閤 The ricardian Approach to Budget Deficits OR。 Robert J. barro The Journal of Economic Perspectives, Vol 3, No. 2. (Spring, 1989), pp. 37-54 Stable url: http://inks.jstororg/sici?sici=0895-3309%28198921%0293%3a2%03c37%03atratbd%3e2.0.co%3b2-7 The Journal of Economic Perspectives is currently published by American Economic Association Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.htmlJstOr'sTermsandConditionsofUseprovidesinpartthatunlessyouhaveobtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the jsTOR archive only for your personal, non-commercial use Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at Each copy of any part of a JSTOR transmission must contain the same copyright notice that ap on the screen or printed page of such transmission STOR is an independent not-for-profit organization dedicated to and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support @jstor. org Thu mar1505:32:052007
The Ricardian Approach to Budget Deficits Robert J. Barro The Journal of Economic Perspectives, Vol. 3, No. 2. (Spring, 1989), pp. 37-54. Stable URL: http://links.jstor.org/sici?sici=0895-3309%28198921%293%3A2%3C37%3ATRATBD%3E2.0.CO%3B2-7 The Journal of Economic Perspectives is currently published by American Economic Association. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/journals/aea.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is an independent not-for-profit organization dedicated to and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support@jstor.org. http://www.jstor.org Thu Mar 15 05:32:05 2007
Journal of Economic Perspectiues-Volume 3, Number 2-Spring 1989-Pages 37-54 The Ricardian Approach to Budget Deficits Robert j. Barro n recent years there has been a lot of discussion about U. S. budget deficits. Many economists and other observers have viewed these deficits as harmful to the U. S and world economies. The supposed harmful effects include high real int rates, low saving, low rates of economic growth, large current-account deficits in the United States and other countries with large budget deficits, and either a high or low dollar(depending apparently on the time period). This crisis scenario has been hard to maintain along with the robust performance of the U.S. economy since late 1982. This performance features high average growth rates of real GNP, declining unemploy ment, much lower inflation, a sharp decrease in nominal interest rates and some decline in expected real interest rates, high values of real investment expenditures, and (until October 1987)a dramatic boom in the stock market. Persistent budget deficits have increased economists' interest in theories and evidence about fiscal policy. At the same time, the conflict between standard predi tions and actual outcomes in the U.S. economy has, I think, increased economist to consider approaches that depart from the standard paper I will focus on the alternative theory that is associated with the name of David Ricardo The Standard Model of Budget Deficits Before developing the Ricardian approach, I will sketch the standard model. The starting point is the assumption that the substitution of a budget deficit for current a Robert Barro is Professor of Economics, Harvard Uniuersity, Cambridge, Massachusetts, search Associate, National Bureau of Economic Research, Cambridge, Massachusetts; Research Associate, Rochester Center for Economic Research, University of Rochester, Rochester, New york
38 Journal of Economic Perspectives taxation leads to an expansion of aggregate consumer demand. In other words, desired private saving rises by less than the tax cut, so that desired national saving declines. It follows for a closed economy that the expected real interest rate would have to rise to restore equality between desired national saving and investment demand The higher eal interest rate crowds out investment, which shows up in the long run as a sm stock of productive capital. Therefore, in the language of Franco Modigliani (1961), the public debt is an intergenerational burden in that it leads to a smaller stock of capital for future generations. Similar reasoning applies to pay-as-you-go social security programs, as has been stressed by Martin Feldstein(1974). An increase in the scope of these programs raises the aggregate demand for goods, and thereby leads to a higher real interest rate and a smaller stock of productive capital In an open economy, a small country' s budget deficits or social security programs would have negligible effects on the real interest rate in international capital markets Therefore, in the standard analysis, the home countrys decision to substitute a budget deficit for current taxes leads mainly to increased borrowing from abroad, rather than to a higher real interest rate. That is, budget deficits lead to current-account deficits Expected real interest rates rise for the home country only if it influence world markets, or if the increased national debt induces foreign lenders to demand higher expected returns on this countrys obligations. In any event weaker tendency for a country's budget deficits to crowd out its domestic investment in the short run and its stock of capital in the long run. However, the current-account deficits show up in the long run as a lower stock of national wealth -and correspond ingly higher claims by foreigner If the whole world runs budget deficits or expands the scale of its social insurance rograms, real interest rates rise on international capital markets, and crowding-out of investment occurs in each country. Correspondingly, the world's stock of capital is lower in the long run. These effects for the world parallel those for a single closed before The Ricardian Alternative The Ricardian modification to the standard analysis begins with the observation that, for a given path of government spending, a deficit-financed cut in current taxes leads to higher future taxes that have the same present value as the initial cut. This result follows from the government,'s budget constraint, which equates total expendi- tures for each period (including interest payments)to revenues from taxation or other sources and the net issue of interest -bearing public debt. Abstracting from chain-letter cases where the public debt can grow forever at the rate of interest or higher, the present value of taxes(and other revenues)cannot change unless the government changes the present value of its expenditures. This point amounts to economists standard notion of the absence of a free lunch-government spending must be paid for now or later, with the total present value of receipts fixed by the total present value of spending. Hence, holding fixed the path of government expenditures and
