Ricardian Equivalence and the Effectiveness of Tax Cuts during a Recession

By

Rafah Alkhafaji

University of the West of England, Bristol Business School.MSc Economics.Master’s Dissertation.November, 2011.

I’d like to thank my academic advisor, Daniela Gabor for all her help during this process, Andrew Mearmanfor calming me down when my stress levels where high, Dr. Will Cummings for getting me started on

the right path in economics, and my family for all their support throughout my life.

Abstract

This study examines the Ricardian Equivalence in detail. A survey method was

conducted in order to determine the behaviour decisions by consumers in response to a

potential tax cut. Results indicate that consumers treat a tax cut as they would treat an

increase in their own private income, and do not adjust behaviour due to Ricardian effects.

These findings provide evidence against the Ricardian Equivalence hypothesis at a micro

level. Furthermore, the classification of my “savings” variable contributes to the existing

literature on Ricardian Equivalence by differentiating between short-term and long-term

savers, resulting in a more accurate account of consumer behaviour, and therefore, Ricardian

effects on consumers.

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Table of Contents

Page

Introduction ……………………………………………………………………… 3

A. Literature Review ………………………………………………………………… 5

Ricardian Equivalence Assumptions ............................................................. 8

Policy implications ........................................................................................ 19

B. Empirical Analysis ……………………………………………………………….. 20

Twin Deficits Model ...................................................................................... 23

Surveys and Experimental Methods ............................................................... 24

C. Method and Methodology ……………………………………………………….... 29

D. Results …………………………………………………………………………….. 34

E. Conclusion .……………………………………………....………....………………39

References ……………………………………………....…………………………. 40

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Introduction

Since the inception of the modern economy, few issues have been as important, and

triggered as many debates than the issue of whether or not Policymakers should interfere with

the economy. Classical economists, Monetarists and proponents of Adam Smith’s invisible

hand adopt a lazefair approach, where they feel that policy intervention causes inefficiencies,

and is detrimental in the long-run. Keynesian and New Keynesianeconomists believe that

government intervention is needed to correct market failures, and to boost the economy

during a recession.Both sides have feverishly looked for empirical evidence to justify their

own beliefs in an attempt to prove the notion that, if modern economies adopted their

philosophy, it would solve the macroeconomic problems we see today.

A very important theory in this debate is the RicardianEquivalence Hypothesis. This

theory, as understood today, considers Fiscal stimuli funded by government debt useless in

that it creates no increase in output due to rational consumers’ anticipation for a future tax

increase, and their unwillingness to adjust their behaviour in the present tense. (Barro (1974),

Buchannan (1976), Ricciuti (2001)).

The integration and implications of the Ricardian equivalence are vast. Not only have

we witnessed a fundamental change in the global intellectual landscape, butRicardian

Equivalence is actually built into the theoretical framework of many policy decisions. For

example, the New Consensus model currently being used by British policy makers will cite

Ricardian Equivalence when determining the effectiveness of Fiscal policy. In Recent years,

they have dismissed fiscal policy, and have adopted inflation targeting as the policy weapon

of choice. Prior to the 1970’s, both policy tools were used, and both would support each other

in order to achieve economic stabilityas John Maynard Keynes had outlined. As Robert

Solow puts it, “Serious discussion of fiscal policy has almost disappeared. A [current]

reading of the literature on macroeconomic theory and policy would lead you to believe that

there is only one policy goal--the control of inflation - and that task is assigned to monetary

policy. Fiscal policy is either impossible or undesirable or both.” (Solow, 2002).

Fiscal policy led the debate concerning economic policy from the 1930’s to the

1960’s in the periods after the great depression and WWII. Monetary policy was considered

to be a tool simply to keep interest rates at a level to support growth and Inflation was of little

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concern in the post-war period. The 1950’s saw Milton Friedman, the famous economist from

the University of Chicago, gain popularity for his emphasis on the importance of Monetary

Policy. Friedman established the link between money demand and nominal income

determination in his 1956 essay, The Quantity Theory of Money-A Restatement. This meant

that the quantity theory could now explain changes in output as well as in prices, and could

no longer be dismissed as arbitrarily assuming full employment. In 1963, Friedman and

Meiselman published a report called “The Relative Stability of Monetary Velocity and the

Investment Multiplier in the United States, 1897-1958,” where they helped define an

emerging monetarist argument: changes in nominal income are largely determined by

changes in the money supply. Since movements in the money supply are related directly to

policy actions, fluctuations in economic activity are tied to the Central Bank’s policy

decisions. (Friedman and Meiselman, 1963).

The monetarists decided that the central bank’s role should be to keep inflation stable,

and not to help support Fiscal policy as Keynes had illustrated. They believed that

expansionary Fiscal policy created a “crowding-out” effect on investment by causing the

interest rate to increase. The result, according to Friedman, was that this boost in

consumption demand will be offset by a decline in future investment demand caused by the

rise in the interest rate. However, more recently, it has been argued that government spending

results in a “Crowding-in” effect since the injection of high-powered money into the bank’s

reserves causes the interest rate to fall, other things being equal. Monetary policy, on the

other hand, is the culprit for crowding out investment by offering bonds for sale, draining

those reserves.(Tcherneva, 2009).

Friedman’s most significant contribution to economics was perhaps his contribution

to economic methodology, specifically, on determining the effectiveness of a model. In his

opinion, a model’s assumptions were irrelevant as long as it had success in its predictions.

Many economists today follow Freidman’s philosophy and we continue to see models with

unrealistic assumptions emerge from highly prestigious universities. I will critique some of

these assumptions with respect to the Ricardian Equivalence, and attempt to limit the amount

of assumptions made in my own empirical work.

The goal of this paper is to investigate the RicardianEquivalence Hypothesis, the

effectiveness of Fiscal Policy (specifically tax cuts), and whether or not tax cuts can still be

effective in boosting economic growth during a recession.

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Part A) is the Literature review, which highlights the history of economic paradigms

and their views of government debt, a discussion of the Ricardian Equivalence hypothesis,

the theoretical debates surrounding it and most importantly, the assumptions associated with

it, as well asa critical exploration of those assumptions. Succeeding that, is a discussion of the

policy implications for the RicardianEquivalence. Part B)takes a closer look at many of the

empirical studies surrounding Ricardian Equivalence with an analysis of their results. Part C)

is a methodological critique of the majority of empirical work in economics, as well as my

own “quest” to find an appropriate method to test the Ricardian Equivalence hypothesis. Part

D) details my empirical test, and the results of my work. Part E) is the conclusion,

summarizing my findings.

A)Literature Review:

The famous classical economist David Ricardo was the first person to propose the

idea that there is no real difference between a government issuing bonds to fund government

spending, or raising taxes in his “Essay on the Funding System” of 1820. This is because

when the government goes into debt to increase spending or cut taxes, people will anticipate a

future tax increase to repay the debt and will therefore leave their consumption unchanged,

setting money aside in order to pay for the future tax increase.The result would be the same

as if the government had increased taxes now. However, Ricardo doubted the practicality of

his own theory and went on to say, “It would be difficult to convince a man possessed of

£20,000, or any other sum, that a perpetual payment of £50 per annum was equally

burdensome with a single tax of £1000.” (Ricardo, 1820). He never made a point on the

effectiveness of fiscal policy to boost growth, but was comparing different methods of

financing government spending (in this case it was for war). Ricardo, being unconvinced of

the rational expectations of consumers, did not explore the Ricardian Equivalence any

further, and so the idea lay dormant for some time. Attempts to improve on the theory proved

unsubstantial for many years. It wasn’t until 1974 when an American economist named

Robert J. Barro revived Ricardo’s original idea in his paper “Are Government Bonds net

Wealth?” (1974),and reformed it into what we now call Ricardian Equivalence.

Barro’s adaptation of Ricardo’s theory was based on Milton Friedman’s permanent

income hypothesis (1957), which states that a person’s consumption decisions are not based

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solely on their income, but also on their expected future income. In Barro’s theory,

consumers behave as if they have infinite lives because it is assumed they care about their

children, and their grandchildren’s future and wish to leave behind money for them, a

phenomenon he calls “Intergenerational Altruism”. He says “It was shown [with the

Overlapping-generations model1] that households would act as if they were infinitely lived,

and, hence, that there would be no marginal net-wealth effect of government bonds, so long

as there existed an operative chain of intergenerational transfers which connected current to

future generations.” (p. 1116, Barro, 1974).

This differs from Ricardo’s theory in two key ways. Barro used Freidman’s

permanent income hypothesisto explain why a consumer plans their expenditure over their

entire life, and that consumption decisions are based on aggregate future income, and not just

current income. He also added this notion of intergenerational transfer to extend consumption

decisions infinitely into the future. This is important, because with these two additions to

Ricardian theory, the date of the future tax rise to fund current government debt is

insignificant. In other words, Barrosuggests that planning to tax future generationsthrough the

use of government debt will yield the same results as raising tax now. This indifference in

regards to government debt was quite a departure from the more recognized economic

paradigms of the time, which were Keynesian and Neoclassical.

Keynesian theory came into popularity after the great depression and throughout the

post WWII period. During the 1970’s mainstream economic thought shifted towards the

Neoclassical and Monetarist school of thought. The Keynesian view held that government

debt can be used to fund government expenditure or tax cuts in order to boost economic

growth in the short-term. Thus appropriately timed deficits have a beneficial effect on the

macro-economy.

