Whelan on Ricardian Equivalence

I’m constantly surprised by the naivety of opponents of Ricardian Equivalence.  There are indeed many reasons why it may not hold. Some of these have already been mentioned in a previous post.  I can add another to the list: hyperbolic discounting. 

In addition, the difficulties associated with econometrically testing the proposition are almost intractable, mainly because of endogeneity considerations.  What is certain is the near impossibility of isolating a particular policy episode and conclusively asserting that it does or does not amount to an expansionary fiscal contraction.

Nevertheless, none of the arguments against Ricardian Equivalence are sufficient to enable us to conclude that there is no tax discounting whatsoever.  Such a view cannot provide “a valuable theoretical baseline”.   The same remark applies to policy.   Otherwise, the sort of spiralling sovereign debt burden, which Ireland is currently experiencing because of the bank bailout, would have no welfare implications because it would not affect private behaviour.

25 thoughts on “Whelan on Ricardian Equivalence”

  1. I am at a loss to see the point being made in this post.   Who exactly is claiming “no tax discounting whatsoever”?   Moreover, the concern with the spiralling debt burden relates to the impact on the risk premium, much of which will be paid to foreign bond holders.  How could that not have welfare implications?   I must be missing something. 

  2. @ Michael Moore,

    There are some very basic assumptions we have made in thinking and debating about the Irish situation over the course of the past couple of years. First and foremost, I believe, is the high moral ground taken by the present minister for finance, Brian Lenehan. He seems to talk a lot about avoidance of a return to an economic bubble. But when you go into it in any depth at all – with the various levels of government, and executive branches we have in Ireland – what those various levels of government constantly seem to require, is an economic bubble. In order to fill their coffers.

    There is exceptional pressure upon Irish people to spend on large ticket items in order to generate taxes for central government. But it is interesting to observe the minister for finance on public broadcasts, is able to distance himself entirely from responsibility, or a vested interest, in re-starting another bubble. We need to be very clear about that. Who does really benefit from an economic bubble. It certainly is not the ordinary people. They have no ability to gather revenue with as large a net as the central government does, in a boom time. It is not the central government either, who suffers the most in a recession, great or otherwise. Now if we had a property tax instead of a stamp duty in Ireland, it might change things a lot. Because ordinary buyers would be aware, the more property they consumed, the more taxes would acrue to a local government. Maybe this would encourage them to invest in property, to enhance services at a local level. Or maybe the opposite.

    But what was a clear recipe for disaster, was a tax on property which only occured once at the point of sale. I.e. It was not a recurring charge which happened year in, year out, and acrued to a local authority. The stamp duty didn’t feel like a tax to ordinary people, in the same way, because it could be borrowed from the bank, and buddled into a ‘debt’ sum, like everything else – along with the non-existence deposit amount – by the time we had 100% mortgages. This is why I say, the government borrowed through its citizens, rather than on behalf of its citizens. The stamp duty which fuelled fiscal expansion in Ireland during the Celtic Tiger was borrowed at rates appropriate to a private borrower. Not at rates appropriate to a central government, or economic sovereign, or whatever way we want to describe it. And without a recurring annual property tax, we have a ‘local government’ which has no economic sovereignty whatsoever. BOH.

  3. @ Karl
    I agree. Perhaps you can provide now me with a theoretically consistent model which achieves this without treating soverign debt as wholly or partly a subtraction from private wealth.

    @John

    The argument that there is no Ricardian Equicvalence is isomorphic to the proposition that there is no tax discounting.

    The risk premium on sovereign debt is second order compared to the debt itself. Nevertheless, consider the following thought experiment: continuously roll over debt interest so that it is never a current burden. With no tax discounting, neither current icome nor private wealth is affected.

  4. @ Michael Moore,

    I spoke above, about property tax being related to a location. There is awareness on the party of those paying a property tax, that their local authority will receive the money. Maybe that gives the home occupier more leverage when it comes to demand for better schools, hospitals, roads etc. I don’t know. The other interesting thing we do know, based on studies by David Duffy etc, on the subject of negative equity, is that is very much related to regions. Basically, negative equity has the effect of tying people to a particular area. If you like, negative equity is an investment over the long term in a particular area.

