Nova workboard

a blog from young economists at Nova SBE

Ricardo Vs Reagan: theory Vs practice

The Ricardian Equivalence is a proposition by Ricardo and Barro stating the timing of lump-sum taxes does not matter for consumer spending, so temporary tax cuts will not expand spending (unchanged demand) because what consumers consider is the present value of their after-tax income. Once the government announces a tax cut, while keeping or even increasing government spending (i.e. the theory requires the cut not be offset by government spending cuts), consumers see their disposable income increase, ultimately increasing their spending (boosting demand and consequently the economy). However, as individuals are considered rational, they perceive the government must raise debt currently if it is raising investment meanwhile cutting taxes, which implies in the future, to repay its debt, the government will increase taxes. Therefore, if consumers are aware of this process and its implications, the Ricardian Equivalence predicts an increase in savings rather than an increase in expenditure in the period of the tax cutting to finance the future period of increased taxation.

The timing of this discussion could not be better as following the 2008 economic crisis, economists started returning to more Keynesian economic approaches [1] (demand driven), truly observed during President Obama´s mandates, in which payroll taxes were cut in $120 billion as part of a $787 billion economic stimulus package launched [2]. However, the results of these policies, by 2009, were rather disappointing the administration, as taxpayers were saving most of what they got through the tax cut (for each “new government dollar, consumer spending rose just 8 cents”) and giving some space for Ricardo´s theory to shine [3]. Now, with a republican administration, the economic stimulus proposals surely will come from the supply side, as for example, the proposal to cut corporate taxes from 35% to 20%, adding to lower personal income taxes, through increased deductions and less federal income tax brackets [4]. Therefore, it is important to look at the consequences of similar pursuit strategies in the past to avoid committing to future strategies that will not produce the desired effects. Baring this in mind, the following analysis will discuss the strong assumptions the model requires and their need to be relaxed once we move to the real world, leading to the failure of the Ricardian Equivalence. The empirical case of President Reagan´s pursuit supply driven economic policies (also known as Reaganomics) will be presented as a counterfactual to the theory as it had indeed unpredictable consequences by equivalence (what President Trump intends to replicate).

Poterba and Summers [5] published in 1986 a paper focusing the deficit experience lived at that moment, considering it the time par excellence to evaluate the accuracy of the Ricardian Equivalence in practice. Reagan´s presidency took place between 1981 and 1989 and so did the deficit fatten, motivated by ideology rather than economic reasons (previously deficit “obesity” had been observed, though they occurred in war periods). The primary objective of the Economic Recovery Act of 1981 was to boost investment via increased national savings [6], though the Ricardian Equivalence predicted consumers raising their savings rate, perfectly foreseeing a future tax rise, to repay in the future the acquired debt during this period. However, data summed up in Figure 1 shows just the opposite – both the failure of Ricardian Equivalence and Reagan´s prediction – with saving rates lower than in all five-year periods from 1955 (and even with further factors contributing to higher expected saving rates, as increased real interest rates with no positive impact on future income prospects) and consumption levels rising, rather than private investment increasing. The results account for possible cyclical conditions, inflation or stock market behavior impacting the reduction of the national savings, empowering the counter fact to the Ricardian Equivalence.

Sem Título.png

Figure 1 [5]

Rejecting the Ricardian Equivalence in the Reagan period does not destroy its argument. Ricardo and later Barro built the theory under several strong and unrealistic assumptions, hardly verified in the real world, so what is of interest to us is to analyse which conditions failed to hold leading to an impactful deficit based expansionary economic policy.

One relevant assumption in this debate is consumers having an infinite lifetime horizon, not allowing for debt burdens to be shifted to future generations. In practice, this could hold if there can be observed high levels of intergenerational altruism, meaning even though consumers are aware the generation benefiting from tax cut will not be the same paying for it, they value future generations´ wealth as theirs so they save to ease the future burden imposed on the younger generation rather than just maximizing their subjective utility. Despite econometric models from the Reagan period rejecting the hypothesis of this theory holding [7], different papers ([5] and [8]) point to the fact that the crowding out of investment altering national savings in the short-run has little statistical significance hence it is of “secondary importance for judging whether deficits have short-run crowding out effects, even though they are primary determinants of the long-run effects of deficits” [5] .

Secondly, the model assumes perfect foreseeing consumers with no liquidity constraints, meaning the implementation of a lower personal taxes policy should have no impact on consumption. Interestingly, Poterba and Summers [5] found evidence of households having borrowing constraints due to imperfections in the financial market, since once the tax cuts took place, consumption increased indicating consumers used the tax decrease as a form of credit. The authors also highlight two stages Reagan´s tax policy went through and that allow for the distinction of different effects: the advanced announcement of the new policy and its gradual implementation. The results display room for consumer myopia (a term used to describe some difficulty in foreseeing the economic future) as earlier announcements of tax policy were statistically insignificant for consumption changes but its actual implementation was not (if consumers understood the future implications of the announced policies, significantly statistics would show an immediate negative (positive) reaction in consumption (savings)).

