Economic policy
David Ricardo (1772–1823)
1799 Britain introduces income tax during war with revolutionary France. Public debt approaches 250 percent of national income.
1945 Following World War II, government spending, taxation, and borrowing rise in developed economies to meet new welfare commitments.
1974 US economist Robert Barro revives the idea of Ricardian equivalence, which says that people spend in the same way regardless of whether their government taxes or borrows.
2011 The European debt crisis intensifies, sparking debate about the limits of taxation and public borrowing.
Should government spending be financed by borrowing or taxation? This question was first addressed in detail by British economist David Ricardo during Britain’s expensive Napoleonic wars against France (1799–1815). In his 1817 book Principles of Political Economy and Taxation, Ricardo argued that the method of financing should make no difference. Taxpayers ought to realize that government borrowing today will lead to more taxation in the future. In either case they will be taxed, so they should set aside savings that are equivalent to the amount they would have been taxed today in order to meet that eventuality. Ricardo suggested that people understand a government’s budget constraints and continue to spend in the same way regardless of its decision to tax or borrow because they know these will ultimately cost them the same. This idea became known as Ricardian equivalence.
Imagine a family with a gambling father who resorts to taking money from his sons. The father tells his sons that he will let them keep their money this month because he has borrowed from his friend Alex. The happy-go-lucky younger son, Tom, spends his extra cash. The wise older son, James, realizes that next month, Alex’s loan will have to be repaid with interest, at which point his father will probably ask him for money. James hides away today’s extra cash, knowing he will have to give it to his father in a month. James has recognized that his overall wealth hasn’t changed so he has no reason to alter his spending today.
Ricardo was theorizing, and did not suggest that Ricardian equivalence would ever be apparent in the real world. He believed that ordinary citizens suffer from the same fiscal illusion as Tom in our example, and will spend the money on hand. However, some modern economists argue that citizens suffer no such illusions.
The idea reemerged in an article by US economist Robert Barro (1944–) in 1974, and modern analysis has focused on examining the conditions under which people spend regardless of taxation or borrowing. One assumption is that people are rational decision makers and have perfect foresight; they know that spending now means taxes later. However, this is unlikely to be the case. Borrowing and lending must also take place at identical interest rates without transaction costs.
A further problem is that human life is finite. If people are self-interested, they are unlikely to care about taxes that will be imposed after they die. Barro suggested, however, that parents care about their children and often leave bequests, partly so that their children can pay any tax liabilities that arise after the parents’ deaths. In this way individuals factor into their decision making the impact of taxes that they expect to be imposed even after they die.
Ricardian equivalence, which is sometimes known as debt neutrality, is a hot topic today because of the high spending, borrowing, and taxation of modern governments. Ricardo’s insight has been used by new classical economists to argue against Keynesian policies—government spending to increase demand and drive growth. They claim that if people know that a government is spending money to lift an economy out of depression, their rational expectations will ensure they anticipate greater taxes in the future so they will not blindly respond to the increased amount of money in the system now. However, the practical evidence—for or against—is inconclusive.
The Greek state was forced to borrow large sums in 2011 to avoid bankruptcy. The civil unrest that followed made it clear that there are limits to how much a government can borrow and tax.
US economists Robert Barro, Robert Lucas, and Thomas Sargent formed the school of new classical macroeconomics in the early 1970s. Its key tenets are the assumption of rational expectations and market clearing—the idea that prices will spontaneously adjust to a new position of equilibrium. New classical theorists claim that this applies in the labor market: wage levels are set through the mutual adjustment of supply (number of people seeking work) and demand (number of people needed). Under this view everyone who wants to work can, if they accept the “going wage.” Therefore, all unemployment is voluntary. Rational expectations claims that people look to the future as well as the past when making decisions so they cannot be fooled by a government when it chooses to borrow or tax.