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Morgan Rose

Does It Matter How You Pay for a State Dinner? A Lesson on Ricardian Equivalence

Morgan Rose*

Imagine that you are in complete control of the finances of Freedonia. You are the fiscal authority in the country, with final say over all of the taxing and spending the government does. If so much as a can of soup is to be bought, the decision has to go through you.

While we're imagining, let's suppose that, due to your almost superhuman ability and discipline, Freedonia's total spending exactly equals its total tax revenues, a perfect balance. But even the best laid plans sometimes go awry, and you have just realized that there are some additional purchases the government needs to make right away—maybe $1,000 worth of food and decorations needs to be bought for a hastily-planned state dinner. You now have a decision to make. Will you impose a special new tax to cover this extra spending, or will you leave taxes as they are and issue $1,000 of government debt? In other words, will you finance through taxation or borrowing? Being a responsible leader, you want to choose the option that will be less painful for the loyal and hardworking Freedonian people. But which one is it?

Almost 200 years ago, David Ricardo gave an answer to that question. Although his original writing on the subject involves a somewhat separate question, the economic intuition behind his answer applies directly to your quandary, as well as to the unending concerns about the handling of government deficits in any number of countries that actually are on the map. In Ricardo's view, it does not matter whether you choose debt financing or tax financing, because the outcome will be the same in either case. Flip a coin if you like, because in terms of the final results, raising taxes by $1,000 is equivalent to the government borrowing $1,000. This concept, appropriately called "Ricardian equivalence," may be unfamiliar and counterintuitive. The key to understanding it is recognizing that debt financing is essentially just future taxation. If a government issues a bond today to avoid raising taxes, it will need to raise taxes tomorrow to pay off the bond when it comes due. According to Ricardo's argument, it makes no difference to the public whether those increased taxes will come sooner (tax financing) or later (debt financing).

Let's see how Ricardo's reasoning applies to Freedonia. Assume you can either impose $1,000 in taxes now to pay for that state dinner, or you can issue $1,000 of government debt, payable in one year for, let's say, 10% interest. If you go with the taxes, Freedonians have $1,000 less to spend today. That's straightforward enough.

If, on the other hand, you go with the debt, then Freedonians, being a savvy bunch who've seen this debt financing in action before, realize that in one year, it will be time for you to pay back the people who buy the government debt. You will owe those people $1,000 plus $100 in interest, for a total of $1,100. Freedonians know that money must come from somewhere, so they expect that in one year, their taxes will go up by $1,100. In order to be ready for that one year from now, they put $1,000 into saving today, earning 10% interest, so that they will have the $1,100 they will need.1 This is $1,000 dollars today that they cannot spend today or save for reasons other than paying future taxes, so the outcome is that Freedonians have $1,000 less to spend today, just like they do if you raise taxes today.

The actual example Ricardo wrote about is slightly different, involving a tax being imposed against a manufacturer and looking at the price a customer would need to pay for the manufacturer's product at the end of the year under the two situations. Ricardo reasoned that if "Government delayed receiving the tax for one year... it would, perhaps, be obliged to issue an Exchequer bill bearing interest, and it would pay as much for interest as the consumer would save in price." Even though his example is a bit more complicated than the choice facing Freedonia, the conclusion is the same.

James M. Buchanan and Richard E. Wagner, in Chapter 9, paragraph 26 of Democracy in Deficit: The Political Legacy of Lord Keynes (1977), also discuss Ricardian equivalence, with their example involving a permanent increase in government debt rather than a debt issue lasting only one year, but their conclusion is similar: "The imposition of a tax directly reduces the net worth of the taxpayer, but the issue of an equivalent amount of government debt generates an equal reduction in net worth because of the future tax liabilities that are required to service and to amortize the debt that is created." Again, the fundamental insight is that debt is not so much an alternative to taxes as an alternative timing of taxes.

