Ragbralbur
24-11-2006, 07:39
In The Principles of the Political Economy and Taxation, David Ricardo develops what a system of equivalence based on expectations that has come to be known as Ricardian Equivalence. Interestingly enough, it has never been completely clear whether or not Ricardo believed it was true in practice or just had interesting implications. It was not until Robert Barro reworked the theory and republished it 150 years later that it was pushed back to the forefront of modern macroeconomic theory.
So what is Ricardian Equivalence? Basically, Ricardo analyzed that the government could either pay for its spending now or buying borrowing money to be repaid in the future. Regardless, the present value of the money would have to be the same. The question was whether it was paid now or delayed. Some had maintained that by the government spending money now and paying it back later, they could grow the economy enough that it would cover its costs later. Basically, the government would leverage itself like a common firm.
Ricardo thought otherwise. The average person, he reasoned, is rational. Any spending by the government that isn't paid for immediately will have to be paid for at some point in the future. Thus, he reasoned, individuals will use the money provided by the government at the current time to save up in anticipation of the future taxes they know they will have to pay. The logical conclusion of this line of thought is that government spending has no positive effect on output either way, as it is either paid for immediately by taxes, or compensated for by individuals saving up for future taxes.
As nice as this theory is in terms of supporting free market policies over government demand management, I recently came across a flaw in its logic. Simply put, people die. If you probably won't be paying these future taxes for several years and you are 95, you likely won't bother to save the government's extra money to pay off taxes. Normally, the other rational individuals in society would factor this in and save more than just their share of the original pay-out to compensate for the government not being able to collect taxes from dead people. However, not all of these future taxpayers exist, as some of them likely have not been born yet. In many cases, children are born unexpectedly, and in many other cases, people die without any heirs. This results in an imperfect compensation. Therefore, some of the government's original pay-out is used to stimulate the economy and not factored in by all the individuals in society.
That said, this theory only explains minor fluctuations in Ricardian Equivalence. The theory itself is still mostly true, which means that output, while not completely unresponsive, is rather inelastic in terms of fiscal policy. However, sometimes things outside of the usual realm of factors for economic theory need to be considered. I believe this is one of those times.
So what is Ricardian Equivalence? Basically, Ricardo analyzed that the government could either pay for its spending now or buying borrowing money to be repaid in the future. Regardless, the present value of the money would have to be the same. The question was whether it was paid now or delayed. Some had maintained that by the government spending money now and paying it back later, they could grow the economy enough that it would cover its costs later. Basically, the government would leverage itself like a common firm.
Ricardo thought otherwise. The average person, he reasoned, is rational. Any spending by the government that isn't paid for immediately will have to be paid for at some point in the future. Thus, he reasoned, individuals will use the money provided by the government at the current time to save up in anticipation of the future taxes they know they will have to pay. The logical conclusion of this line of thought is that government spending has no positive effect on output either way, as it is either paid for immediately by taxes, or compensated for by individuals saving up for future taxes.
As nice as this theory is in terms of supporting free market policies over government demand management, I recently came across a flaw in its logic. Simply put, people die. If you probably won't be paying these future taxes for several years and you are 95, you likely won't bother to save the government's extra money to pay off taxes. Normally, the other rational individuals in society would factor this in and save more than just their share of the original pay-out to compensate for the government not being able to collect taxes from dead people. However, not all of these future taxpayers exist, as some of them likely have not been born yet. In many cases, children are born unexpectedly, and in many other cases, people die without any heirs. This results in an imperfect compensation. Therefore, some of the government's original pay-out is used to stimulate the economy and not factored in by all the individuals in society.
That said, this theory only explains minor fluctuations in Ricardian Equivalence. The theory itself is still mostly true, which means that output, while not completely unresponsive, is rather inelastic in terms of fiscal policy. However, sometimes things outside of the usual realm of factors for economic theory need to be considered. I believe this is one of those times.