16.4 The Ricardian View of Government Debt

The traditional view of government debt presumes that when the government cuts taxes and runs a budget deficit, consumers respond to their higher after-tax income by spending more. An alternative view, called Ricardian equivalence, questions this presumption. According to the Ricardian view, consumers are forward-looking and, therefore, base their spending decisions not only on their current income but also on their expected future income. As we explore more fully in Chapter 17, the forward-looking consumer is at the heart of many modern theories of consumption. The Ricardian view of government debt applies the logic of the forward-looking consumer to analyze the effects of fiscal policy.

The Basic Logic of Ricardian Equivalence

Consider the response of a forward-looking consumer to the tax cut that Parliament is debating. The consumer might reason as follows:

The government is cutting taxes without any plans to reduce government spending. Does this policy alter my set of opportunities? Am I richer because of this tax cut? Should I consume more?

Maybe not. The government is financing the tax cut by running a budget deficit. At some point in the future, the government will have to raise taxes to pay off the debt and accumulated interest. So the policy really represents a tax cut today coupled with a tax hike in the future. The tax cut merely gives me transitory income that eventually will be taken back. I am not any better off, so I will leave my consumption unchanged.


The forward-looking consumer understands that government borrowing today means higher taxes in the future. A tax cut financed by government debt does not reduce the tax burden; it merely reschedules it. It therefore should not encourage the consumer to spend more.

One can view this argument another way. Suppose that the government borrows $1,000 from the typical citizen to give that citizen a $1,000 tax cut. In essence, this policy is the same as giving the citizen a $1,000 government bond as a gift. One side of the bond says, “The government owes you, the bondholder, $1,000 plus interest.” The other side says, “You, the taxpayer, owe the government $1,000 plus interest.” Overall, the gift of a bond from the government to the typical citizen does not make the citizen richer or poorer, because the value of the bond is offset by the value of the future tax liability.

The general principle is that government debt is equivalent to future taxes, and if consumers are sufficiently forward-looking, future taxes are equivalent to current taxes. Hence, financing the government by debt is equivalent to financing it by taxes. This view is called Ricardian equivalence after the famous nineteenth-century economist David Ricardo, because he first noted the theoretical argument.

The implication of Ricardian equivalence is that a debt-financed tax cut leaves consumption unaffected. Households save the extra disposable income to pay the future tax liability that the tax cut implies. This increase in private saving just offsets the decrease in public saving. National saving—the sum of private and public saving—remains the same. The tax cut therefore has none of the effects that the traditional analysis predicts.

The logic of Ricardian equivalence does not mean that all changes in fiscal policy are irrelevant. Changes in fiscal policy do influence consumer spending if they influence present or future government purchases. For example, suppose that the government cuts taxes today because it plans to reduce government purchases in the future. If the consumer understands that this tax cut does not require an increase in future taxes, he feels richer and raises his consumption. But note that it is the reduction in government purchases, rather than the reduction in taxes, that stimulates consumption: the announcement of a future reduction in government purchases would raise consumption today even if current taxes were unchanged, because it would imply lower taxes at some time in the future.

Consumers and Future Taxes

The essence of the Ricardian view is that when people choose their consumption, they rationally look ahead to the future taxes implied by government debt. But how forward-looking are consumers? Defenders of the traditional view of government debt believe that the prospect of future taxes does not have as large an influence on current consumption as the Ricardian view assumes. Here are some of their arguments.4


Myopia Proponents of the Ricardian view of fiscal policy assume that people are rational when making decisions such as choosing how much of their income to consume and how much to save. When the government borrows to pay for current spending, rational consumers look ahead to the future taxes required to support this debt. Thus, the Ricardian view presumes that people have substantial knowledge and foresight.

One possible argument for the traditional view of tax cuts is that people are shortsighted, perhaps because they do not fully comprehend the implications of government budget deficits. It is possible that some people follow simple and not fully rational rules of thumb when choosing how much to save. Suppose, for example, that a person acts on the assumption that future taxes will be the same as current taxes. This person will fail to take account of future changes in taxes required by current government policies. A debt-financed tax cut will lead this person to believe that his lifetime income has increased, even if it hasn’t. The tax cut will therefore lead to higher consumption and lower national saving.

Borrowing Constraints The Ricardian view of government debt assumes that consumers base their spending not only on current income but on their lifetime income, which includes both current and expected future income. According to the Ricardian view, a debt-financed tax cut increases current income, but it does not alter lifetime income or consumption. Advocates of the traditional view of government debt argue that current income is more important than lifetime income for those consumers who face binding borrowing constraints. A borrowing constraint is a limit on how much an individual can borrow from banks or other finanical institutions.

