Opinion Editorial | |
| Wednesday, March 10, 1999 | |
Are Budget Surpluses Equivalent To Tax Cuts? |
One of the reasons why Republicans have had difficulty getting traction on tax and budget issues lately is because they have failed to update either their rhetoric or their economic model to account for an era of budget surpluses. If they are to make progress, they must do both.
At the rhetorical level, Republicans are prisoners of an unfortunate decision made long ago to equate deficits with big government. The truth is the vast amounts of economic research have failed to show any consistent relationship between budget deficits and inflation, interest rates or economic growth. What really matters is the overall size of government. Big government is generally bad for growth. Inflation and interest rates, on the other hand, are almost entirely a function of Federal Reserve policy, which operates independently of fiscal policy.
Explaining why big government is bad, however, proved to be too difficult for Republicans. It was much easier to just attack deficits, because people instinctively view them as bad. For many years, it mattered little that Republicans were attacking the wrong target because deficits and big government tended to grow together. And indeed, insofar as people think that programs paid for with deficits cost nothing in terms of higher taxes, they may view such programs as costless. Hence, deficit spending may encourage growth in government.
A major challenge to this view was put forward in the 1970s by economist Robert Barro of Harvard University. He postulated that people really are not fooled into thinking that programs paid for with deficits are costless. Instead, they view deficits as deferred taxes, reacting exactly as they would if the new programs were financed with higher taxes instead of government bonds. Barro called this theory the Ricardian equivalence theorem, after the great economist David Ricardo who first suggested the idea.
Ricardian equivalence is still controversial among economists, but it can be tested. For example, if you believe that taxes will be higher in the future than today, then you will tend to reduce your consumption and increase your saving now in order to pay that bill when it comes due. Thus we observe that higher deficits are often associated with higher private saving. It also explains why deficits do not appear to be stimulative, as Keynesian economic theory supposes.
Interestingly, almost all analysis of Ricardian equivalence has been under conditions of budget deficits; almost none has dealt with surpluses. But if the theorem holds at all, we should expect the opposite effects under surpluses. This means that people implicitly view surpluses as de facto tax cuts. This must be the case if they view deficits as equivalent to taxes. And it also means that people will tend to reduce their saving and increase their consumption -- the opposite of what deficits do under Ricardian equivalence.
In fact, we now see people acting precisely in accord with the predictions of Ricardian equivalence. The personal savings rate has collapsed to near zero. Meanwhile, consumers are spending like there is no tomorrow and economic growth is exceeding all expectations. Furthermore, Ricardian equivalence explains why taxpayers seem so lukewarm to the idea of a tax cut and why the notion of paying down the national debt is popular. If Ricardian equivalence holds, then paying down the debt is exactly the same as getting a tax cut.
With the disappearance of deficits, Republicans must now do what they should have been doing all along: explaining why big government is bad. And if there is any truth to Ricardian equivalence, they will continue to find their tax cut message falling on deaf ears as long as surpluses persist.
Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, March 10, 1999.
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