The equivalence is established between lump-sum taxes and bond financing, unfaltering agents´ economic choices. However, in real life, taxes are typically a proportion of income, granting them a distortionary character, i.e. an intertemporal substitution effect is induced by which an agent, under (quasi) perfect foresight, may “decide” to work more in the lower marginal taxation period since the higher the marginal tax rate (the lower the marginal benefit of each hour worked) to compensate for a future tax rate increase and by then employ more of his hours in leisure (this trade-off option does not exist with lump-sum taxation) [9]. Having said this, leisure becomes more expensive in the first period, while consumption becomes cheaper (in concordance with the data found following the ERA of 1981)

It could even be discussed the highly demanding assumption of the model of complete markets economies in which there is no government default and debt restructuring options, resulting in unlimited credit and enabling the government to use debt as an instrument to smooth shocks. However, this does seem the most relevant point to the discussion since governments do not have to pay back their debt in the same way as families do, as they can keep on growing debt if their tax base grows faster as a means of committing to their investors. In particular, U.S.´s gross public debt keeps on growing each year and though it is not a truly complete market economy (there is a very tiny option of even the U.S. government defaulting, for example), it is one of the few world market economies with barely no difficulty in obtaining credit and hence use it as an instrument to smooth shocks.

Therefore, if we had to pin point the assumptions that most contributed to the Ricardian Equivalence failure during President Reagan´s supply side policies, the most likely candidates would be perfect foreseeing consumers with no liquidity constraints and lump-sum taxation, though it is not possible to guarantee these results, to ignore the contribution of the failure of other assumptions and to exclude the possibility of a joint effect of different variables (as some authors seem inclined to). In light of President Trump´s statement “My tax cut is the biggest since Ronald Reagan”, what should interest economic policy makers is whether U.S.´s modern conditions will allow for a savings rate increase as a result of tax cutting, and if so, how will the economic distribution vary, i.e. will savings change shift to consumption as in Reagan´s period, requiring the country to attract foreign capital flows to sustain high levels of indebtedness that will not translate into economic investment? Or will President Trump´s administration be able to give the right incentives so that the shift goes to American consumption but also and significantly to internal investment?

Margarida Castro Rego, 23848

____________________________________________________________________________________________

References:

[1]Krugman, P. (2009, September 05). How Did Economists Get It So Wrong? Retrieved from http://sweet.ua.pt/afreitas/aulas/MacroMSC/HowDidEconomistsGetItSoWrong.pdf

[2]Amadeo, K. (n.d.). What Has Obama Done? 13 Significant Accomplishments. Retrieved from https://www.thebalance.com/what-has-obama-done-11-major-accomplishments-3306158

[3]Scoffield, H. (2017, March 26). THE RICARDIAN EQUIVALENCE. Retrieved from https://www.theglobeandmail.com/report-on-business/the-ricardian-equivalence/article4278224/

[4]How your tax bracket could change under Trump’s tax plan, in two charts. Retrieved from http://www.businessinsider.com/tax-brackets-trump-tax-plan-chart-2017-9

[5]M., P. J., & H., S. L. (1986). Finite Lifetimes and the Crowding Out Effects of Budget Deficits. Retrieved from https://dspace.mit.edu/bitstream/handle/1721.1/63615/finitelifetimese00pote.pdf?sequence=1

[6]Summers, L., Carroll, C., & Blinder, A. S. (1987). Why is U.S. National Saving so Low? Brookings Papers on Economic Activity, 1987(2), 607. Retrieved from https://www.brookings.edu/wp-content/uploads/1987/06/1987b_bpea_summers_carroll_blinder.pdf

[7]The Economics of Public Debt Proceedings of a Conference Held by the International Economic Association at Stanford, California. (2014). Palgrave Macmillan. Retrieved from https://books.google.pt/books?id=KguwCwAAQBAJ&pg=PA108&lpg=PA108&dq=Boskin+and+Kotlikoff+(1985)&source=bl&ots=3EbZucsmP6&sig=5CXYmjLmBhBzCD1Agy04cRpiumA&hl=en&sa=X&ved=0ahUKEwiixZH61OPXAhVGthQKHSuiCTkQ6AEIJzAA#v=onepage&q=altruism&f=false

[8]Leiderman, L., & Blejer, M. I. (1988). Modeling and Testing Ricardian Equivalence: A Survey. Staff Papers – International Monetary Fund, 35(1), 1. Retrieved from https://link.springer.com/article/10.2307/3867275

[9] Seater, J. J. (1993). Ricardian Equivalence. Journal of Economic Literature, 31(1). Retrieved from http://www.jstor.org/stable/2728152

 

Advertisements

Author: studentnovasbe

Master student in Nova Sbe

Comments are closed.