The Neoclassical view held that consumers are farsighted and plan their consumption

throughout their lifetime. Budget deficits will increase consumption in our own lifetime.

However, “If economic resources are fully employed, increased consumption necessarily

implies decreased savings. Interest rates must then rise to bring capital markets into balance,

1The Overlapping Generations Model (OLG) was a popular economic model at the timein which agents live a finite length of time but live long enough to endure at least one period of the next generation's lives.

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thus persistent deficits ‘crowd out’ capital accumulation.” (Bernheim, 1989). In other words,

Neoclassical theory regards persistent government debt as a significant problem in the long

run.It must also be noted that according to the Fiscal Theory of the Price Level, most

governments are non-Ricardian, in that they make no promises to raise taxes in the future.

This results in expansionary fiscal policy leading to an increase in the price-level now due to

the consumption boost, which erodes the real value of the government debt. (Woodford,

1996).

According to the Ricardian logic, cutting taxes will increase savings, and not

consumption. We then have to ask, why is this not desirable for economic growth? Keynes

theory says that Savings = Investment and that Consumption + Investment + Government

spending + exports - Imports = Output (Y). Therefore an increase in Investment leads to an

increase in output. However, when the tax cut occurs, the government must lower the price of

bonds to fund the tax cut. This drives up interest rates and crowds out investment (in other

words, it has a negative effect on investment). In Keynes’s theory, crowding out occurs in the

long run, while short run economic output is still increased because we can adjust monetary

policy to keep interest rates low. But according to the Ricardian logic, monetary policy

should follow the natural rate of interest within the economy, so it is incompatible with

Keynesian’s exogenous monetary policy. In other words, Keynesian theory often used

monetary policy in conjunction with Fiscal policy to achieve the desirable policy goals. For

example, increasing government spending while simultaneously lowering interest rates,

would be very expansionary, and best used during a recession. Keynes believed monetary

policy could be adjusted to achieve economic goals (exogenous) and is not simply a reaction

to the level of inflation (endogenous), as it behaves in many economies today.

Many economists doubt the validity of Barro’s theory, and especially the assumptions

associated with his theory. Each household is assumed to have made an optimal intertemporal

consumption-saving plan. They are all forward looking and rational, and any influx of

temporary income from the government will disturb their plans and cause them to set money

aside to account for the sudden increase. These are lofty assumptions, but if they hold, the

effect of a publicly financed tax cut will be zero. Whatmight interfere with this predicted

result? If households lacked liquid assets and are unable to borrow freely then the added

liquidity from the tax cut would let them consume more now. If the treasury is more efficient

and less risky of a borrower than many households, then the sudden increase in new public

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debt would also affect real behaviour. (Solow, 2002). And, of course, “If consumers do not

look ahead very far or very carefully, if they give little weight to the interests of descendants,

or if they tend to ignore or underestimate the future implications of current budget actions,

then Ricardian equivalence will fail, and tax reduction financed by borrowing will indeed be

expansionary.”(p. 11, Solow, 2002).Recent theoretical work has clarified the explicit and

implicit assumptions of Barro’s theory.

Ricardian Equivalence Assumptions

There are quite a number of assumptions in the RicardianEquivelence theory, which

have been criticized heavily for not properly reflecting reality. However, as is the case with

many economic theories, as long as these assumptions are made clear, and the formal

mathematical models are testable, then they are still valid academic works. Most importantly,

it is up to the reader to gauge how useful a particular theory is.

Assumptions of Barro’sRicardian Equivalence include: (1) Intergenerational

Altruism, the belief that that the current generation is motivated by altruism for the next

generation; (2) Consumption smoothing, where consumers wish to maintain a smooth level of

consumption throughout their lifetime; (3) Nondistortionary taxation and redistribution, in

order for the Ricardian equivalence to hold, taxes must be nondistortionary since

distortionary taxes distort consumer preferences. This also means redistributive policies

cannot be present because they are distortionary in the labour sector; (4) Perfect capital

markets exist, or if they are imperfect, they fail in specific ways which are predictable; (5)

Perfect information, specifically in regards to consumers being perfectly informed about their

future income and planning their lives accordingly, and consumers being perfectly informed

about the political-economy (including the details on tax cuts); (6) Consumers are indifferent

when choosing between tax cuts or government debt; and (7) The government faces an

intertemporal budget constraint.

The theoretical debate surrounding the Ricardian equivalence has focused on the

underlying assumptions of Barro’s proposition. Most results indicate that Ricardian

equivalence is almost impossible to hold given the combination of assumptions required.

(Buchannan 1976, Buiter 1979, Abel 1985, Bernheim 1989, Bohn 1992, Trostel 1993),

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however, Seater (1993) believes Ricardian equivalence may hold as a good approximation.

This is due to the way societies have retired their debt, and how the observable effects of debt

have been inconclusive. Therefore he says, so long as modern societies continue to deal with

debt in the same manner, Ricardian effects may have some truth to them. (Seater, 1993).

The majority of Empirical studies have tested the validity of the assumptions, as well

as testing the Ricardian equivalence with one or more assumption relaxed.By relaxing the

assumptions, and if evidence is found in favor of Ricardian Equivalence, it allows the theory

to possibly remain relevant to the real world since all those assumptions, collectively, may

not exist. I’ll be explaining the theory and empirical research surrounding these assumptions

below.

1) Intergenerational Altruism

As highlighted above, Barro’s theory depends heavily on Intergenerational transfers,

which itself is being carried by the assumption of intergenerational altruism. If this

assumption does not hold true, in other words, if the current generation are not being

motivated by altruism for the next generation, then consumption will increase for the current

generation. While this seems like a realistic assumption, how can we explain the

environmental degradation we have experienced in the past 200 years? Surely if people cared

about their children’s future, they would want to leave them with a less polluted earth as

opposed to a more polluted one, they would vote for policies that protect the environment,

and would elect policymakers who maintain the environment as a priority. Either the public is

not as informed (in this case, about the state of the environment) as Barro would like to

believe, or they don’t care about future generations. This disregard for the condition of

environmental public goods seriously hampers the legitimacy of this assumption.

A number of authors empirically analysed the intergenerational altruism assumption

(Buiter 1979, Carmichael 1982, Weil 1984, Abel 1985, Kimball 1986). However, many of

them reject certain specifications of preferences due to dynamic inconsistency, which is when

a person’s preferences change over time, in this case it is between members of successive

generations.“Dynamic inconsistency is simply a manifestation of conflict within families, and

I see no reason to rule it out.”(P. 265, Bernheim, 1987).In other words, it’s best not to drop

observations and outliers in econometric analysis. There are always exceptions in real life

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scenarios and the data should reflect that. We can argue about the probability of these

conditions, however, we must still acknowledge them. In fact,Barro’s specifications for

intergenerational altruism, which portrays families as perfectly harmonious units, is

extremely restrictive, and the preferences of distinct family members will conflict. According

to Bergstrome (1986), the case where the presence of altruism automatically harmonizing

objectives is unlikely. (Bernheim, Schleifer, and Summers, 1985).

Furthermore, there is the case of childless families. Individuals or couples without

children will alter their behaviour after a tax cut because they have no concern for taxes on

future generations. (Tobin and Buiter, 1980). Proponents of RicardianEquivelence argue that,

because household decision-makers are perfectly informed (a bold assumption, but one that

we will discuss in detail later), they will realise that their children will bear a disproportionate

burden due to childless families, and they will increase their bequests appropriately, but these

higher bequests may not fully offset the excess tax burden.Barro (1989) argues that as long as

there are large families with many children, the “childless family” effect is counteracted.

(Ricciuti, 2001, citing Barro, 1989).

The motives for intergenerational transfer are debatable, and Seater (1993) argues that

intergenerational transfer could occur for strategic reasons as a form of insurance, or through

accidental death. (Seater, 1993).

Testing the situation in which households are bequest-constrained, but generations are

linked by an altruistically motivated human capital investment, Lord and Rangazas (1993)

found that Deficits could have real effects on behavior by shifting the consumption

possibility frontier outward for families that are bequest-constrained. “The wealth effect will

increase consumption, whereas the substitution effect, due to diminishing returns to human

capital investment, will decrease the return on investment of parental consumption, since

greater investment is required to maintain a given level of after-tax wealth for the children.

The calibrated model of bequest-constrained households shows that a deficit will reduce the

children’s after-tax wealth, despite the presence of altruistic human capital transfers.” (Adji

2006, citing Lord and Rangazas 1993).

2) Consumption Smoothing

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Consumption smoothing is one of the related theories that Ricardian Equivalence

depends on. It describes people’s desire to have a stable pattern of consumption, therefore

when income shocks occur, it will not affect their spending patterns because they have

already saved money in anticipation for these shocks, and they will simply dip into their

savings when the shocks occur. If they cannot save appropriately, they will borrow money.

This is based on Milton Friedman’s Permanent income Hypothesis (1956) and Brumberg’s

Life-Cycle Model (1954). Unfortunately, when borrowing constraints are present,

consumption smoothing fails to hold according to empirical work done by Wilcox (1989) and

Zeldes (1989). In addition, numerous studies (Campbell and Mankiw (1989) using aggregate

data, Hall and Mishkin (1982), Zeldes (1989), and Carroll and Summers (1991) using

household data), have shown that people are more sensitive to current income than future

income which undermines the basic consumption-smoothing model. (Elmendorf and

Mankiw, 1998).