    If one is sure one will be in negative equity at some stage in the future, one will probably aim to live in an area, where at least their are employment prospects. But many folk in the midlands of Ireland, live in areas where the worst of both worlds exists. High unemployment and high negative equity. I heard one young lady on radio last weekend (who was in very steep negative equity, and in default of her mortgage) saying, it was better than applying for a home loan today and not getting it at all. In other words, she is prepared to have her credit status damaged severly, and swallow a large slice of negative equity, in order to ‘own’ a property of some kind, in a particular area. That is what I call an extremely firm committment to an area. It is something that stamp duties to a central government, do not cater for, in that the local authority doesn’t receive the stamp duty.

    The last point I want to make is in relation to land value taxation. The idea being, that if the tax on the value of the land gets too large for the occupant to pay, there is incentive on them to move to an area, where the land taxation is more affordable. The idea of this, is to free up land for uses, where the higher land tax is not a problem. I.e. If there is a public train line at the end of the road, the idea would be to free up that particular land for workplaces, so that many people could travel to that destination to work day-by-day. So property taxes if related to land values have the effect of moving people. Negative equity has the effect of keeping people stuck where they are – even if that area is the midlands of Ireland, with high unemployment rates. BOH.

  5. @ MM

    I wrote this to Greg Connor earlier but might as well repeat it.

    Economic theory is well stocked with clear and elegant proofs of propositions that turn out to be wrong. Forget the overfitted quarterly models, many of the crucial underlying assumptions of the proof clearly don’t hold.

    For starters, why would someone react to the emergence of a large fiscal deficit by assuming that the path of government spending will remain unchanged, so that the PDV of taxes remains the same?

    An increase in taxes is what it is, an increased deficit on the other hand may trigger increased taxes in the future or it might trigger lower government spending. Certainly there’s no sensible reason for someone to assume that a €1 billion deficit will have the exact same effect on their present discounted sum of tax payments as a €1 billion tax increase.

  6. @Karl

    You are simply restating one of the well-known arguments as to why Ricardian Equivalence might not fully hold. Indeed, the above point applies to any rational expectations model.

    Now let me repeat my question. Are you asserting that there is no tax discounting whatsoever and that the stock of soverign debt has no impact on private wealth at all?

  7. @ MM

    I’m not sure I exactly understand the question as you’ve phrased it. But if your question is whether I’m asserting that the public completely ignores the stock of debt when formulating it’s expectations of future tax burdens, then the answer is no.

    Arguing that something isn’t black isn’t the same thing as arguing that it’s white.

  8. Michael Moore says:

    Are you asserting that there is no tax discounting whatsoever and that the stock of soverign debt has no impact on private wealth at all?

    Guys, it would be a lot simpler to have this debate, if we actually made an attempt to trace the sequence of events as it actually tends to happen, on the island of Ireland. We have a system of taxation which moves funds from local level to central government. Then, as a means to re-distribute the same back down to a local level (but maintain control of expenditure at central levels), we have to invent policies such as de-centralisation. Which is effectively the giving back of taxes, taken from local levels in the first place. Minus an excessive cost in administration for moving around all of the said funds.

    Forget about the Irish central government running a deficit on behalf of the Irish citizen. That is never going to happen, because the central government of Ireland doesn’t have enough confidence in itself to do so. Instead we see the central government in Ireland renege on any committment to borrow on behalf of its citizens and spend the money in a responsible and forward thinking manner. What we have, is summarised in the phrase of Charlie McCreevy: When I have it, I spend it.

    That is a whole lot different from a situation, where the central government runs a deficit for the benefit of its people, and thereby accepts some degree of risk that its policies might not succeed. Before you have any meaningful discussion about Ricardian equivalency, in relation to Ireland, you first have to dispense with the notion that our central government ever had the courage to purposefully run a deficit for any useful purpose. Then you have to understand, that all central government in Ireland has been doing, is taken money which should have gone to local government and giving it back to them again, through various ‘programmes’ such as the National Development Plan, and the National Spatial Strategy. BOH.

  9. Excuse my comparative ignorance, but isn’t there relevance for game theory in all of this?

    For instance, if I see the government running huge deficits I can rationally calculate that any attempt to save – in order to be able to afford the later taxation required to repay the deficit – will prove to be a bad idea because other people will not save and my savings will be punitively and disproportionately taxed in the future.

    Others who have not saved would be unable to contribute to paying the bill so the bill would fall entirely on me. I would, after all, be the one most able to “afford” the taxation required later.