 

For more detail on Ricardian equivalence and an example in a two-period model, see Marc Law and Jason Clemens's essay, The Ricardian Equivalence Theorem: Back to the Future? on the Fraser Institute website.

In the 1970s, Buchanan participated in a protracted debate, carried out in a flurry of papers written by him and others, over how far the implications of Ricardian equivalence can be extended.2 The main issue of contention was whether, given that debt financing is simply a means of postponing taxes, people's behavior really will be such that the outcomes from debt financing and tax financing will be the same. In particular, to what extent will key economic variables like interest rates and spending be different, if at all, under each of the two policy alternatives? If Ricardo's argument is correct, then no real values are affected! For a given amount of government expenditure, real interest rates, real income, real savings, and real private utilities and welfare, are unaffected by the government's choice between current and future taxes.

During the course of that debate, Buchanan and others pointed out that while the fundamental insight of Ricardian equivalence is true, many of the assumptions that must be true for outcomes to be exactly the same are questionable in real world situations. (Some of the following points are expressed by Buchanan and Wagner.)

1. For instance, there must be complete access to perfect capital markets so that all of the required saving and borrowing can be accomplished without friction, and people must be able to borrow at the same interest rate at which the government borrows, or the equivalence breaks down.

2. Additionally, people must care about what happens in the future, when the government debt will be repaid. If the future taxes only will apply so far in the future that the person will be dead, why save now? But if people refuse to offer to save more now, then offered savings in the economy are reduced, so interest rates would have to be higher if the government tried to borrow than if it taxed people directly today. Thus, it is assumed that either all people live long enough to see the debt be repaid, or they have children (that the parents care about and to whom they leave sufficient bequests) who will live to see that day.

3. Even if these requirements are satisfied, people must also recognize the equivalence between tax finance and debt finance in order to act accordingly. This may be the most tenuous assumption required—regardless of how fine the Freedonian educational system is, it is unlikely that public debt theory and present value calculations are included in basic, compulsory schooling.

Through this debate, several good arguments supporting and contradicting the implications of Ricardian equivalence have emerged.3 As a result, determining the practical policy consequences of Ricardian equivalence boils down to an empirical issue, and it is possible that even if the equivalence of outcomes from tax finance and from debt finance does not strictly hold, the disparity between those outcomes is not a profound one. In any case, the fundamental insight Ricardo provided so long ago, that the choice of debt versus taxes is one of timing, remains valid—something to keep in mind when considering government finances and tax policy, whether you are reading the paper, watching the news, or ruling a country.


Footnotes
1.

If you are worried that the citizens can't possibly earn 10% interest, then relax. Recall that by our assumption the government simultaneously has to paysomeone 10% in interest. When the government sells its bonds, offering 10% interest, the citizen can buy them and get the very same 10% interest. When people accept lower interest rates for their savings, it is often because they are paying for services such as their bank's dealing for them with the complexities of the government bond market technicalities. They are still getting 10% interest, and then using some of it to buy other services.

2.

For example, see Robert J. Barro, "Are Government Bonds Net Wealth?" The Journal of Political Economy, Volume 82, Issue 6 (Nov.-Dec. 1974), pp. 1095-1117, and Martin Feldstein, "Perceived Wealth in Bonds and Social Security: A Comment," James M. Buchanan, "Barro on the Ricardian Equivalence Theorem," and Barro, "Perceived Wealth in Bonds and Social Security and the Ricardian Equivalence Theorem: Reply to Feldstein and Buchanan," all three from The Journal of Political Economy, Volume 84, Issue 2 (Apr. 1976).

3.

For a summary of the arguments, see B. Douglas Bernheim, "Ricardian Equivalence: An Evaluation of Theory and Evidence," NBER Macroeconomics Annual 2, pp. 263-303.


*Morgan Rose is a Ph.D. candidate in economics at Washington University in St. Louis, with research interests in industrial organization, corporate governance and economic history.

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