3)Nondistortionary Taxation and redistribution

One of the assumptions for Ricardian theory to hold, is that the taxation in question must

be non-distortionary. Therefore when an economy has a nonlinear estate tax schedule,

Ricardian equivalence does not hold. (Abel, 1986).A distortionary tax is one which alters

economic preference, and as a result, economic behaviour. For example, a tax on petrol will

distort people’s preferences away from petrol because it is now relatively expensive

compared to letting the market decide on the price. A lump sum tax, is meant to have the least

distortionary effects, as it does not pertain to a particular good, and is therefore inescapable

and non-distortionary. However labour market distortionary effects will still occur as long as

there is a nonlinear income tax system. A nonlinear income tax requires the taxpayers to be

taxed a different percentage of income depending on how much they make, and this distorts

labour market preference. This can be extended to the non-linear estate tax which distorts, not

only present day labour markets, but also inter-temporal markets as well.

Most developed countries have a progressive tax schedule on bequests, which is

nonlinear, and thereforeRicardian equivalence fails. The reason for this, is that when this

lump sum tax occurs, even if the consumer’s consumption remains unchanged, he/she is

driven into a marginally lower tax bracket, and in order to maintain consumption, their

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savings rate drops. This reduction in savings implies a reduction in the consumer’s estate and

therefore, a reduction in the marginal estate tax rate. This reduces the price of the heir’s

consumption relative to the parents. Therefore, the parent will reduce their own consumption

because, at the margin, it is more profitable to save.The Ricardian method was predicted to

leave consumption unchanged because of “consumption smoothing.” The fact that

consumption drops in order to save more (due to the more appealing lower tax bracket on

savings) distorts behaviour, and “destroys the RicardianEquivalence.”(p. 12, Abel, 1986).

Henning Bohn makes a very good point(1992) when he says that, following the Ricardian

logic, but assuming distortionary taxes, higher taxes increase the marginal cost of publicly

provided goods. If consumers observe a tax cut in this environment, they rationally anticipate

that tax cuts today will be accompanied by future government spending cuts. Therefore their

consumption increases because they will not assume that taxes will increase in the future

since it is more economically efficient for the government to simply cut future spending. (p.

589, Bohn, 1992).The key assumption here is distortionary taxes will generate a greater

deadweight-loss than non-distortionary ones. Again, according to Bohn, if the government is

concerned with macro-efficiency it is in their best interest, marginally, to cut future

government spending. While I agree that government debt increases the likelihood of

government program cuts (for example, as of this writing, a massive government program cut

is being debated in the Unites States congress due to their large gov’t debt figure), I feel the

need to challenge Bohn’s claims that distortionary taxes reduce welfare. Many distortionary

taxes are observable in the real world, for example, progressive income tax, and an extra tax

on alcohol and tobacco. A progressive income tax may distort behaviour and reduce workers

incentives to work harder and gain a higher wage. However, it reduces income inequality and

that, in turn, will reduce labour strikes, animosity between classes, and health issues resulting

from poverty. (Baumal, 1972). Overall effects are debatable, and it is beyond the scope of

this paper to delve into any more detail on the effects of that particular tax. Other

distortionary taxes may include Pigoviantaxes, which are intentionally distortionary, and are

used to correct negative externalities. These include things such as an extra tax levied on

tobacco, alcohol, or pollution. They still distort behaviour and therefore may increase the

nominal deadweight-loss of taxation, but again, the reduction in medical costs as a result of

these taxes may offset the loss to efficiency created by the distorted behavior. Nominally it

would be difficult to determine the net outcome of these Pigovian taxes.Socially, the benefits

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to society would seem to increase as a result of these taxes, but again, with a black market

arising from high tax rates, even that is debatable. Therefore, are we to believe that a

government who values the welfare of its state, would reduce these taxes to boost efficiency?

And should we believe that consumers will predict this?These thoughts seem to undermine

Henning Bohn’s argument, and the effects on the RicardianEquivelence theory are uncertain.

If consumers don’t expect a reduction in future government spending, would they expect an

increase in future taxes? I suppose it depends on their knowledge and opinion of distortionary

taxes, their overall foresight, and their interest in economics and politics.

Trostel (1993) conducted a test allowing for a distortionary tax using a model of

individual intertemporal optimization. He finds that, with a non-linear tax on labour, a

temporary substitute from taxation to debt caused a Keynesian-like reaction: increasing

consumption and output in the short-run and decreasing them in the long-run. (Ricciutti 2001,

citing Trostel 1993).

If distortionary taxes are present, the timing of these taxes is very important. This is

especially true when deficits are used to postpone capital income tax since a reduction in

marginal capital income tax rates may cause individuals to save more and consume less.

(Bernheim 1987, Auerbach and Kotlikoff 1986). It must be noted that much of this outcome

depends on intertemporal substitution elasticities, which is empirically difficult to determine.

Most importantly, Deficits may substantially depress the long-run capital stock even when

the short-run effect is Crowd-in investment. (Bernheim 1987).

Redistribution between generations, as well as between different income groups of the

same generation cause serious problems for the Ricardian theory. As stated earlier, a

progressive tax system, which itself is a form a redistribution policy, causes problems for

Ricardian predictions. However, when the distribution of future taxes is uncertain, deficits

may actually “Crowd-In” investment. (Chan 1983). Since uncertainty for the future will

increase savings, and Savings = Investment, this will have a positive effect on short-term

investment. Unfortunately, it is difficult to determine the significance of this factor in

quantitativeterms. “If the world was otherwise Ricardian, then one would never expect to

observe deficits since the electorate would universally oppose the gratuitous introduction of

uncertainty.” (Bernheim, 1987). In other words, we would expect to see massive surpluses to

curb future uncertainty, which we haven’t seen for some time. However, Barro (1979) finds a

reasonable explanation for government debt. He argues that government expenditure is

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cyclical in nature, and the capital needed today is not produced immediately from a rise in

taxes. In addition, transaction costs from tax collection, (and raising taxes) add to the

deadweight loss of taxation, making issuing bonds a relatively cheaper option. (Barro, 1979).

4)Perfect Capital Markets

One of Barro’s main assumptions is the existence of perfect capital markets, or if they

are imperfect, they fail in specific ways, which are predictable. During this day and age,

we’ve surely seen examples of imperfect capital markets. Consumers who need loans are

unable to get them because the default risk during a recession is too high, or that risk is

miscalculated due to asymmetric information (more on that later). What happens when

imperfect capital markets exist? When consumers are unable to receive loans, Government

deficits may have a real effect on the economy.

Liquidity constraints play a very important role when comparing the effectiveness of a

tax rise versus deficit spending. “Under the assumption that 20 percent of the population is

liquidity constrained, they show that a $1 deficit-for-tax swap would increase consumption

by 25 cents.”(Hubbard and Judd 1986, cited by Bernheim 1987). This conflicts directly with

Barro’s predictions of a 1 dollar deficit-for-tax swap resulting in a 5 cent increase in

consumption. In other words, perhaps more people are liquidity constrained than Barro, or

even Ricardo had imagined. Or perhaps, the economic environment is vastly different to how

it was in the 1820’s and possibly even in the 1970’s. The general consensus is that that there

are two types of households in the economy that react differently to tax cuts: Those who are

liquidity constrained, and those who are not. Those who are liquidity constrained will spend

the money immediately, living from paycheck to paycheck. Therefore, as the proportion of

liquidity constrained households increases, the less impact Ricardian consumers have on

economic policy. The question of debate is how large a proportion of the population are

liquidity constrained? Approximations have it pegged around 20-23% in 2007 (Gorbachev

and Dogra, 2010). It’s interesting to note that even though more and more households have

gone into debt over the past 30 years, the proportion that are liquidity constrained hasn’t

changed much. The reason for this is that “The demand for debt has increased in line with the

supply, due to historically low real interest rates, increasing house prices and increased

income volatility.”(Gorbachev and Dogra, 2010).But there seems to be more to this story.

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The literature agrees (including Barro himself) that Liquidity constrained consumers do

not behave in a Ricardian fashion, but what about those who are not liquidity constrained, but

still in debt?It’s safe to assume they would use a tax cut for consumption or to pay off their

debt. Logically, we wouldn’t expect these people to save it long-term when they have

outstanding debts incurring heavy interest fees.Looking at credit card payments after the

2001 U.S. tax credit, Agarwal, Liu and Souleles(or ALS) found that consumers initially

increased their credit card payments to repay their debt. Shortly afterwards, their spending

increased, counter to the RicardianEquivalence hypothesis. (Agarwal, Liu and Souleles,

2007). Although in their report, ALS consider credit card repayment as a form of saving and

perhaps it is technically a form of saving, but is it the heavy interest fees, or the Ricardian

Equivalence which weigh more heavily on the decision to repay debt as opposed to consume?

It seems we cannot compare repayment of debt to a pure long-term saver (which isn’t in debt)

because the interest rates are so skewed that they greatly influence disposable income

decision-making. In other words, the incentive for someone to save their money and receive a

5% nominal interest rate per year (which in real terms would be closer to 2-3%), is not equal

to the incentives for a consumer to repay their debt incurring 20% interest (or 17% in real

terms). Therefore, the definition of savings as ALS described it, is not the same as the

Ricardianconsumers savings that Barro described. This theoretical debate is important

because it is currently estimated that 43% of American households spend more than they earn

each year. (World Bank, 2010).

