Are Budget Surpluses Equivalent To Tax Cuts?
March 10, 1999
Economic research has 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. Insofar as people think 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. Barro called this theory the Ricardian equivalence theorem, after the great economist David Ricardo.
- For example, if you believe taxes will be higher in the future, then you will tend to reduce your consumption and increase your saving now in order to pay that bill.
- Thus we observe 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.
Almost all analysis of Ricardian equivalence has been under conditions of budget deficits; almost none has dealt with surpluses. But if the theorem holds we should expect the opposite effects under surpluses. This means that people implicitly view surpluses as de facto tax cuts.
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 lukewarm to tax cuts and why the notion of paying down the national debt is popular. If Ricardian equivalence holds, paying down the debt is the same as getting a tax cut.
Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, March 10, 1999.
Browse more articles on Tax and Spending Issues