    On this expectation, even if I rationally understand the Ricardian equivalence issue, I can also rationally understand that there is no benefit in me trying to make any personal attempt to save for the future..

  10. @ MM

    “So how much tax discounting is there? What fraction of sovereign debt is consolidated into private wealth?”

    The context of my original comments was Trichet’s statement:

    “Indeed, the strict Ricardian view may provide a more reasonable central estimate of the likely effects of consolidation.”

    Whatever fraction is the right answer, I don’t believe Trichet’s baseline of RE as the “reasonable central estimate” is accurate. Do you?

  11. @Karl
    You have confidently argued against the idea of an expansionary fiscal contraction ever having occurred. You must have some fraction in mind. Is it zero?

    @Kevin
    A bit of a non-sequitur. Procyclical fiscal policy can be consistent with full Ricardian Equivalence, no Ricardian Equivalence or anything in between..

  12. @ KO’R,

    It is not only pro-cyclical fiscal policy. It is pro-cyclical policies in general. I need to say something here again, about local versus central government. I argued as such in a blog entry I wrote recently. It is where we have to be wary about local government and their interventions into the market place. Namely where they impose many kinds of standards and taxations on the private sector. The impulse on the part of local government is to be lax on standards in the depth of the recessionary cycle, and then quickly scale up their standards and rules, as the boom part of the cycle creates the room for improvements. But that in turn has a pro-cyclical influence, in that it encourages all kinds of over-production from the private sector in advance of new rules passed by local government. The obvious case in point, was the ‘new rules regarding design of apartments in Dublin’, which were published as an ammendment to an older development plan, around the end of the Celtic Tiger. I.e. When most of the building stock had been delivered, and most of it was over-priced and empty too.

    In other words, there are places where influence by local government can be a bad, bad thing. Because they tend not to look at the overall cycle, and how their actions can affect economic cycles adversely. That I believe is an area where central government can contribute a great deal, with its greater resources to study the progress of the cycle and what impacts on it. It is about finding areas where local government is more appropriate to deal with matters, or visa versa. What we have in Ireland though, for much of the time, is a central government which tries to perform duties which would best be performed at local levels. BOH.

    http://designcomment.blogspot.com/2010/08/house-of-cards.html

  13. @ MM

    The debate about EFCs is not really the same as the debate about Ricardian equivalence, which is a very precise statement about the equivalence of taxes and deficits.

    As for the requested fraction, it will clearly depend upon the circumstances. In relation to your generic deficit-financed tax cut (e.g. US style tax rebates where they mail everyone a cheque) I’d imagine the fraction is pretty close to zero. Meaning, the amount of people who will effectively ignore this extra income on the grounds it has added to the deficit and they’ll have to pay higher taxes later would be very small.

    Of course, the MPC out of such a tax cut may be low because people know that it’s temporary. That’s one of the reasons Keynesian tend to prefer expansions in government spending on stuff instead.

  14. @ KO’R,

    In the House of Cards blog entry linked above I wrote:

    In other words, it incentivises the creation of very large players in the supply chain for building stock delivery.

    What we have in Ireland is a great deal of confusion about the definition of wealth. We tend to mistake the creation of a number of large borrowers involved in the (very cyclical) building trade, for the creation of wealth. When in fact, they are not the same at all. The only reason the large borrowers in the building trade are a requirement in Ireland, is in order to race ahead of the standards improvement instigated by local governments during periods of economic boom. I.e. You need to over-produce before the local authority increases its cycle. So in other words, the local government creates the condition, which creates the necessity for the large borrower. Which we in turn, in Ireland, mistake for the creation of wealth. All of the large borrowers go bust in the down part of the cycle, and we sit around wondering why Ireland doesn’t generate any wealth? We need to understand these crucial dynamics, which repeat time and again in Ireland, before we can relate anything to Ricardian equivalency. BOH.

  15. I can’t see how accepting that Ricardian equivalence has good theoretical grounding, but clear evidence of it’s real life existance is “naive”, rather than a simple observation of the (stylised) facts.

  16. I think it’s time for a new stylised truism in Economics –

    “Blog Banter Equivocation” –

    This theory states that no matter how clear, well-stated and convincing a blog entry, by the time you get to comment (what am I here…..) twenty, the debate will have degenerated into a muddled compromise, with which neither side is happy, and out of which nothing useful can be distilled.