Consumers who are not liquidity constrained will possibly save the tax cut, the reasons

for which are not so clear. According to Freidman’s permanent income hypothesis (to which

Barro’s theory are based on), they adjust their expenditure plans over such a long period of

time, that their short-term household expenditure increase will be miniscule. In addition, in

line with Barro’sRicardian theory, they will tend to save the money in anticipation of future

tax increases, even so far as to leave it behind for their children if the tax increase happens

after their death. Therefore, it is very important to ask, is this how consumers actually behave

and what exactly are their motives? Are they acting Ricardian? Or are they, in fact, simply

acting as they normally would if their disposable income had increased? In other words, does

the fact that the money is being given from the government influence their marginal

propensity to consume it? I intend to provide an answer to this question in section D.

15

5) Perfect information

The Permanent Income hypothesis assumes that consumers will know their future

income and plan their lives accordingly. However, when uncertainty is introduced events may

not go exactly as planned.Barro’s theory contains implicit assumptions of perfectly informed

and forward-looking consumers. In a time when less than 60% of America’s public votes in

presidential elections (Federal Election Commission, 2008), are we to believe that the

majority of the public is informed about public policy, let alone perfectly informed on the

details of policy?Imperfect information may also help to explain the cases forimperfect

capital marketsmentioned previously. An empirical testconducted by Stiglitz and Weiss on

credit rationing shows that potential borrowers, who are even willing to take loans at a higher

interest rate, are denied loans, while at the same time, observationally identical borrowers are

not denied. Due to adverse selection, the bank cannot increase interest rates or loan

requirements because it could increase the riskiness of the loan by attractinghigh risk

investors and possibly lower the profits of the bank’s loan portfolio. (Stiglitz and Weiss,

1981). Here we can see an example of a non-market-clearing equilibrium. If perfect

information existed, this would not be possible because the extra supply of loans a bank gives

out could have interest rates adjusted to meet various credit scores. Adverse selection is a

side-effect of asymmetrical information and is observable in many other areas such as the

insurance market, medical, and even a used car lot. In this case, it helps explain the

mechanism for market failures in the credit market.

Empirical work conducted by Michael Reiter (1999) found that Ricardain Equivalence

fails to hold when thereis a lack of perfect information concerning government debt. His

explanationwas that households face difficulties when attempting to obtain information about

government debt. Even for educated households, “the problem begins with the fact that data

from different sources source country statistics, OECD, IMF that sometimes differ by

nonnegligible amounts, due to subtle differences in definitions. Further questions concern the

decision of market vs. par values and the treatment of government assets.” (Reiter, 1999). For

uneducated households, who obtain most of their economic information from popular media

outlets, it’s even less accurate. Most media outlets focus on “gross” rather than “net” public

debt. Most importantly, the changes in gross and net debt can differ substantially. (Reiter,

1999). Reiter goes on to say that much of the debate is concerned with deficits and not the

overall debt, failing to recognize the inflationary devaluation of debt over time. In general,

16

changes in debt by news networks are given in nominal terms, which can be largely arbitrary

during periods of high inflation. (Reiter, 1999).Reiter’s work assumes rational expectations,

and even still, as long as perfect information is not available, Ricardain Equivalence fails to

hold.

Further evidence of the public’s lack of perfect information was found by Allers, Haan,

and Kam’s (1998) microeconomic tests in the Netherlands on the knowledge of public debt.

Only 27% of respondents gave a fairly correct answer when asked about the size of

government debt/deficit. (AHK, 1998).

6) Consumers are indifferent when comparing tax cuts to government debt.

This is a very important piece of the Ricardian puzzle because if this were true, people

would not be willing to take on debt at a high interest rate. The reason for this is that

many“consumers’ discount ratesare greater than the government interest rate on debt.”

(Blanchard, 1985). In other words, these consumers gain more utility from consumption, even

though they incur a high interest rate (ex: many credit card companies charge over 20% APR)

than from saving. If they plan out their expenditure across their lifetimes, as the life-cycle

hypothesis suggests, they are losing a great deal of lifetime income due to their high discount

rates (ie: their preference to have the money now, for consumption, rather than save for future

consumption). Consumers in credit card debt have discount rates that are higher than the APR

on their credit cards, otherwise, they would not borrow. Since there is no credit card in

existence that has an interest rate as low as a government bonds rate (3-5%), then we cannot

say they are indifferent when the choice arises to pay more taxes now, or to pay more in the

future. Put another way, since their credit card debt indicates they are already willing to pay

the principle amount + 20% so long as it’s in the future, they will gladly forego paying the

tax now in order to pay a future amount + 5% interest (or whatever the discount rate on

government debt is.) This helps explain the behavior of consumers which are liquidity

constrained, and also the consumers which are not constrained but still are willing to take on

debt.This is just one example of the failure of the “tax cuts = government debt” assumption.

7) The government faces an intertemporal budget constraint.

17

An Intertemporal budget constraint means that if the government cuts tax in period one,

it must raise tax in the future (period 2). Logically this makes sense, however the reality,

especially in the case of the United States government is not so clear. It is assumed, in

regards to Ricardian equivalence, that the government cannot run a Ponzigame. In other

words, they cannot spend more than they earn continuously, while constantly gaining new

investors and selling them bonds, all while only paying interest payments and not the actual

principle owed. Unfortunately, the past 30 years have been a “Ponzi” period for the United

States, and there’s no clear indication that it will stop.

Since we’ve seen the U.S. National Debt rise, while only interest payments have been

going out, we cannot assume that the U.S. government faces anintertemporal budget

constraint. If they do, it spans a large period of time, well into the future and is dependent

upon a multitude of variables. Policy decisions on whether to increase/decrease government

spending or raise/cut taxes all depend on who the policy leaders are, as well as the economic

climate, and all add to the uncertainty. Political fads, affecting the public’s voting decisions

will affect fiscal and monetary policy.The future brings a great deal of uncertainty in general,

and we cannot say for certain that the government cannot run a Ponzi game until it collapses

at an unforeseeable future date. In other words, it’s not an obviousassumptionas many authors

believe it to be. In Fact, Woodford argues that governments do not necessarily face spending

constraints unless they are artificially imposed, and it is also possible for the fiscal authority

to run deficits without any offsetting action in the future. (Tcherneva, 2009 citing Woodford,

1996).Feldstein (1976) makes a very similar argument and uses this reasoning to contradict

Ricardian Equivalence when he said that if the growth rate of the economy (the sum of the

rates of population growth and technical progress) exceeds the interest rate, the government

can permanently postpone the repayment of debt so that no generation has to repay the debt

left by previous generations. (Feldstein, 1976).On average, the interest rate on debt in the

U.S. has been lower than the growth rate of the economy, however, they exhibit different risk

characteristics and therefore risk/reward payout is cannot be compared by only looking at

average returns. (Elmendorf and Mankiw 1998, referencing Abel, 1989). Furthermore, there

is no empirical evidence that shows that the growth rate of the economy is greater than the

interest rate over the long run. (Ricciuti, 2001).

There is no reason to believe that consumers that observe this trend of “interest only”

18

payments by their government should expect to see their taxes increase in the future to pay

off the principle owed by the government, aside from a slight increase due to higher interest

rate payments (to cover the larger government deficit). In fact, to many people, an increase in

inflation is more observable, and would provide incentives against saving, especially when

the interest rates are at historically low levels. Therefore, at least from the view of the

younger generation of taxpayers, perhaps they don’t expect taxes to increase since it hasn’t

happened in their lifetime.

The Macroeconomic implications of the government not having an intertemporal

budget constraint means that the bond price reduction to fund expansionary fiscal policy will

not be offset by future tax increases. This occurs in a non-Ricardian government regime,

where they make no promises to increase future taxes. The effects of this policy will improve

actual wealth, which in turn will increase output and cause upward inflationary pressure

because the economy is assumed to be at full employment. According to Tchernerva, this

only works if the government is explicit in its intentions to not raise future taxes. “A bond

drop will do little to stimulate the economy unless it has an impact on expectations.”

(Tcherneva, 2009).

Policy Implications

“Public debt issue permits the generation in power to shift tax burdens to generations

without a political voice.” (Buchannan, 1976). This is the very nature of public debt.

However, if we believe Ricardian Equivalence to be true, then it means that massive

government deficits can be created by this generation without worrying about future

generations because the current generation will set aside resources and give them to future

generations. For example, a very plausible scenario is that the current generation’s

policymakers can increase wartime spending significantly, funded by treasury bonds. They

will not raise taxes to cover the debt for a long period of time, say 30 years, which will affect

the second generation, as Buchannan claimed. However, policymakers that believe in

Ricardian Equivalence would dismiss Buchannan’s claim that we are taxing those without a

political voice because they assume that the current generation has set aside resources in

anticipation of the future tax increase. Therefore, policymakers can pursue their own agenda

(for example: increase wartime spending while not raising taxes—since raising taxes would

hurt their chances for re-election) all thanks to the Ricardian Equivalence. Ironically, they can

19

dismiss a Fiscal stimulus package during a recession as completely ineffective and quote the

same theory (the irony is that both are forms of government spending).

