The Ricardian Equivalence Proposition

Ever since Reagan’s trickle-down economics was established as a legitimate fiscal policy in the ’80s, there has been a constant debate about the effectiveness of tax cuts. The simplest and most common argument for more tax cuts is that they will put more money in the hands of consumers, raise total consumption, and ultimately raise aggregate demand. Unfortunately, it isn’t that simple. If it was, George Bush would be a hero.

Yeah.

David RicardoAnyway, a 19th century economist by the name of David Ricardo (1772-1823) developed a theory that addresses this very issue. His theory (later dubbed “The Ricardian Equivalence Proposition”) says that tax cuts don’t directly affect consumption because consumers internalize the government’s budget constraint and therefore plan for future tax increases. From the government’s viewpoint, when it comes to financing government spending, they have to choose to “tax now or tax later.” Financing the spending through bond sales would require a “tax later” policy to eventually pay back the debt (assuming the government doesn’t continue to raise the debt ceiling and just borrow itself into oblivion).

What I find interesting with this theory is that it assumes the complete rationality of consumers. It also assumes consumers have keen financial foresight and will act accordingly. We all know both of these are not true for the majority of Americans. How can we assume that people internalize the government budget constraint when most people don’t event know what the government is doing?

I think the relationship between tax cuts and consumption that the Ricardian Equivalence Proposition presents is flawed because of the lofty assumptions attached to it. David Ricardo eventually went back and criticized his own theory, and he probably didn’t support it anymore by the time he died.

The marginal propensity to consume (MPC) most likely determines the effectiveness of tax cuts. If the MPC is 0.9, consumers will immediately spend $0.90 for every $1.00 they receive in tax cuts. Other factors that affect MPC and the effectiveness of tax cuts is whether the tax cut is a fixed payment or a continuous tax cut.

But that isn’t the main point I am trying to get at.. (yeah it’s 1 A.M. right now, so this may sound a bit A.D.D. so far..)

When investigating this theory, it made me think of a peculiar trait of human nature in regards to money and economics: once there is a tax cut, people won’t put up with a tax increase in the future. Basically once you give them a tax cut in the name of “temporary stimulus”, people are not willing to give that up with a future tax increase. If the government tries to increase taxes, people will instinctively oppose them or just move away from the area that is being taxed. That is exactly what is happening in historically liberal states such as California, New York, and Michigan. Years of reckless spending through wasteful government programs left them with massive deficits that had to be funded by new taxes. The 2010 census revealed that people just decided to move instead of enduring a tax increase in these economically collapsing areas.

I think this all ties back to the fundamental economic law of incentives. Incentives are what drive consumer choice.

Another place where this applies is in the realm of government agencies/organizations. They are allotted x dollars every year to carry out their activities. When was the last time you heard of a government agency telling Congress that the money appropriated for their agency was TOO MUCH? Never! Because if they ever revealed that to Congress, they would receive less money in the next year’s appropriation. This is the major cause of government waste. There is no incentive to be efficient and cut costs.

Once people are given tax cuts, they refuse to give them up. Once agencies are appropriated funds, they refuse to accept anything less in the future. This is why I don’t think the Ricardian Equivalence Proposition is valid. It neglects to consider the most important economic assumptions of all: the fact that incentives drive consumer choice, and that people are instinctively going to make decisions that provide themselves with the most resources—because economics is all about how we allocate resources, and humans will always choose themselves over others when deciding who gets them.

~ by rfreeland on February 14, 2011.

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