In defense of Ricardian equivalence – sort of

On his blog, Dr Mankiw titled a post “so much for Ricardian equivalence” after noticing that US retail recovered following the government rebates. This off the cuff statement comes from the fact that the government rebate also had no reduction in the long-term level of spending, and so “in theory” consumers will have saved all the tax rebate, realising that they will have to pay this tax later anyway.

The excellent division of labour blog then takes this claim to task stating that the income tax rebate mainly went to low-middle class families, causing a common pool problem with the income tax – as the rebate is temporary, but it is not clear what form the future funding of government spending would take (although I’m not sure if this is actually a common pool problem, it just seems to be to do with giving a progressive rebate and then placing the future spending burden evenly across society, effectively increasing the net tax income of the poor who are liquidity constrained – as long as the amount the poor spends does not impact on the future need for tax income).

However, I don’t see why either side has to be wrong. Dr Mankiw know far more about Ricardian equivalence (and all economics) then I can ever hope to, and he did come up with the rule of thumb consumer argument (*).

Fundamentally, Dr Mankiw is only saying “look, strict Ricardian equivalence does not hold”. Liquidity constraints, the better interest rates that government gets than consumers, and a little bit of intergenerational selfishness are sufficient to knock down the pillar of strict Ricardian equivalence. However, I also agree with division of labour that ultimately, putting the occurrence of additional spending down as a failure of Ricardian equivalence in general is inappropriate – and could give people the wrong impression about why economists care about Ricardian equivalence so much.

In a general sense, Ricardian equivalence tells us that if the government decides it wants to spend outside its means, the tax payer, as the ultimate financier of government activity, will have to pick up the debt at some point. Although liquidity constraints and bounded rationality may lead to a falsification of the strictest form of Ricardian equivalence, the idea is still vitally important when analysing long-term government fiscal positions.

Take New Zealand for an example. Our government raised more in taxes than it needed to spend – even in a cyclical sense. This lead to the belief in the public that tax cuts must come – the government cannot run a perpetual surplus. As a result, New Zealand consumers borrowed from overseas (in order to smooth their lifetime income) leading to a deterioration in our current account deficit. It will be interesting to see what happens to our current account deficit as the recent tax cuts come into play.