A person who would like to consume more than his current income—perhaps because he expects higher income in the future—has to do so by borrowing. If he cannot borrow to finance current consumption, or can borrow only a limited amount, his current income determines his spending, regardless of what his lifetime income might be. In this case, a debt-financed tax cut raises current income and thus consumption, even though future income is lower. In essence, when the government cuts current taxes and raises future taxes, it is giving taxpayers a loan. For a person who wanted to obtain a loan but was unable to, the tax cut expands his opportunities and stimulates consumption.


A Test of Ricardian Equivalence

In 1994, changes in Canada’s personal income tax system forced many individuals to increase the amount of taxes they paid on a quarterly installment basis (rather than paying taxes just once each year in April on income that does not involve automatic tax deductions by one’s employer). Does a change of this kind affect consumer spending? Some evidence is available from a similar change that was introduced in the United States just two years earlier.

The American policy was an attempt to deal with a lingering recession by lowering the amount of income taxes that were being withheld from workers’ paycheques. The policy did not reduce the amount of taxes that workers owed; it merely delayed payment. The higher take-home pay that workers received during 1992 was to be offset by higher tax payments, or smaller tax refunds, when income taxes were due in April 1993.


What effect would you have predicted for this policy? According to the logic of Ricardian equivalence, consumers should realize that their lifetime resources were unchanged and, therefore, save the extra take-home pay to meet the upcoming tax liability. Yet the first George Bush, the U.S. president at the time, claimed his policy would provide “money people can use to help pay for clothing, college, or to get a new car.” That is, he believed that consumers would spend the extra income, thereby stimulating aggregate demand and helping the economy recover from the recession. Bush seemed to be assuming that consumers were shortsighted or faced binding borrowing constraints.

Gauging the actual effects of this policy is difficult with aggregate data, because many other things were happening at the same time. Yet some evidence comes from a survey two economists conducted shortly after the policy was announced. The survey asked people what they would do with the extra income. Fifty-seven percent of the respondents said they would save it, use it to repay debts, or adjust their withholding in order to reverse the effect of Bush’s executive order. Forty-three percent said they would spend the extra income. Thus, for this policy change, a majority of the population was planning to act as Ricardian theory posits. Nonetheless, Bush was partly right: many people planned to spend the extra income, even though they understood that the following year’s tax bill would be higher.5

These U.S. results suggest that the Canadian policy (which was essentially the reverse of the American initiative in 1992) would lower the government’s budget deficit temporarily and dampen aggregate demand temporarily (thereby weakening Canada’s recovery slightly). It is the first of these two effects that appealed to the Canadian government.


Future Generations Besides myopia and borrowing constraints, a third argument for the traditional view of government debt is that consumers expect the implied future taxes to fall not on them but on future generations. Suppose, for example, that the government cuts taxes today, issues 30-year bonds to finance the budget deficit, and then raises taxes in 30 years to repay the loan. In this case, the government debt represents a transfer of wealth from the next generation of taxpayers (which faces the tax hike) to the current generation of taxpayers (which gets the tax cut). This transfer raises the lifetime resources of the current generation, so it raises their consumption. In essence, a debt-financed tax cut stimulates consumption because it gives the current generation the opportunity to consume at the expense of the next generation.

Economist Robert Barro has provided a clever rejoinder to this argument to support the Ricardian view. Barro argues that because future generations are the children and grandchildren of the current generation, we should not view them as independent economic actors. Instead, he argues, the appropriate assumption is that current generations care about future generations. This altruism between generations is evidenced by the gifts that many people give their children, often in the form of bequests at the time of their death. The existence of bequests suggests that many people are not eager to take advantage of the opportunity to consume at their children’s expense.

According to Barro’s analysis, the relevant decisionmaking unit is not the individual, who lives only a finite number of years, but the family, which continues forever. In other words, an individual decides how much to consume based not only on his own income but also on the income of future members of his family. A debt-financed tax cut may raise the income an individual receives in his lifetime, but it does not raise his family’s overall resources. Instead of consuming the extra income from the tax cut, the individual saves it and leaves it as a bequest to his children, who will bear the future tax liability.

We can see now that the debate over government debt is really a debate over consumer behaviour. The Ricardian view assumes that consumers have a long time horizon. Barro’s analysis of the family implies that the consumer’s time horizon, like the government’s, is effectively infinite. Yet it is possible that consumers do not look ahead to the tax liabilities of future generations. Perhaps they expect their children to be richer than they are and, therefore, welcome the opportunity to consume at their children’s expense. The fact that many people leave zero or minimal bequests to their children is consistent with this hypothesis. For these zero-bequest families, a debt-financed tax cut alters consumption by redistributing wealth among generations.6


Why Do Parents Leave Bequests?