It would seem that the policymakers with the most faith in the Ricardian Equivalence

are those in the United Kingdom. After producing a stimulus package in spring of 2008, they

later decided that a tax rise or a public expenditure cut was to be implemented in the autumn

in compliance with their strict fiscal rules. When asked what the correct framework to think

about the change was, Governor and Chief economist of the bank of England, Mervyn King

replied, “RicardianEquivalenceis not a bad place to start.” (Giles 2008 quoting King 2008).

In other words, the “Fiscal rules” of the British government dictate the actions they take when

reacting to a recession. These rules are part of “The New Consensus” economic model, which

hasRicardian Equivalence built into its theoretical framework.

B) Empirical Analysis

Direct tests on Ricardian equivalence have taken a few forms. One way is to see if large

deficits result in an increase in the interest rate.Another way, which is more commonly used,

is to test whether an increase in government bonds leads to an increase in household income

and consumption, or an increase in savings. An alternative approach is a test to see whether

government debt leads to a trade deficit (twin deficits).Finally, there are surveymethods

testing consumer behavior.

The most common econometric technique for testing RicardianEquivalence is the

Ordinary Least Squares estimator (OLS). As with many econometric tests, the results can be

questionable because they may not be exogenous to the data. (Bernheim, 1987). In other

words, variables such as debt, gov’t expenditure, income, and interest rates may all be

determined at the same time. The main limitations to this method are that the connection

between the estimated equations and their underlying theoretical models are not specified

explicitly, and that most empirical applications focus on the current changes in variables

(such as taxes, labour, consumption, etc.) and speak very little of the expected changes in the

future variables. (Leiderman and Razin, 1988).

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Feldstein (1982) tests consumption andis among the most cited study testing

RicardianEquivalence. He finds that fiscal policy can have a significant effect on aggregate

demand. The rejection of the Ricardian Equivalence is especially apparent when looking at

the coefficient on his ‘government transfer’ variable.(Feldstein, 1982). However, Seater

(1993) argues that Feldstein omits variables including the marginal tax rates and business

cycle indicators, which leaves the interpretation of his government transfer variable unclear.

(Seater, 1993).

Kormendi (1983) tests the Ricardian Equivalence using a consumption function

“Consolidated Approach” method. A consolidated approach nests previous tests of Ricardian

Equivalence. He assumes rational expectations of individuals with respect to fiscal policy. He

says the standard approach does not model a person’s rational expectations. His results are in

favor of the Ricardian Equivalence. (Adji 2006 referencing Kormendi 1983).

Since the late 1980’s the Euler equation has dominated the tests for Ricardian Equivalence

(tests such as Auschauer (1985), Evans (1988), Haug (1990), Himaarios (1996)). The Euler

equation was formed in order to obey the first order conditions of optimal consumption for

farsighted and rational conditions. With these assumptions in place, the results are usually in

favor of Ricardian Equivalence for industrial countries, while tests for developing countries

yield mixed results. (Adji, 2006). Again, we have to highlight the rational expectations and

farsighted consumers assumptions, and question thevalidity of these assumptions, the

methodological approach of these studies, and therefore the results.

Leiderman and Razin (1988) estimate a stochastic-intertemporal model for

consumption behavior and use it for testing Ricardian Equivalence with time series data.

They focus on the “co-movement” of consumption and government-budget variables. They

use monthly, time-series data for Israel from the periods of 1980-1985. As they state, “This

case is of particular interest in testing the Ricardian-equivalence hypothesis because of the

high volatility of movements in the budget deficit, taxes, and private consumption in an

economy with unusually high government budget deficits, amounting to 15 percent of

aggregate output, on average, during this period. The sizeable deficits have resulted in a

relatively large government debt, which was twice the size of GNP at the end of the

period.”(Leiderman and Razin, 1988). This is significant because most of the literature

beforehand had focused on testing Ricardian properties in a relatively stable economic

21

environment. Therefore, they claim that it could potentially enable a more powerful

hypothesis test related to the co-movements of private-sector consumption and public sector

spending. (Leiderman and Razin, 1988). Their results are in favor of the

RicardianEquivalence Hypothesis.

Kostas Drakos (2001) tests the hypothesis that increased private savings will match an

increase in government borrowing, looking for a positive correlation between the two. If a

positive relationship is found, it provides evidence in favour of the Ricardian Equivalence

and if a negative relationship is found, it provides evidence against the Ricardian

Equivalence. He used time-series data from Greece from the periods of 1981-1996. In order

to account for inflation the values are expressed in real terms by using the Consumer Price

Index. The macroeconomic variables were non-stationary, so he had to explore the link

between government borrowing and savings within a possibly cointegrated system2. He used

the Johansen procedure to test for cointegration. This test permits more than one

cointegrating relationship so is more generally applicable than the Engle-Granger test.

(Johansen, 1991). To test the order of integration, a Dickey-Fuller unit root test was used,

which is an econometric technique seen commonly in the literature. The results indicated that

the system satisfied the no-autocorrelation3 assumption, which is a critical assumption in the

Johansen procedure.Drakos’s empirical results suggest there were some Ricardian effects

when the government increased borrowing, in the form of increased private savings.

However, he notes that the increase in savings doesn’t completely offset the government

debt. In other words, households do perceive the government bonds as net wealth to some

extent, and consequently increase their consumption, contrary to the Ricardian Equivalence.

This behaviour is attributed to liquidity constraints and myopia due to uncertainty regarding

the future path of taxes among consumers. (Drakos, 2001).The coefficient of Drakos’s

“government borrowing” variable in the long-run can be interepreted as the Marginal

Propensity to save out of increased wealth due to holding government bonds. This was only

7%, while the Marginal propensity to consume it was 93%. (Drakos, 2001). In other words,

Ricardian effects in the long-run were minimal.

2Cointegration of a vector of variables implies that the number of unit roots in the system is less than the number of unit roots in the corresponding univariate series. (Drakos, 2001 citing Granger (1981), Granger and Weiss (1983), Granger (1986), Engle and Granger (1987)).

3Autocorrelation is when the residuals (error-terms) show a pattern over time.

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It is interesting that in Drakos’s conclusion, he sounds as if the results produced a

“mixed bag”, but when reading through his empirical work, he shows very strong evidence

against Ricardian Equivalence. Furthermore, he does not include data on changes in the

interest rate. I find this particularly puzzling since a decrease in the price of bonds can result

in an increase in the interest rate (although this in itself would test Ricardian equivalence as

well). If the interest rate increases, this can have an effect on private savings. Therefore, due

to a potential omitted variable bias, Drakos’s results are questionable.

Testing the behavior of the labour market, Karen Conway (1999) uses a two-period

perfect foresight model in which the individual maximizes utility over two periods. The

empirical results suggest that state government budget deficits increase male labour supply

and point to workers being Ricardian, howevershe goes on to say, “the results found here for

state government policy should not be directly applied to an analysis of the labor supply

effects of federal deficits because of the multitude of differences between federal and state

government policy.” (P. 187, Conway, 1999). Therefore, this study is applicable to local

governments who are debating the effects of public debt. Her assumption,as with much of the

literature, is perfect foresight, and therefore the application of her results to the real world is

questionable.

Twin Deficits Model

When the subject of government debt arises, The Twin Deficits model must be

mentioned. It is a related theory that describes how a trade deficit can occur as a result of

government debt. Following Keynesian theory,

C+I+G+X-M = Y

X-M = Y-C-I-G

X-M = S – I

X – M = Public Savings + Private savings – Investment

X – M = (T-G) + (Private savings – Investment)

And since Private savings – Investment = approximately 0,

X – M = (T-G)

In other words, the Account deficit = Trade deficit.

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Therefore if taxes are decreased, consumption (and imports) will increase, and interest

rates will increase, which means foreign investors will buy more currency, this will affect the

exchange rate and exports will decrease as a result. If the world were Ricardian, we would

not expect to see consumption (and therefore interest rates and imports) increase when taxes

are decreased. Therefore if we can find examples where an account deficit did not lead to a

trade deficit, then it would provide evidence in favor of the Ricardian Equivalence.

According to the literature on this Twin Deficits phenomenon, a number of studies have

found a correlation between an increase in government debt and an increase in the trade

deficit. (Lau and Tang (2009) referencing Hutchison and Pigott (1984), Zietz and Pemberton

(1990), Bachman (1992), Vamvoukas (1999), Piersanti (2000) and Leachman and Francis

(2002)). More specifically, some researchers have found a uni-directional causal relationship

between government deficits and the current account balance; This includes Baharumshah

and Lau (2007), who analysed data in Thailand, Acaravci and Ozturk (2008) in Turkey, and

Hakro (2009) in Pakistan. (Lau and Tang, 2009). However, empirical work by Enders and

Lee (1990), Evans and Hasan (1994), and Kaufmann et al. (2002) have concluded that there

is no link between the twin deficits and are therefore supportive of the Ricardian

Equivalence. (Lau and Tang, 2009). Overall, there is no real consensus over the causality of

the Twin Deficits Hypothesis. Most researchers agree that they are correlated, however, and

that is enough evidence to question the Ricardian Equivalence, and to motivate further

potential research in the field.

Surveysand Experimental Methods

One of the assumptions of Barro’s theory involves a nondistortionary, lump sum tax.

