David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 20 Monetary and fiscal policy
Ricardian equivalence
says that it does not matter
when a government finances
a given spending programme.
Tax cuts today do not affect
private spending if, in present
value terms, future taxes rise
to match.
in the real world. Economists are still arguing about the extent to which Ricardian
equivalence should hold.
Why Ricardian equivalence is too strong
There are three reasons why the tax cuts today do stimulate demand a bit even if
future taxes are correspondingly higher. First, people without children get the
benefit of tax cuts without paying the full burden of higher future taxes in the
distant future. They spend more at once.
Second, by reducing marginal tax rates and distortions, tax cuts may increase potential output and raise
income. Expecting higher incomes, people spend more immediately.
Third, solvent governments can borrow at a low interest rate. Ricardian equivalence holds only if we can
borrow as easily as the government. If only! Households and firms are riskier than governments. Private
people have no residual power to tax or print money when things go wrong. Hence, lenders charge private
borrowers a higher rate of interest, and may refuse to lend at all.
Now do the sums again. £1 billion is the value of the tax cut, the extra government bonds and the present
value of extra tax payments discounted at the interest rate faced by the government. We face a higher interest
rate when we try to borrow. As viewed by us, the present value of our extra future taxes is less than £1 billion
because we discount at a higher interest rate.
The tax cut is a fiscal expansion because in effect the government borrows on the good terms it enjoys, then
lends to us at better terms than the capital market. It gives us a loan, tax cuts today, which we repay later in
higher taxes. But we are charged the government's low interest rate for our loan. We are better off and
spend more. Aggregate demand increases.
Theory and evidence suggest that complete Ricardian equivalence is too extreme to fit the real world. Tax
cuts do boost aggregate demand today (though higher future taxes will reduce demand at some future
date). Ricardian equivalence is not completely right, but not completely wrong. Expectations of future
conditions affect current behaviour. Private saving rises a bit when public saving falls. The private sector
does substitute between present and future, despite obstacles to doing this easily. These obstacles make
consumption demand more sensitive to current disposable income than it would be if borrowing were
easy and only permanent income mattered.
Current demand by firms and households depends both on current fiscal policy and expected future fiscal
policy. Since one does not fully offset the other, for simplicity we can look at current fiscal policy in
isolation. We need to remember only that some of its quantitative effects will be smaller if people expect
fiscal policy to have to be reversed at some future date.
If Ricardian equivalence held exactly, government efforts to prop up aggregate demand during 2009 by
running budget deficits would have been largely a waste of time. But understanding the trade-off between
the present and the future allows three insights into the events of 2009 /10:
1 It was precisely in 2009 that banks were most scared to lend and the private sector had so much
difficulty borrowing. These are the circumstances in which bond-financed tax cuts are most powerful.
They increase private sector liquidity at the critical time.
2 Conversely, as governments get closer to the limits of what they can easily borrow and guarantee to
repay, the differential between private sector and government creditworthiness narrows. At some future
point, deficit-financed tax cuts (or other subsidies to the private sector) may lose most of their power.
3 Two specific measures - the temporary VAT cut and the temporary subsidy to scrappage of old cars -
work not by increasing the permanent income of households but by persuading them to bring forward
spending from the future to the present. This is great when the measures are first introduced (and
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