government spending, borrowing and taxation all play together in R.E. so when looking for natural experiments we have to look at the entire complex... let's call it stimulus versus austerity. (I can't believe I am actually about to replay this whole chain of reasoning again, but there still seem to be a lot of people who haven't considered the facts.)

    The classic case is provided by the two decades following 1930 in the U.S. 1930 stimulus on - GDP up and unemployment drastically down. 1937 austerity on - GDP and employment go the other way. 1939 stimulus on - GDP and employment improve again. 1942 stimulus on full throttle - GDP and employment accelerate. Where is the crowding out in that time series?

    There are lots more examples out there... for example compare U.S. experience since 2008 with that of Spain, Ireland, Italy, etc. (tepid stimulus versus austerity). Or just look at the self inflicted wounds of the British lately.

    (Sigh)


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  4. Joseph Stiglitz said “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.” That’s according to Lars Syll here:

    http://larspsyll.wordpress.com/2012/12/09/the-doctrine-behind-the-fiscal-cliff-so-wrong-so-wrong-it-could-only-be-invented-in-chicago/

    Also I agree with Jerry Fields above, namely that two important words are missing from Prof. Simon’s post: “empirical” and “evidence”. The evidence, far as I can see, is that households spend a significant proportion of tax cuts fairly quickly (roughly a third). E.g. see:

    1. http://www.nber.org/digest/mar09/w14753.html

    2.http://www.kellogg.northwestern.edu/faculty/parker/htm/research/johnsonparkersouleles2005.pdf

    3. http://finance.wharton.upenn.edu/~rlwctr/papers/0801.pdf

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  5. "This spring, the US government handed out $100 billion in tax rebates. Twentieth century economic thinking – permanent income hypothesis, Ricardian equivalence, and the like – suggests that most would have been saved, as Martin Feldstein recently argued. Not so. Recent research on microdata shows that the typical family increased spending by 3.5% when the rebate arrived, boosting overall non-durable consumption by 2.4% in 2008Q2. The number should be 4.1% in 2008Q3."

    http://www.voxeu.org/article/did-2008-us-tax-rebates-work

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  7. Wren-Lewis is absolutly right, political uncertainty is hard to find in reality and hard to measure too. But even in a world with perfect political certainty and zero intrest rates, Ricardian Equivalence appears to fail resoundingly. Why, because consumers just make mistakes when optimizing or use simple rules instead. I wonder why economists never discuss these aspects. Actually, I searched the entire web and just found one paper that shows that Ricardian Equivalence does not hold even though all the required, rather rigid assumptions hold. Do Tax Cuts Increase Consumption? An Experimental Test of Ricardian Equivalence

    Still, I really wonder how a measure of political uncertainty would look like. Imho it seems impossible to measure such an inconceivable concept. I guess Scottish independence is the worst thing that could happen to us.

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