The traditional view of a tax cut is that it will stimulate consumer spending, reducing saving, which implies an increase in interest rates and a reduction in investment. Another view though was suggested by David Ricardo – that of Ricardian Equivalence. This is the idea that consumers are forward looking and therefore will base their spending decisions not only on their current income but also on their expectations of future income. A tax cut will therefore be unlikely under this view to increase consumer spending, because consumers will realise that the only way the government will be able to finance the tax cut is by increasing taxes in the future, unless government spending decreases, but then it will be the fall in G not T that stimulates consumer spending.
If the government issued every citizen a bond worth 1000 plus interest, this would have the same effect as a tax cut. The government could finance such a policy either by reducing its current expenditure, or by planning to raise taxes in the future. Thus it would seem that government bonds are not net wealth, because the government is effectively giving you 1000 that you have paid for yourself, therefore there will be a zero net effect on wealth, implying also (if consumers are forward looking and realise that this is the case) that there will be no wealth effect, and no change in current consumption.
It is not necessarily clear though that consumers are forward looking. Indeed Ricardo himself thought that people were actually most likely not to act in this manner, saying that “the people who pay taxes…do not manage their private affairs accordingly. We are apt to think that the war is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes.”
Firstly it is often thought that consumers are short sighted, perhaps because they do not realise the longer-term implications of a cut in taxes, or simply choose to ignore them. This would suggest that actually the tax cut would have similar effects to that of the traditional view.
Another possibility is that consumers face borrowing constraints and therefore, despite having a strong preference for current consumption (implying that they wish to borrow to finance this) they are unable to come by a loan, or are unable to borrow as much money as they would like to. They may be perfectly aware that this will limit their future consumption, and not view this as a problem. Therefore, if they are issued with a government bond that will eventually have to be paid for in the form of increased taxes, this is the equivalent of being given a loan. They will therefore be happy to spend this on current consumption.
It is further possible that consumers will expect the burden of repayment to fall on future generations rather than on their own. This implies that for the current generation a tax cut will raise their lifetime income and have a positive wealth effect. However, as Robert Barro responds, this is not necessarily the case – why, after all, do people leave bequests to their children if they do not care about them footing the bill for the older generation’s expenditure? Because of this the relevant decision maker is not the individual but the family, which could theoretically last forever, and therefore a tax cut or bond issue will have no effect on their net wealth. It seems most plausible however that whilst this will be the case for many families, it will not be the case for all.
Barro further argues that the wealth effect from government debt will depend on the efficiency of government – if the transaction cost of issuing bonds and later collecting taxes were high enough it could be that there would be a negative wealth effect.[1]
Overall though, despite Barro’s conclusion that there can be no telling whether the effect will be positive or negative, it seems most likely that myopia and the existence of borrowing constraints, plus the lack of concern in some cases (either through myopia or the assumption that they will have greater income or through meanness) for the additional burden placed on future generations, will lead to an overall positive wealth effect from government debt. This may be offset to a degree by Ricardian equivalence, but the effect is likely to be positive nevertheless.
[1] Robert J. Barro; ‘Are government bonds net wealth?’; Journal of Political Economy; Vol. 82 No. 6; 1974