Changes in Taxes

If the Ricardian perspective is an accurate description of how people behave, then much of our analysis in this chapter becomes irrelevant. Deficits are not needed to spread out the costs of major government expenditures because households can do this smoothing for themselves. Changes in taxes have no effect on aggregate spending, so there is no crowding-out effect. As for a balanced-budget amendment, it too would be much less significant in such a world. Ricardian households effectively “undo” government taxation decisions. However, the exact effect of an amendment would depend on how the government chose to ensure budget balance. Suppose the economy went into recession, so tax revenues decreased. There are two ways to restore budget balance. One is to increase taxes. According to the Ricardian perspective, this would have no effect on the economy at all. The other is to cut government purchases. As we have seen, this would have some effects. Evidence The Ricardian perspective seems very plausible when we consider a thought experiment such as a tax cut this year matched by a corresponding tax increase next year. At the same time, a typical tax cut is not matched by an explicit future tax increase at a specified date. Instead, a tax cut today means that at some unspecified future date taxes will have to be increased. Furthermore, the Ricardian perspective requires that households have a sophisticated economic understanding of the intertemporal budget constraint of the government. It is therefore unclear whether this Ricardian view is relevant when we evaluate government deficits. Do households understand the government budget constraint and adjust their behavior accordingly, or is this just an academic idea—theoretically interesting, perhaps, but of limited relevance to the real world? This is an empirical question, so we turn to the data. There are two natural ways to examine this question. The first is to determine the relationship between government deficits and real interest rates in the data. The second approach is to examine the relationship between government deficits and private saving. Deficits and Interest Rates We want to answer the following question: do increases in government deficits causereal interest rates to increase?