Adji, Alm and Ferraro (AAF) find that, while the Ricardian view largely holds in the

presence of nondistortionary taxes, the existence of distortionary taxes on savings generates

inconsistent behaviour, and the Ricardian equivalence fails. Following Cadsby and Frank

(1991), Slate et al. (1995), and Ricciuti and Di Laurea (2003), AAF’s experimental design

uses an intergenerational utility function in an overlapping generations setting. Their

experiment consists of 2 treatments. The first conforms to Barro’s assumption of a lumpsum,

nondistortionary tax. The second, includes a tax on savings (distortionary) in which one unit

of savings does not generate one unit of future income. Details of the experiment are as

24

follows:

“The baseline treatment consists of 12 three-period rounds with a

nondistortionary tax…. Thirty-two subjects, drawn from a subject pool

maintained by the Experimental Economics Center at Georgia State

University, participated in the experiment. The subjects were undergraduate

students with various majors, and most students had taken 2-3 economic

courses.” (P. 3, AAF, 2009).

AAF opted for a simple multiplicative utility function, also used by Cadsby and Frank

(1991), Slate et al. (1995), and Ricciuti and Di Laurea (2003) who concluded that the

multiplicative form generated less noisy behavior than the other utility functions. AAF

created quite a complex experiment and really seemed to look at all angles when designing

the experiment to be as nonbiased as possible on a theoretical basis. However, the fact that

they chose subjects who had taken an economic course is not necessary indicative of the rest

of the public. How many people in America, for example, have taken a college-level

economics course, let alone 2-3 courses? The methods used for this experiment were perhaps,

overly complex, and as a result, required a test subject who was proficient in economics in

order to even understand what was being asked.However, despite that, even with the

unrealistic assumption of the public’s extensive knowledge of economic vocabulary, the

results showed that when distortionary taxes are present on savings,

Barro’sRicardianEquivalence fails.

In the Netherlands, Allers, Haan and Kam (AHK) conducted a survey among readers of

14 regional Dutch newspapers. With 15,507 replies, it is quite a large sample size. However,

it is still only 1.2% of the newspapers sold which could be an indication of potential sample

selection bias. (AHK, 1998). This survey about government debt was combined with a

psychology survey which reduces potential sample selection bias. Because their survey

targeted newspaper readers, those that are more educated were overrepresented, which means

that their sample would over-estimate the public’s knowledge on government debt. (AHK,

1998).

Three questions were asked by AHK in order to test the Ricardian Equivalence. The

first question asked how large the deficit was (the correct answer was 375 billion GLD, but

responses in the range of 250 – 450 billion were deemed close enough). The second question

25

asked how much government debt increased in the previous year, again allowing a range of

numbers as “close enough.” Finally they asked, “When the government debt increases, taxes

have to rise in the future. Do you save extra money now explicitly in order to be able to pay

those higher future taxes?” (AHK, 1998). The third question is the most direct inquiry into

the microeconomic validity of the Ricardian Equivalence I have seen in the literature.

However, it is not without it’s faults. He is projecting an assumption onto the respondents by

saying that when government debt increases, taxes must rise in the future. This assumption is

still being debated, and I have outlined criticisms of it in section A: namely that the

government could choose to cut government programs instead of raising taxesand that the

government may not, in fact, face an intertemporal budget constraint.Despite that, the results

of his survey were quite interesting: 27% of respondents knew the level of public debt, and

39% answered correctly about the previous year’s deficit. Most people underestimated public

debt levels. 88% of respondents indicated that expected future tax increases do not influence

their saving decisions. (AHK, 1998).

Looking at historical tax cuts, Damien Echevin’s analyses the effects of the 2002 tax

cut on the French economy in his 2010 paper, “Ricardian or Spender Consumers? Evidence

from a taxpayer survey questionnairewas an important entry to determining the legitimacy of

Ricardian Equivalence. She says that due to liquidity restraints faced by households, many of

them can be considered “spender consumers” where by they spend a large portion of their tax

cut. According to Mankiw (2000), “both these realities may actually coexist: some consumers

have short-term prospects while others have longer-term ones. In the Fall of 2002, the French

households received an additional 2.6 Billion Euros, which corresponds to a 5% income tax

cut. The mean tax cut being 100 Euros, and the median was 60. Looking at those two

numbers alone, we can see that the higher income groups received a larger lump sum tax cut

than the lower income groups. The tax cut was concentrated on the top income group, where

the average tax cut was 500 euros. Furthermore, the top marginal income tax rate was

decreased by 2.6%, from 52.75% to 50.1%, whereas the lower marginal income tax was

decreased by 0.4% (from 7.5% to 7.1%). (Echevin, 2010). However, because the tax cut has

been applied to income tax before reductions and credits which benefit lower income

households, it changed from regressive to slightly progressive.”(Echevin, 2010).

26

The results from Echiven’s survey were as follows: “As seen on table 3, among the

households who benefit from the income tax cut, 669 (52.6%) state that they have spent this

money on consumption while 99 (7.8%) say they have saved it; 63 (5.0%) say they have used

it both for consuming and saving, while 75 (5.9%) have used it for other purposes; 356

(28.8%) do not know. Most of the households answer that they have consumed the tax cut,

while another significant share say they don’t know how they have spent it.” (P.4, Echevin,

2010).

The main problem I have with Echevin’s method is the way she dealt with the nonresponses.

The group of people who answered that they “don’t know” what to do with the money were

split equally into the various groups. This method tends to artificially inflate the lower

numbers. She should have omitted those responses as they are not helpful in assessing the

impact of the tax cut, or she should have split the responses proportionally to how the others

responded (which would yield the same result as my first suggestion, as the percentages

would not change). For simplicity, if we drop the last two groups in her survey, we are only

left with those who responded that they would spend it, or save it. The 3rd group can be split

equally since they are both saving and spending half. This would yield the following results:

Spend on Private Consumption

84.24% 700

Save it 15.76% 131Total 100% 831

Echevin’s results yielded 81.5% of consumers that would spend the tax cut, which is

close to my approximation of her data: 84.24%. Compared to other similar studies, a figure of

81-84% is quite large. For instance, using the same methodology, “Shapiro and

Slemrod(1995) also find evidence of a large response to the 1992 US tax cut with 48 per cent

of the respondents who planned to mostly spend the tax cut, while according to Shapiro and

27

Slemrod (2003a) only 21 per cent planned to spend the 2001 US tax cut.” (Echevin 2010).Of

course, no two tax cuts are equal and many factors can come into play when determining the

effectiveness of the policy. Factors such as the economic environment at the time it was

issued, as well as which groups were targeted play a very important role in the repercussions

of the tax cut. Of particular importance is the Marginal Propensity to Consume (MPC) of the

individual, but we will explore that in detail later.

The findings are quite interesting, but what happens when the lump sum tax cut is a

larger amount? Echevin conducted a similar survey, this time testing household behavior

when the tax cut in question was equal to 10% of their annual income. The results can be

seen in the table below.

These results favor Barro’sRicardianEquivelence hypothesis more so than the previous

survey because the number of respondents that would save the money has increased

significantly. I would have liked to see a follow-up question asking how long the household

would save the money, because if they only save it for a few months to a year, then it would

still boost short-term economic growth. Echevin notes that, in consistency with the life-cycle

hypothesis, households headed by older individuals appear to consume a larger share of the

tax cut,” and, “contrary to what is conventionally believed, there is evidence that lower-

income households save a larger proportion of the tax cut, all the more so when the tax cut is

small.” (P.8, Echevin, 2010). These results are significant, and it leads me to believe that if a

policymakers wanted to boost consumption using a tax cut, it may yield better results if the

tax cut was a small amount, or if they wanted an even larger boost, they could try giving

small lump sums in intervals, say every few months, instead of one large amount. What truly

surprises me is the way that the low income groups responded. Would they really save the

money when they are living on the border of poverty? I only wish we could have seen a

28

follow-up question because this goes against logic and observed behavior. Perhaps most of

these people would save the money until the end of the month and use it to pay bills.

Unfortunately, Echiven’s survey was not detailed enough to account for this behavior and,

according to her, they act as Ricardian Consumers.

C) Method and Methodology

When deciding on the optimal method for my research, I had tworeal choices. The

first choice was to use econometrics. Among this first choice, there were also choices as to

which variables would be tested:

1.a) One way was to find various macroeconomic data on consumption and fiscal policy and

to run a regression and analyse the data, attempting to determine if a reduction in taxes (or an

increase in government spending) led to an increase in consumption, and if it did, how large

the multiplier was.

1.b) A similar approach to this method would involve different variables, this time analysing

data on government debt and savings, and whether an increase in government debt leads to an

increase in savings. If savings increases with government debt then we could see evidence of

Ricardian consumer effects.

1.c) I also could have run a regression testing whether deficits increase the real interest rate.

1.d) Finally, I could have tested the twin deficits hypothesis to see if a current account deficit

led to a trade deficit.

Choice 2):The other choice was to orchestrate a survey asking specific questions directly to

consumers about their behaviour.

I had to compare the benefits and shortcomings of each method in order to decide on my

method.