    Empirical evidence for the existence of Blog Banter Equivocation has been hampered, however, by problems of endogeneity…

  17. @ Michael Moore,

    I made the post at the link below on the other thread by KW. You speak about the ‘sovereign debt’ and private wealth. It is important to point out a few basic points I think. The ‘sovereign’ in an economic context, does that relate finances of local or central government or both? The fact is, that the largest borrowers in the state, tend to have many more interactions with local government than they do, with central government. I think it is worth pointing that out. While local government in Ireland does not have the ability to run huge deficits at the moment, it should not be ignored in the overall equation, as far as policy implementation goes. As I said, most of the largest borrowers in the state have deep interaction with several local government bodies at once. You only have to look at the Dublin Docklands Development Authority, which waded all the ways in, and became a property investor itself. What message does that send to private wealth? ? ? In particular, when the minister for finance (then Brian Cowen) was extending the borrowing limit of the DDDA.

    Worth throwing into the mix also perhaps, is a comment made recently on the Irish Economy blog. Namely, that all departments of central government had an attitude – that finance was a matter for the dept. of finance. I.e. Every other department didn’t consider it a part of their responsibility. It became apparent to many of the largest (private) borrowers in Ireland that was the case. It also became apparent during the same time, that local governments were spending a lot of money too. How this impacts on the behaviour of private wealth – if we had any – I will leave others to speculate. A final twist worth mentioning, is that government at European level relies a lot on the strong member states to source its taxes. Does that incentivise the peripheral states to go on spending binges? The knowledge the Franco-German core will pay for it? It is impossible to ignore this aspect. Obviously, when you look at things at that level, the Irish banks, such as Irish Nationwide Building Society, were the ‘borrowers’. They were the ‘private wealth’. BOH.

    http://www.irisheconomy.ie/index.php/2010/08/30/trichet-on-ricardian-equivalence/#comment-68817

  18. @ All,

    A couple of basic definitions relavant to this thread, to remind ourselves: What is a semi-state? What is a quango?

    I suppose, a quango is a visible manifestation of spending by central government. Something to squash and get rid of, in the recession part of the cycle. Something to re-introduce or re-invent in some form, when coffers are full again. A semi-state on the other hand, is a visible manifestation of investment by the state’s in the past, and is seen as an asset. Something to be sold in the recession part of the cycle. The sale of an asset, is a help when our deficits threaten to spiral. The quango on the other hand doesn’t appear to have any sale-able value. The value of the semi-state is based on its ability to generate its own revenue, either for the state or for the shareholder.

    Question: Is there a sense in which a quango could be a very early form of a semi-state company? I mean to say, during the Celtic Tiger, many quangos did borrow to invest in projects. We may not have seen the maturity of those substantial investments yet. Eircom for instance, was the product of investment made by the young Irish state over a considerable period of time. In the 1950s, would many people have seen Post and Telegraphs as a quango, rather than as a viable state asset? If things had worked out better for the DDDA, could the investment have matured into a valuable state asset? Remember, the Irish Sugar Company, for instance was the first client of a computing machine and software in Ireland. Followed afterwards by agencies such as Aer Lingus. Air travel was hardly the mass market service we know it as today, when the Lemass government first became seriously involved. BOH.

    http://www.irisheconomy.ie/index.php/2010/08/30/trichet-on-ricardian-equivalence/#comment-68919

  19. An increase in taxes is what it is, an increased deficit on the other hand may trigger increased taxes in the future or it might trigger lower government spending. Certainly there’s no sensible reason for someone to assume that a €1 billion deficit will have the exact same effect on their present discounted sum of tax payments as a €1 billion tax increase.

    The main problem with this line of thinking, though, is that certain US commentators find it essential to arguing that Bush’s recession was in fact voters anticipating the future Obama administration (that the same people nod-and-wink at the Obama-is-a-Commie/Muslim/Kenyan/Indonesian/etc. nonsense says it all).

  20. BOH.
    1st comment:
    Well said! That is the point of “settled” living. Taxes to spend on maintaining their power. Buying off each constituency as they form it, using wedge politics.

    Hugh Sheehy
    Some take this as an invitation to move offshore……. avoiding the worst effects of stupidity? There are many countries where the standard of living is cheap.

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