The debate over Ricardian equivalence is partly a debate over how different generations are linked to one another. Robert Barro’s defence of the Ricardian view is based on the assumption that parents leave their children bequests because they care about them. But is altruism really the reason that parents leave bequests?

One group of economists has suggested that parents use bequests to control their children. Parents often want their children to do certain things for them, such as phoning home regularly and visiting on holidays. Perhaps parents use the implicit threat of disinheritance to induce their children to be more attentive.

To test this “strategic bequest motive,” these economists examined data on how often children visit their parents. They found that the more wealthy the parent, the more often the children visit. Even more striking was another result: only wealth that can be left as a bequest induces more frequent visits. Wealth that cannot be bequeathed, such as pension wealth, which reverts to the pension company in the event of an early death, does not encourage children to visit. These findings suggest that there may be more to the relationships among generations than mere altruism.7

Making a Choice


Having seen the traditional and Ricardian views of government debt, you should ask yourself two sets of questions.

First, which view do you agree with? If the government cuts taxes today, runs a budget deficit, and raises taxes in the future, how will the policy affect the economy? Will it stimulate consumption, as the traditional view holds? Or will consumers understand that their lifetime income is unchanged and, therefore, offset the budget deficit with higher private saving?

Second, why do you hold the view that you do? If you agree with the traditional view of government debt, what is the reason? Do consumers fail to understand that higher government borrowing today means higher taxes tomorrow? Or do they ignore future taxes, either because they are borrowing-constrained or because future taxes fall on future generations with which they do not feel an economic link? If you hold the Ricardian view, do you believe that consumers have the foresight to see that government borrowing today will result in future taxes levied on them or their descendants? Do you believe that consumers will save the extra income to offset that future tax liability?


Ricardo on Ricardian Equivalence

David Ricardo was a millionaire stockbroker and one of the great economists of all time. His most important contribution was his 1817 book Principles of Political Economy and Taxation, in which he developed the theory of comparative advantage, which economists still use to explain the gains from international trade. Ricardo was also a member of the British Parliament, where he put his own theories to work and opposed the corn laws, which restricted international trade in grain.

Ricardo was interested in the alternative ways in which a government might pay for its expenditure. In an 1820 article called “Essay on the Funding System,” he considered an example of a war that cost 20 million pounds. He noted that if the interest rate were 5 percent, this expense could be financed with a one-time tax of 20 million pounds, a perpetual tax of 1 million pounds, or a tax of 1.2 million pounds for 45 years. He wrote:

In point of economy, there is no real difference in either of the modes; for twenty million in one payment, one million per annum for ever, or 1,200,0000 pounds for 45 years, are precisely of the same value.

Ricardo was aware that the issue involved the linkages among generations:

It would be difficult to convince a man possessed of 20,000 pounds, or any other sum, that a perpetual payment of 50 pounds per annum was equally burdensome with a single tax of 1000 pounds. He would have some vague notion that the 50 pounds per annum would be paid by posterity, and would not be paid by him; but if he leaves his fortune to his son, and leaves it charged with this perpetual tax, where is the difference whether he leaves him 20,000 pounds with the tax, or 19,000 pounds without it?

Although Ricardo viewed these alternative methods of government finance as equivalent, he did not think other people would view them as such:

The people who pay taxes . . . do not manage their private affairs accordingly. We are apt to think that the war is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes.

Thus, Ricardo doubted that people were rational and farsighted enough to look ahead fully to their future tax liabilities.

As a policymaker, Ricardo took seriously the government debt. Before the British Parliament, he once declared,

This would be the happiest country in the world, and its progress in prosperity would go beyond the powers of imagination to conceive, if we got rid of two great evils—the national debt and the corn laws.

It is one of the great ironies in the history of economic thought that Ricardo rejected the theory that now bears his name!


We might hope that the evidence could help us decide between these two views of government debt. Yet when economists examine historical episodes of large budget deficits, the evidence is inconclusive. History can be interpreted in different ways.

Consider, for example, the experience of the 1980s. The large budget deficits run by most Western countries seem to offer a natural experiment to test the two views of government debt. At first glance, this episode appears decisively to support the traditional view. The large budget deficits coincided with low national saving, high real interest rates, and large trade deficits. Indeed, advocates of the traditional view of government debt often claim that the experience of the 1980s confirms their position.

Yet those who hold the Ricardian view of government debt interpret these events differently. Perhaps saving was low in the 1980s because people were optimistic about future economic growth—an optimism that was also reflected in a booming stock market. Or perhaps saving was low because people expected that the tax cut would eventually lead not to higher taxes but to lower government spending instead. Because it is hard to rule out any of these interpretations, both views of government debt survive.