Robert / Barro 39 non-tax revenues, a cut in today's taxes must be matched by a corresponding increase in the present value of future taxes. Suppose now that households'demands for goods depend on the expected present value of taxes-that is, each household subtracts its share of this present value from the expected present value of income to determine a net wealth position. Then fiscal policy would affect aggregate consumer demand only if it altered the expected present value of taxes. But the preceding argument was that the present value of taxes would not change as long as the present value of spending did not change. Therefore, the substitution of a budget deficit for current taxes(or any other rearrangement of the timing of taxes)has no impact on the aggregate demand for goods. In this sense, budget deficits and taxation have equivalent effects on the economy -hence the term Ricardian equivalence theorem. To put the equivalence result another way, a decrease in the government's saving (that is, a current budget deficit)leads to an offsetting increase in desired private saving, and hence to no change in desired Since desired national saving does not change, the real interest rate does not have to rise in a closed economy to maintain balance between desired national saving and investment demand. Hence, there is no effect on investment, and no burden of the public debt or social security in the sense of Modigliani(1961)and Feldstein(1974) n a setting of an open economy there would also be no effect on the current-account balance because desired private saving rises by enough to avoid having to borrow from abroad. Therefore budget deficits would not cause current-account deficits Theoretical Objections to Ricardian Equivalence I shall discuss five major theoretical objections that have been raised against the Ricardian conclusions. The first is that people do not live forever, and hence do not care about taxes that are levied after their death. The second is that private capital The calculations use the government's interest rate in each period to calculate present values, and assume perfect foresight with respect to future government expenditures and taxes. For further discussion see Ben McCallum(1984)and Robert Barro(1989) The term, Ricardian equivalence theorem, was introduced to macroeconomists by James Buchanan(1976) After Gerald O Driscoll(1977)documented Ricardo s reservations about this result some economists have referred to the equivalence finding as being non-Ricardian. But, as far as I have been able to discover, David Ricardo(1951)was the first to articulate this theory. Therefore, the attribution of the equivalence theorem to Ricardo is te even if he had doubts about some of the theorem's assumptions. As to whether the presence of this idea in Ricardos writings is important for scientific progress, I would refer to Nathan Rosenberg's(1976, p. 79)general views on innovations in the social sciences happens in economics is that, as concern mounts over a particular problem.. an increasing number of professionals commit their time and energies to it. We then eventually realize that there were all sorts of sophisticated present-day understanding back into the work of earlier writers whose analysis of our more treatments of the subject in the earlier literature.. We then proceed to read much inevitably nore fragmentary and incomplete than the later achievement. It was this retrospective view which doubtless inspired whitehead to say somewhere that everything of importance has been said before-but by someone who did not discover it. "(This last point relates to"Stigler's Law, which states that nothing named after the person who discovered it
40 Journal of Economic Pers markets are"imperfect, " "with the typical person s real discount rate exceeding that of the government. The third is that future taxes and incomes are uncertain. The fourth is that taxes are not lump sum, since they depend typically on income, spending wealth, and so on. The fifth is that the Ricardian result hinges on full employment. I assume throughout that the path of government spending is given. The Ricardian analysis applies to shifts in budget deficits and taxes for a given pattern of government expenditures; in particular, the approach is consistent with real effects from changes in he level or timing of government purchases and public services In many cases it turns out that budget deficits matter, and are in that sense non-Ricardian. It is important, however, to consider not only whether the ricardian view remains intact, but also what alternative conclusions emerge. Many economists raise points that invalidate strict Ricardian equivalence, and then simply assume that the points support a specific alternative; usually the standard view that a budget deficit lowers desired national saving and thereby drives up real interest rates or leads to a current-account deficit. Many criticisms of the Ricardian position are also inconsistent with this standard view Finite horizons and related Issues The idea of finite horizons, motivated by the finiteness of life, is central to life-cycle models--see, for example, Franco Modigliani and Richard Brumberg (1954)and Albert Ando and Franco