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 explored more fully in Chapter 16, 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 analyzing the effects of fiscal policy.

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Consider the response of a forward-looking consumer to the tax cut that the Senate Budget Committee is considering. 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 involves 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 this 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 exactly 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, she feels richer and raises her 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.

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The essence of the Ricardian view is that when people choose their level of 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.2

Myopia Proponents of the Ricardian view of fiscal policy assume that people are rational when making such decisions 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 into account future changes in taxes required by current government policies. A debt-financed tax cut will lead this person to believe that her 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 on their 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 financial institutions.

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

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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 these various generations 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 deaths. 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, whose life is finite, but the family, which continues forever. In other words, an individual decides how much to consume based not only on her own income but also on the income of future members of her family. A debt-financed tax cut may raise the income an individual receives in her lifetime, but it does not raise her 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 her children, who will bear the future tax liability.

We can see now that the debate over government debt is really a debate over consumer behavior. 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.4

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

First, with which view do you agree? 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 face borrowing constraints or because future taxes will 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?

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.

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Consider, for example, the experience of the 1980s. The large budget deficits, caused partly by the Reagan tax cut of 1981, 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 a large trade deficit. 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, as Reagan promised, to lower government spending. Because it is hard to rule out any of these interpretations, both views of government debt survive.

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