Monday, February 25, 2008


My recent post on tax cuts and budget deficits concluded that evidence does not support the contention that wealth effects result from tax cuts, or that deficits have detrimental effects on interest rates as a result of wealth effects. However, when income taxes are considered, the economy will respond to differences in the timing of taxes.

Because taxes on income and capital affect the after tax marginal product of labor, and after tax return on investment, taxes vs. deficits during different periods may affect the allocation of work, production, and investment over time. A consequence of this may be that if the government cuts taxes today to stimulate the economy then in the next period when the deficit is settled, or taxes are raised, there may be a reduction in output. These opposing reactions still approximate the Ricardian Equivalence result.

It has been proposed that Ricardian Equivalence may fail if the permanent income hypothesis fails to hold across time. ( if the permanent income hypothesis holds, then a temporary increase in income- from a tax cut- would have a minimal impact on spending) If households believe that their future tax liabilities will be high in the future ( to settle a deficit) only if their incomes are high, then they may have less incentive to save a tax cut. In this case a wealth effect is created and they increase consumption. These results would then lead to the problems so often associated with tax cuts and deficits.


David Romer. Advanced Macroeconomics, 2nd Edition. McGraw Hill. 2001

Barsky, Mankiw, and Zeldes. 1986. ‘Ricardian Consumers with Keynesian Propensities.’ American Economic Review 76 (Sept): 676-691

Tuesday, February 19, 2008


While this blog focuses mainly on environmental and agricultural issues, I do occasionally discuss more general economic issues, as there are often important linkages to agricultural economics. While having lunch I recently overheard a conversation at another table regarding tax cuts. This person was discussing the benefits of tax cuts- perhaps stimulative, and the costs of deficits. A few years ago I studied these issues in depth in graduate level macroeconomics, but this inspired me to re-visit the literature.

A major concern is with deficits that may result from tax cuts. According to the traditional Ricardian Equivalence ( R.E.) result, people are indifferent to a tax cut now, and higher taxes in the future to pay for covering the resulting deficit. Tax cuts ( if saved/invested) in the current period provide enough resources to cover the deficit in the future, and provide no wealth effect.

It is the wealth effect that is the problem. If people feel wealthier from a tax cut they may spend more, this leaves less money for settling the deficit. The government has to borrow from fewer resources to cover the deficit, and upward pressure is exerted on interest rates. In the long run this leads to less investment and is detrimental to economic growth. In addition, if other countries are loaning the funds to cover the deficit ( through the purchase of government securities), then our balance of trade is affected.

Why might there be wealth effects? One reason is finite lives. People may feel that they can spend the tax cut and pass the debt on to future generations. Another reason often given for wealth effects is imperfect loan markets. People that are restrained from spending because they have little collateral or face high transaction costs in getting loans to finance spending, see the tax cut as a loan that must be paid back in the future ( via higher taxes). Only, the rate at which their future taxes will increase is less than the high interest rate they would have to pay for a loan equivalent to the tax cut ( providing that they can even get such loan). As a result, a tax cut leads to spending among this group of people.

The reasoning behind finite lives is often refuted with examples of bequests, or long-term investment vehicles that have returns based on a market that factors in future tax liabilities. The imperfect loan markets argument, if it holds, implies that deficits are good in that they would improve the functioning of loan markets. Much empirical research indicates that these mechanisms for wealth effects fail to lead to increases in interest rates.

So, when it comes to lump sum taxes at least, consumers are indifferent between tax cuts now and settling deficits in the future with higher taxes in the future. Empirical evidence does not support the contention that wealth effects result from tax cuts, or that deficits have detrimental effects on interest rates as a result of wealth effects.

i.e. we may not see much stimulus from the current stimulus package that includes a lump sum tax refund, but the resulting deficit may not be something to worry about either since there likley won't be any wealth effects.


Robert Barrow. Macroeconomics- 5th Edition MIT Press 1997