Modigliani(1963). In these models individuals capitalize only the taxes that they expect to face before dying. Consider a deficit- financed tax cut, and assume that the higher future taxes occur partly during the typical persons expected lifetime and partly thereafter. Then the present value of the first portion must fall short of the initial tax cut, since a full balance results only if the second portion is included. Hence the net wealth of persons currently alive rises and households react by increasing consumption demand. Thus, as in the standard approach sketched above, desired private saving does not rise by enough to offset fully the decline in government saving A finite horizon seems to generate the standard result that a budget reduces desired national saving. The argument works, however, only if the typ person feels better off when the government shifts a tax burden to his or her tndants. The argument fails if the typical person is already giving to his or her children out of altruism. In this case people react to the government's imposed intergenerational transfers, which are implied by budget deficits or social security, with a compensating increase in voluntary transfers(Barro, 1974). For example parents adjust their bequests or the amounts given to children while the parents are still living. Alternatively, if children provide support to aged parents, the amounts given can respond(negatively) to budget deficits or social security. The main idea is that a network of intergenerational transfers makes the typical person a part of an extended family that goes on indefinitely. In this setting, households capitalize the entire array of expected future taxes, and thereby plan effectively with an infinite horizon. In other words, the ricardian results, which
The Ricardian Approach to Budget Deficits 4/ seemed to depend on infinite horizons, can remain valid in a model with finite lifetimes Two important points should be stressed. First, intergenerational transfers do not ave to be "large, what is necessary is that transfers based on altruism be operative at the margin for most people. Specifically, most people must be away from the corner solution of zero transfers, where they would, if permitted, opt for negative payments to their children. (The results also go through, however, if children typically support their aged parents. )Second, the transfers do not have to show up as bequests at death. Other forms of intergenerational transfers, such as inter wwos gifts to children, support of childrens education, and so on, can work in a similar manner. Therefore, the Ricardian results can hold even if many persons leave little in the way of formal One objection to Ricardian equivalence is that some persons, such as those without children, are not connected to future generations(see James Tobin and Willem Buiter, 1980, Pp. 86ff ) Persons in this situation tend to be made wealthier hen the government substitutes a budget deficit for taxes. At least this conclusion obtains to the extent that the interest and principal payments on the extra public debt are not financed by higher taxes during the remaining lifetimes of people currently alive. However, the quantitative effects on consumption tend to be small. For example, if the typical person has 30 years of remaining life and consumes at a constant rate, a one-time budget deficit of $100 per person would increase each persons real consumption demand by $1. 50 per year if the annual real interest rate is 5 percent, and by $2.10 per year if the real interest rate is 3 percent. The aggregate effect from the existence of childless persons is even smaller because people with more than the average number of descendants experience a decrease in wealth when taxes are replaced by budget deficits. (In effect, although some people have no children, all children must have parents. In a world of different family sizes, the presumption for a net effect of budget deficits on aggregate consumer demand depends on different propensities to consume out of wealth for people with and without children. Since the propensity for those without children larger(because of the shorter horizon), a positive net effect on aggregate consumer demand would be predicted. However, the quantitative effect is likely to be trivia Making the same assumptions as in the previous example, a budget deficit of $100 per capita would raise real consumption demand per capita by 30 cents per year if the real interest rate is 5 percent, and by 90 cents if the real interest rate is 3 percent a variety of evidence supports the proposition that intergenerational transfers defined broadly to go beyond formal bequests -are operative for most people Philippe Weil (1987) and Miles Kimball (1987) analyze condition ure an interior solution for tergenerational transfers. Douglas Bernheim and Kyle Bagwell (1988) argue that difficulties arise if truistic transfers are pervasive, See Barro( 1989)for a discussion of their analysis The assumption is the real debt remains permanently higher by the amount of the initial deficit. For some related calculations, see Merton Miller and Charles Upton (1974, Chapter 8)and James Poterba and Lawrence Summers( 1987, Section I