The first method (and all its sub-choices) involves econometrics, which has been the

preferred choice for empirical economic research, and especially for macroeconomics. This is

due to macroeconomic data becoming more widely available, and innovations in econometric

methods that allow it to be more accurate. However econometric methods still exhibit many

problems. I’m not referring to the problems of heterogeneity, spurious regressions, or omitted

variable bias, but a more philosophical problem. Usually in statistical methods, one presents a

hypothesis and attempt to prove it false. If unable to prove it false, they do not dismiss the

29

null hypothesis. However, “..do subsequent observations of confirming evidence necessarily

increase the confidence in the general statement as opposed to its denial?” (Boland,

1982).Boland uses the example of testing the hypothesis that “all swans are white.” He argues

that the confirmation criteria of conventionalists would have us believe that each past

observation of white swans will necessarily increase the likelihood that next swan found will

be white.(Boland 1982). “This alleged necessity is based on a prior, and unsupported,

assumption that the general statement is true.” In other words, “you will see confirming

evidence for your empirical generalizations only because you have already assumed they are

true!” (Boland, 1982). Boland speaks at length about the “Conventionalists” and their

“Criterion of Confirmability” and since I’ve mentioned them, an explanation is in order.

Conventionalism as a methodology in economics gained popularity after general

agreement over the glaring problem with Induction, which was “finding a general method of

providing an inductive proof for anyone’s claim to empirical knowledge.” (Boland, 1982).

Induction includes the Positive/Normative debate, in other words should we attempt to

present only empirical evidence (positive), or suggest solutions to problems (normative). The

problem of induction was made clearer after Newtonian physics (which was inductively

proven) turned out to be possibly untrue. Therefore a retreat to conventionalism took place,

especially among neoclassical economists. Conventionalism is not concerned with absolute

truth, but instead looks at a conditional deductive argument for why the chosen theory is a

“best” theory available.(Boland, 1982). But how do we measure the “best” theory? This leads

to the problem with conventionalism: “the problem of finding generally acceptable criteria

upon which to base any contingent, deductive proof, or any claim to knowledge.” (Boland,

1982). The most widely used criterion is confirmability. In other words, if we can observe, or

confirm, a theory in the real world, then we can say it is confirmed (although not necessarily

true). (Boland, 1982). A highly confirmed theory, such as the white swan example, can still

be false in the presence of a black swan. The reason that this philosophical debate is so

important is because the criterion for confirmability is so widely used in econometrics.

Another problem with conventionalism occurs when choosing the “best theory/model”

for a particular hypothesis. “The central difficulty is that several different models may all

seem reasonable given the data, but lead to very different conclusions about the parameters of

interest. In these circumstances, presenting the results of a single preferred model can often

be misleading. It leads the reader to underestimate the uncertainty actually present about the

30

parameters, because the reader is rarely made aware of the inevitable uncertainty surrounding

the form of the model.” (Temple, 1999).Other problems in econometrics have to do with

regression analysis. If two variables move together over time, we must assume a lot to infer

that one is causing the other to move. How many other possible variables have an effect on

that particular variable, and have we discovered all of them? Of course we can measure the

degree of confidence with a particular variable by looking at the error term, but what if there

are problems with the data, or proper measurement of the variables? For example, Seater

(1993) makes the argument that instead of using data for a country’s total deficit (including

local and state debt), much of the empirical work surrounding Ricardian Equivalence only

specifies the federal deficits. (Seater, 1993).Perhaps looking at macro data is the wrong

method in determining how consumers behave, and asking them directly would provide a

more accurate answer. With that, I decided that econometrics contained too many problems,

inherently within it, so I chose to conduct a survey as my empirical method.

However, a survey method is also guilty of presenting results in a manner of

confirmation and also exhibited other problems as well. I am assuming those taking the

survey will not only answer the questions honestly, but will actually follow the behaviour that

they indicated in the survey. For example, someone could have the intention of saving a

bonus received from their employer, but when it actually occurs, they may very well lack the

self-control and spend it immediately. There could be a potential problem with the sample I

choose not properly reflecting the population. However all things considered, I still feel that a

survey method exhibits fewer problems than econometric methods.

The beauty of the survey method is that we are not required to assume anything about

consumer behavior. Debating whether consumers are farsighted, rational, consumption

smoothing, perfectly informed, or altruistic is a completely avoidable process in a survey

because the hypothesis is tested directly. I would argue a survey method is the most direct

test because different consumers may behave in different ways due to their specific

philosophy (such as being farsighted, altruistic, etc. or any combination), therefore lumping

all consumers into a specific category (for example farsighted), is unnecessary and avoidable

because we are testing behavior directly. This allows the survey method to accurately

represent a population without making unrealistic assumptions about the entire populace.

Now I had to choose the type of survey, and I chose to conduct a face-to-face survey

around Bristol, England. I was lucky to have studied in England because if I had conducted a

31

face-to-face survey in my hometown of San Diego, California, I don’t think the results would

accurately reflect the population. This is because I conducted the survey mainly outdoors,

usually on the sidewalks during a sunny period in England. Because nice weather is so rare in

England, a great deal of the population comes out into the sun. In California, nice weather is

very common, so those who normally stay indoors will continue to stay indoors. Combine

that with the fact that most people drive in America, results in a very limited sidewalk

survey.Statistical concerns for representative sampling caused me to chose a variety of

locations for my survey, over various hours throughout the day. Since a significant proportion

of the population may be working during daytime hours, I included employees of various

retail outlets. In addition I took some surveys during the weekends as well.

Advantages of a face-to-face interview include the following: enhancing respondent’s

participation, answering the respondent’s questions, clarifying the meaning of questions and

responses, making sure the questionnaire is answered in the correct order and by the

respondent herself/himself. (Troitzsch, 2006).

Disadvantages to a face-to-face interview as opposed to other types of survey methods

include the fact that it is difficult to maintain anonymity and difficult to ensure

confidentiality. However in regards to my particular survey, this is not a concern because I

didn’t ask the respondent’s name or any personal questions (ie: address, phone number, etc.).

Another disadvantage stems from the interviewer effects that occur during face-to-face

interviews. This includes subtle visual cues from the interviewer that may influence the

respondent’s answers. Although this behaviour is often difficult to control, I tried to maintain

a completely neutral visual position when asking my questions. Another disadvantage is that

the interviewer can interject values or expectations: “The interviewer may change the

wording of a question or of response choices slightly, or in clarifying them, distort them.

Telephone interviewing can be better supervised and is less prone to these distortions.” (p.

77, Troitzsch, 2006). Again, this problem has been addressed because of the way I designed

my survey. Half of the sample were asked if they would save or spend a tax cut, while the

other half were asked if they would spend or save it. Note that the positions of the words

“spend” and “save” were swapped for 50% of the sample in order to reduce interviewer bias.

Now that my empirical method was chosen, I want to highlight some methodological

debates in which much of my critiques regarding the Ricardian Equivalence stem from.

32

Milton Friedman’s contribution to economic methodology was his emphasis on a model’s

ability to predict. Whether or not its assumptions were realistic was not important. “More

than thirty years ago I noted that economists could be divided into two groups: Those that

agreed with Freidman’s [methodological] essay and those that did not. Given the

overwhelming dominate emphasis on formal mathematical model building in today’s

graduate schools, we are considered free now to assume whatever we want so long as we are

explicit and the result is a mathematically tractable model. With this in mind, it should be

clear to everyone that today the latter group has become very small.” (P. 4-5, Boland, 2003)

I personally belong in the latter group. I don’t have very much faith in most basic

economic models due to their unrealistic assumptions, and detachment from the real world.

For example, why spend a significant portion of introductory economics courses teaching

theories based on perfect competition, when perfect competition is rarely observable in the

real world? I see these models being useful as elementary teaching aids, but I feel that a better

method of teaching would involve examining real world examples and breaking them down,

in other words, a top-down approach. Secondly, emphasis should be placed on the majority of

the population, such as the welfare of the majority of consumers. For example, too much of

economics is concerned with exceptions to the rule. The Ricardian equivalence itself is based

on an exception that consumers will rationally anticipate a future tax increase (as shown by

my own study). Before any theory is taken seriously, we ought to conduct a study

determining if the majority of the population do in fact behave as the theory suggests. If not,

then how large is the proportion that does? We can use this data for policy decisions, and to

compare policy options. For example, because so much of economics today is based on

theory being backed by mathematical models, often with assumptions which are detached

from reality, we have policymakers who don’t believe in involuntary unemployment, ones

who consider the majority of the population as forward looking, rational, and perfectly

informed, and those that believe perfect capital markets exist. If they don’t believe in these

assumptions, but back the theories that incorporate them, then they themselves are examples

of individuals that are not perfectly informed.

33

When analysing the paragraph above, you can see some of my implicit assumptions

and methodological approach. I believe the majority of people to be honesthence I favour

studies based on face-to-face surveys.I don’t believe all employment is voluntary because I

myself, as well as many people I’ve spoken with, have been involuntarily unemployed. I

don’t think consumers are perfectly informed, and I don’t believe perfect capital markets

exist (if you check the assumptions section in the Literature review, you can see why). I have

little faith in mathematical models because, while numbers cannot lie, the people creating

these models can represent an idea, no matter how unrealistic, false or otherwise

insignificant, with the correct mathematical model, and while, they are proficient in

mathematics, the theory backing it can often be very poor. As Deirdre McCloskey put it,

“The progress of economic science has been seriously damaged. You can’t believe anything

that comes out of [it]. Not a word. It is all nonsense, which future generations of economists

are going to have to do all over again. Most of what appears in the best journals of economics

is unscientific rubbish.I find this unspeakably sad. All my friends, my dear, dear friends in

economics, have been wasting their time.They are vigorous, difficult, demanding activities,

like hard chess problems. But they are worthless as science."(McCloskey, 2002). McCloskey

observed, as I have, that actual inquiry into the world (which is a fundamental principle of

science), is rarely taking place in economics. However, unlike McCloskey, I believe there is

still hope for the future of economics. By placing such a strong emphasis on a model’s

assumptions, and how well it reflects the real world, we can start to rebuild the foundations of

economics.

