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December 12, 2008
Ricardian Equivalence
By Wade Rousse
Recently, there has been a lot of talk about the economic policies the new administration may quickly implement once in office. I’ve heard utterances of tax cuts for the middle class, and an increase in infrastructure spending, to name just a couple. One thing is for certain. Both will increase the government’s debt.
In this posting, let’s discuss the middle class tax cuts. It’s interesting to think about the different economic theories that lie beneath this policy. The traditional view of this type of government program, which “temporarily” increases the budget deficit, is that consumers will respond to their increase in after-tax income by spending more. As a result, this increase in spending will help the overall economy.
But let’s consider an alternative view. It’s called Ricardian Equivalence. Here, consumers are forward-looking. They consider their current incomes, as well as their future incomes, when making consumption decisions. Realizing that the government seldom reduces spending, consumers know that their increase in current income will be offset by a reduction in future income because the government must eventually raise taxes to re-pay the increased budget deficit. As a result, consumers do not spend more. Therefore, a person who subscribes to Ricardian Equivalence believes a middle-class tax cut would not affect the overall economy.
I’m curious as to which one of these views do you think is correct? In addition, how forward-looking do you think consumers really are?
Posted by Wade at December 12, 2008 6:47 PM
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