42 Journal of Economic Perspectives Michael Darby(1979, Ch 3)and Laurence Kotlikoff and Lawrence Summers(1981) calculate that the accumulation of households'assets in the United States for the purpose of intergenerational transfers is far more important than that associated with the life cycle. This observation that most people give or receive intergenera tional transfers; a conclusion that supports the ricardian position. franco Modigliani (1988)contests this conclusion, but Laurence Kotlikoff(1988)shows that Modiglianis findings derive from an extremely narrow view of intergenerational transfers Modigliani focuses on bequests at death, and he also does not treat interest earnings on prior bequests as income attributable to intergenerational transfers Some authors accept the idea that intergenerational transfers are important, but argue that the motivation for the transfers matters for the results. Douglas Bernheim Andrei Shleifer and Lawrence Summers(1985) consider the possibility that bequests instead of being driven by altruism, are a strategic device whereby parents induce eir children to behave properly. Some imaginative evidence is presented(involving how often children visit and communicate with their parents) to document the importance of strategic bequests. In this strategic model, if the government redis- tributes income from young to old(by running a deficit or raising social security benefits), the old have no reason to raise transfers to offset fully the government's actions. Instead, the old end up better off at the expense of the young, and aggregate nsumer demand rises. Then, as in the standard approach, real interest rates increase or domestic residents borrow more from abroad One shortcoming of this approach is that it treats the interaction between parents and children as equivalent to the purchases of services on markets. In this setting parents would tend to pay wages to children, rather than using bequests or other forms of intergenerational transfers. These features-as well as the observation that most parents seem to care about their childrens welfare-can be better explained by introducing altruism along with a desire to influence childrens behavior. In this case Ricardian equivalence may or may not obtain. Consider the utility that a parent would allocate to his or her child if there were no difficulty in motivating the child to perform properly. Suppose that the parent can design a credible threat involving bequests that entails the loss of some part of this utility for the child. (Note that if no threats are credible, the whole basis for strategic bequests disappears. If the threat is already large enough to induce the behavior that the parent desires, Ricardian equivalence still holds. For example, if the government runs a budget deficit, the parent provides offsetting transfers to the child, and thereby preserves the child's level of utility, as well as the behavior sought by the parent. On the other hand, the parent may have to allow excess utility to the child to secure a sufficient threat against bad performance. Then a budget deficit enables the parent to reduce the childs utility(as desired), while maintaining or even enhancing the threat that influences behavior. In his case Ricardian equivalence would not hold. Other economists argue that the uncertainty of the time of death makes many bequests unintended, and that such bequests would not respond very much to budget deficits. The imperfection of private annuity markets is usually mentioned to explain
Robert / Barro 43 why unintended bequests are significant. But this reasoning is backwards, since annuities do not entail greater adverse selection problems than many other types of insurance. The small amount of private annuities outstanding, other than the substan- tial amount in the form of pensions, reflects primarily a lack of demand, which itself is an indication that people desire to make the most of the bequests that occur. In any event, since the Ricardian results involve a broad concept of intergenerational transfers, rather than especially bequests at death, a focus on formal bequests is misplaced Imperfect I Many economists argue that the imperfection of private credit markets is central to an analysis of the public debt; see, for example, robert Mundell (1971). To consider this argument, assume that a closed economy consists of two types of infinite-lived economic agents; those of group a who have the same discount rate,r, as the government(and are therefore willing to hold the government's debt), and those of group B who have the higher discount rate, F>r. The constituents of group A would include large businesses, pension funds, and some individuals. The members of group B, such as small businesses and many households, possess poor collateral therefore, loans to these people imply large costs of evaluation and enforcement. It follows that the members of group B face higher borrowing rates(even after an allowance for default risk)than the government. Whether or not they are actually borrowing, the high discount rate i for group B corresponds to a high rate of time preference for consumption and a high marginal return on investment. Suppose that the government cuts current taxes and runs a budget Further, assume that the division of the tax cut between groups A and fifty-fifty-is the same as the division of the higher future taxes needed extra debt. Since those from group A experience no net change in wealth, they illingly hold their share of the extra public debt. For group B, where the discount rate i exceeds r, the present value of the extra future taxes falls short of the tax cut The members of this group are better off because the tax cut effectively enables them to borrow at the lower interest rate, r. This cut in the effective borrowing rate motivates the members of group B to raise current consumption and investment B In the aggregate a budget deficit now raises aggregate demand, or equivalently aggregate of desired private saving increases by less than one-to-one with the government's deficit It follows that the real interest rate r, which applies to group A and the government, must rise to induce people to hold the extra public debt. Hence there is crowding out of consumption and investment by members of group A. For group B, the opportunity to raise current consumption and investment means that the rate of time preference for consumption and the marginal return to investment would decline. That is, the discount rate F falls. Thus, the main effects are a narrowing of the spread between the two discount rates, r and i, and a diversion of current expendi tures from group a to group B In the aggregate investment may either rise or fall and the long-term effect on the capital stock is uncertain. The major change, however
