Are Tax Cuts Actually Benevolent?

-Penned by Apoorva Grewal & Sakshi Sharma

What would you do if there was a sudden cut in direct taxes due to which the income in your pocket at present increased? Would you spend the surplus? Would you save it? Would you be wary of the fact that taxes could increase in the future? From a consumer’s perspective who lives in the moment, it makes sense to spend the surplus and increase consumption if the previous income was unable to fulfill the demands and maximize utility. But think of the bigger picture, why does the government tax its citizens? How would the government meet its expenditure if the revenue fell short?

We know that the annual budget presents the government’s strategy to match its revenue and expenditure every year. If the revenue falls short. i.e., fiscal deficit, the government needs to borrow from the market to meet its expenses. As there is no such thing as a free lunch, forgoing tax revenue in one year is bound to increase the debt burden for the future. This simply means that what you don’t pay today will be paid by the future generations with interest. If you were to know this, how would it impact your decision now? Let us explore the idea of Ricardian Equivalence to understand this better.

What does it mean?

The Ricardian equivalence proposition is an economic hypothesis holding that consumers are forward looking and so internalize the government’s budget constraint when making their consumption decisions. This leads to the result that, for a given pattern of government spending, the method of financing such spending does not affect agents’ consumption decisions, and thus, it does not change aggregate demand. The government may have given the tax cut to increase disposable income hence the spending but consumers are smarter than that. They are rational decision makers so they save for the future when the taxes may increase.

Who proposed it?

This theory was developed by David Ricardo in the early 19th century and later was elaborated upon by Harvard professor Robert Barro. Thus, it is also known as the Barro-Ricardo equivalence proposition.

What are the implications of the equivalence? The proposition implies that there would be no change in the aggregate demand from increased consumer spending. There would only be change in the level of savings with the timings of the taxation. This translates to the fact that the Keynesian fiscal policy will generally be ineffective at boosting economic output and growth

The above figure shows how expansionary fiscal policy attempts to increase aggregate demand but savings due to Ricardo-Barro effect keep it constant and hence market equilibrium does not shift.

Is there any real-life evidence of the equivalence?

Ahmed Ikiz’s study examined the relevance of Ricardian Equivalence theory in Turkey. For this purpose, the researcher explored the long-run relationship between the government domestic borrowings and private savings for the period 1980–2017. The objective was to study gross domestic savings and increase in government debt with the objective to find the impacts of government borrowings on household savings and consumption decisions. The results imply to the presence of Ricardian equivalence in Turkey. This means that any tax cuts in the present times in the country would be compensated with a tax increase in the future and public is aware about this scenario.

We can look at it the other way round as well. What would happen if the government temporarily increased taxes with the aim to decrease consumption and generate more revenue? Ricardian equivalence tells us that consumption would not change because people understand that present increase in taxes decreases future tax burden. This is what happened in the US in 1968. A temporary income-tax surcharge aimed to cool down the overheated economy failed and even a decrease in income at hand didn’t reduce the aggregate demand in the economy.

Criticisms of the Equivalence

The proposition has been criticized by Paul Krugman, Lucas and many others economists. The opposition for the theory primarily stems from the irrelevance of the same in real life world. For instance, the equivalence doesn’t hold when the credit market is imperfect (like different borrowing and lending rates, credit limits, limited commitment and the housing model, asymmetric information), consumers and governments face different life spans, distortionary taxes (not lump-sum) affect the decision to work etc.

The PAYGO (pay as you go) pension plan is a retirement arrangement where the plan beneficiaries decide how much they want to contribute, either by having the specified amount regularly deducted from their paycheck or by contributing the desired amount in a lump sum. The case has often been used as an argument against Ricardian Equivalence. As per popular notion, the savings behavior of forward-looking individuals is determined by their expected income, the rate of return, and the expected returns from the mandatory pension system whereas myopic individuals live in the moment, so to speak. They would like to enjoy the benefits of the cash-in-hand right then. Thus, RE doesn’t hold in this context.

Does RE hold in developing countries?

Prima facie, since the REP requires a number of assumptions that might not appear to be satisfied in developing countries, it seems that the REP should not hold. However, the empirical evidence provided so far is mixed. REP does hold for countries like Burundi, El Salvador, Ethiopia, Honduras, Morocco, Nigeria, Pakistan, and Sri Lanka. Additionally, Ghatak (1996) provided evidence to support REP does not hold in one developing country, India.

Fiscal sustainability in India

We understand that growing deficit creates a large debt burden, that certainly cannot be good news. It threatens fiscal sustainability i.e., the government’s ability to sustain its current spending along with taxes in the long run. Matters are further complicated by the fact that we live in an open economy. We trade with other countries, borrow from them. A large debt burden threatens the very macroeconomic stability of the country and makes it vulnerable to external shocks.

Are we sure that all citizens are rational, would be able to predict future government expenditure and save enough for it? Think of 1.3 billion minds, each individually trying to solve its own optimization problem, balancing consumption, borrowing and lending across time. If successful, the shift in tax burden would be neutral to generational welfare. But what if it is not?

This is why the Government of India has introduced a tool to maintain this delicate balance, the Fiscal Responsibility and Budget Management Act (FRBM) Act, 2003. The act aims to distribute debt more equitably over the years by limiting the targeted fiscal deficit and government’s debt within a comfortable range, presented as a percentage of the GDP. However, even after almost two decades and several reforms and amendments, we are yet to achieve the set targets due to various internal and external factors. In the midst of a global pandemic, fiscal consolidation is akin to walking a tightrope. We have institutionalized fiscal discipline, let’s see how successful this long-term vision of fiscal management proves to be.

References

Gianluigi Giorgioni & Ken Holden (2003) Does the Ricardian Equivalence Proposition Hold in Less Developed Countries?; International Review of Applied Economics, 17:2, 209-221, DOI: 10.1080/0269217032000064062
https://www.investopedia.com/terms/r/ricardianequivalence.asp
Testing the Ricardian Equivalence Theorem: Time Series Evidence from Turkey, Ahmet Salih Ikiz, Economies 2020, 8, 69; doi:10.3390/economies8030069
Ricardian Equivalence in Developing Countries: Fiscal Policy, Private Consumption and Investment in Indonesia; http://dx.doi.org/10.13140/2.1.3177.7282
https://www.business-standard.com/about/what-is-frbm-act