D) Results

I carried out a survey to see how consumers would behave if a lump sum tax cut was

put into place. In my survey, I specifically designed it to be as simple as possible so I do not

confuse the general public with complex economic vocabulary or theory.120 people split into

2 groups were asked to take a face-to-face survey. Response rates were close to 95%, with

very few people refusing to participate in this quick survey. These people were asked in a

variety of locations around Bristol, England. Locations include a supermarket, a bank, a

shopping mall, a pedestrian crossing area outside a city counsel building, a gym, and a local

park. The survey was conducted at various times from 10am to 6pm. The first 60 were asked

34

the following: “If the government gave a tax cut in the form of a lump sum of 500 pounds4,

would you save or spend it?”

The second group of 60 were asked the same question except that the words “save” and

“spend” had their positions swapped. I designed the survey in this manner in order to reduce

potential bias because whichever word is spoken first can have a psychologically

manipulative effect on the participants.It’s important to note that the first group who were

asked the question with “save” appearing first were more likely to save than the second

group. This brings into question the validity of former studies done on the subject when

asking participants a uniform question. I believe my 50/50 double question format is

preferable, as there is no possible way to ask a single question like this without causing bias.

If the person said that they would save the money, a follow up question was asked in

order to ascertain the length of time they would save it for. This is my main contribution to

the field, and I feel that it’s significant because if the person spends the money within one

year of obtaining it, it will still affect short-term growth (although obviously it will suffer

from more lag-time). Other similar studies do not specify the length of time that consumers

will save the tax cut. This can often lead to falsely classifying consumers as Ricardian, which

in this case would mean that they save the tax cut until a future tax rise goes into effect. Most

importantly for policymakers, however, is the need to boost short-term growth during a

recession, and if the money is spent in the short-term, it will affect short-term growth. Some

may criticise my method of classification for savings, however, by asking a consumer how

long they will save a tax cut, it accomplishes three goals. 1) I am forcing them to consider

their intertemporal budget constraints as well as their expectations of their own future

income, therefore, if they are still willing to spend the money in this frame of mind, there is

no reason to believe they would save it otherwise. 2) I’m checking to see if there’s a

significant difference between short-term savers and savers in general, and as it turns out,

there is. 3) I’m measuring dynamic actions as opposed to static. The effects of any policy,

fiscal other otherwise, are not immediate, therefore why have previous survey literature only

measured static savings data? I noticed a gap in the literature and decided to provide a more

detailed choice for consumers.

4Great British Pounds (GBP) currency.

35

Of the 120 survey participants, 76 would spend the tax cutimmediately, 44 decided to

save the money, however, 36 of those people said they would spend the money within 1 year

of receiving it. Only 8 people total said they would save the money for over a year.

Spend Save (Less than 1 year) Save (More than 1 year)76 36 863.33% 30% 6.67%

Spend63%

Save (less than 1 year)30%

Save (more than 1 year)7%

Consumers' Response

SpendSave (less than 1 year)Save (more than 1 year)

These results are significant in the sense that they directly conflict with Barro’s

theories of RicardianEquivalence. In fact, only 6.67% of participants would behave as Barro

predicted.Even if we assume a 25% liquidity constrained population who are required to

increase spending due to their liquidity constraints, that still leaves 73% of the population

behaving in a manner opposite to Ricardian. To put it into perspective, Echevin’s results

indicated 81% would spend. Again, assuming 25% of the population are liquidity

constrained, then we have 56% of the population behaving in a manner opposite to Ricardian.

I attribute the difference in numbers between Echevin’s survey and my own due to the more

detailed classification of my “savings” response (saving more than 1 year).

It’s important to note that not one person answered that they would save money

because they feltthat a future tax rise was eminent. They behaved as if they had just received

36

extra disposable income. Those that would normally save their extra disposable income

answered that they would save, and those that would normally spend answered accordingly.

The fact that this new income comes from the government seems irrelevant to the

participants, and has little to no affect on their behaviour. I did not comment on whether the

tax cuts were temporary or permanent because most people are unaware of the details of tax

cuts. Even if a policymaker puts a permanent tax cut into place, a future administration can

implement a tax raise. Similarly, if a temporary tax cut is put into place, it can always be

extended indefinitely. I attempted to reflect the current state of affairs in terms of the public’s

knowledge on government policy. The aim was to design my study to be as realistic as

possible, to mimic reality. I refused to make the unrealistic assumption of perfect

information, and more importantly, “perfect future information” and my questions were

structured with that in mind.

Many of the people who answered that they would spend the money also stated that

they would spend it on things that they actually need, such as bills, debt, and transportation

costs. I also noted that of the people who saved the money for over a year, 5 of the 8 were

wearing business suits. This suggests, that they are possibly making a relatively higher

income than the majority, and therefore have no need for the 500 pounds now. If that is true it

complies with basic economic theory of higher income groups having a lower Marginal

Propensity to Consume (MPC). Although again, this was simply an inference and there was

not sufficient evidence to prove their income.

In order to investigate the possibility that the source of the funds could affect the

consumer’s MPC, a second survey was conducted. This time I changed the question to the

following: “If your employer gave you a 500 pound bonus, would you spend it or save it?”

Just like before, I asked 60 people the question above, and another 60 people a similar

question in which the words “spend” and “save” swapped positions, in order to reduce bias.

The results were very similar to the first survey, except for the fact that a few people were

unemployed. I instructed them to answer the question as if they were employed (such as a

previous job, or potential job), which they had no problem complying with.

37

Of the 120 survey participants, 73 would spend the money immediately, 47 decided to

save the money, however, 35 of those people said they would spend the money within 1 year

of receiving it. Only 12 people total said they would save the money for over a year.

Spend Save (Less than 1 year) Save (More than 1 year)73 47 1260.83% 39.17% 10%

60.83%39.17%

10.00%

Consumers' Response (private sector bonus)

SpendSave (less than 1 year)Save (more than 1 year)

Looking at the numbers from both surveys, we see very similar results. Robert Barro, in

compliance with his theory, would have predicted that if the source of funds had arisen from

a tax cut, that we would expect to see more people save it because they would anticipate a

future tax rise. My results indicate that this is certainly not the case. Comparing the amount of

people that save in both surveys, we see more people saving the money (for over 1 year) if it

had come from an increase in their private income (10%) as opposed to if it had come from a

tax cut (6.67%).

As stated by Henning Bohn (1992), “The marginal propensity to consume income

obtained from a tax cut can take any value between zero and the marginal propensity to

consume out of ordinary income.” (P. 589, Bohn, 1992). And the results indicate a value very

close to being equal to the MPC out of ordinary income.In both scenarios most people would

spend the money immediately, while still a significant portion would save it for less than 1

38

year, and a small percentage would save it long-term. As previously stated, as long as

consumers spend the money within 1 year, it should help boost short-term growth, although

the lag time will increase depending on how quickly they consume it.

Therefore, if policymakers were to design a tax cut to boost economic growth during

a recession, according to my results, it would seem that the most effective tax cut would

target low-income groups. This is because low-income groups have the highest marginal

propensity to consume out of ordinary income. (Hugget and Ventura, 2000). This is

observable due to their low savings rates, and the largeproportion of the group that are

liquidity constrained. What I have shown is that the marginal propensity to consume income

obtained from a tax cut is nearly identical to the MPC out of ordinary income. Therefore, if

policymakers were to design a tax cut to boost economic growth during a recession, the most

effective tax cut would target those who were most likely to spend it: low-income groups.

E) Conclusion

The most important elements in my analysis of the Ricardian Equivalence are the

assumptions associated with it. Robert Barro assumed that consumers would react to fiscal

spending funded by government debtby smoothing consumption (in anticipation of a future

tax increase) so far into the future that it would affect their bequests for their children. I have

shown that consumers do not, in fact, behave as Barro assumed. Supporters of Ricardian

Equivalence acknowledge the fact that these assumptions may not reflect reality, however

they continue to claim that Ricardian Equivalence is still a good approximation of reality, and

that it's a good place to start when discussing government debt. (Seater, 1993). My question

then is; why would it be a good place to start when it has a multitude of conditions attached

to it? Econometric results have been mixed, and I attribute that to the nature of econometric

techniques in general. My survey method was created to reflect reality, and I believe that type

of methodology is where we should start when discussing consumer behaviour in response to

government debt.

The results of my survey suggest consumers will treat a tax cut as an increase in

disposable income. In other words, those that are more likely to spend an income bonus will

spend a tax cut, and those most likely to save (ie: high income individuals) will save it.

39

Therefore fiscal policy should not be dismissed due to Ricardian effects, as long as the

policies in question target the correct demographic.

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