44 Journal of Economic Perspectives is a better channeling of resources to their ultimate uses. Namely the persons from group B-who have relatively high values for rates of time preference and for marginal returns to investment-command a greater share of current output. In any event the outcomes are non-neutral, and in that sense non-Ricardian The important finding from the inclusion of imperfect loan markets is that the government's issue of public debt can amount to a useful form of financial intermedia tion. The government induces people with good access to credit markets (group a)to hold more than their share of the extra public debt. Those with poor access(group B) hold less than their share, and thereby effectively receive loans from the first group This process works because the government implicitly guarantees the repayment of loans through its tax collections and debt payments. Thus loans between a and b take place even though such loans were not viable(because of"transaction costs)on the imperfect private credit market This much of the argument may be valid although it credits the government with a lot of skill in the collection of taxes from people with poor collateral(which is the underlying source of the problem for private lenders). Even if the government possesses this skill, the conclusions do not resemble those from the standard analy As discussed before, budget deficits can amount to more financial intermediation, and are in that sense equivalent to a technological advance that improves the functioning of loan markets. From this perspective it is reasonable to find a reduced spread between various discount rates and an improvement in the allocation of resources. If the government really is better at the process of intermediating, more of this activit that is, more public debt --raises perceived wealth because it actually improves the orkings of the economy In the preceding analysis, the imperfection of credit markets reflected costs of enforcing the collection of loans. a different approach, followed by Toshiki Yotsuzuka 987) in his extension of the models of Mervyn King H (1987), allows for adverse selection among borrowers with different risk characteristics Individuals know their probabilities of default, but the lenders'only possibility for learning these probabilities comes from observing the chosen levels of borrowing at going interest rates. In this setting the government's borrowing amounts to a loan to a group that pools the various risk classes. Such borrowing matters if the private equilibrium does not involve similar pooling. However, by considering the incentives of lenders to exchange or not exchange information about their customers, Yotsuzuka argues that the private equilibrium typically involves a pooled loan of limited quantity at a relatively low interest rate. Then the high-risk types may borrow additional amounts at a high interest rate. (The assumption is that this additional borrowing is not observable by other lenders. )In this case the government's borrowing replaces the private pooled lending, and leads to no real effects. That is, Ricardian equivalence holds despite the imperfect private loan market where high-risk people face high marginal borrowing rates. The general lesson again is that Ricardian quivalence fails because of imperfect credit markets only if the government does things in the loan market that are different from, and perhaps better than, those carried out privatel
The Ricardian Approach to Budget Deficits 45 Uncertainty about Future T Some economists argue that the uncertainty about individuals' future taxes-( the complexity in estimating them-implies a high rate of discount in capitalizing these future liabilities(Martin Bailey, 1971, pp. 157-58; James Buchanan and Richard Wagner, 1977, pp. 17, 101, 130; Martin Feldstein, 1976, p. 335). In this case, a substitution of a budget deficit for current taxes raises net wealth because the present ralue of the higher expected future taxes falls short of the current tax cut. It the allows that budget deficits raise aggregate consumer demand and reduce desire A proper treatment of uncertainty leads to different conclusions. Louis Chan (1983)first considers the case of lump-sum taxes that have a known distribution acros households. However, the aggregate of future taxes and the real value of future payments on public debt are subject to uncertainty. In this case a deficit-financed tax cut has no real effects. Individuals hold their share of the extra debt because the debt is a perfect hedge against the uncertainty of the future taxes. (This analysis assumes that private credit markets have no"imperfections"of the sort discussed earlier. Suppose now that future taxes are still lump sum but have an uncertain incidence across individuals. Furthermore, assume that there are no insurance markets for relative tax risks. Then a budget deficit tends to increase the uncertainty about each individuals future disposable income. Chan(1983, p. 363)shows for the"usual case (of non-increasing absolute risk aversion) that people react by reducing current consumption and hence, by raising current private saving by more than the tax cut. Consequently, the effects on real interest rates, investment, the current account, and so on are the opposites of the standard The results are different for an income tax(Chan, 1983, pp 364-366; Robert Barsky, Gregory Mankiw and Stephen Zeldes, 1986). Suppose that each person pays the tax Tyi, where y; is the person's uncertain future income. Suppose that there are no insurance markets for individual income risks, and that T is known. (The analysis thus abstracts from uncertainties in relative tax rates across individuals )In this case a budget deficit raises the future value of T and thereby reduces the uncertainty about each individuals future disposable income. In effect, the government shares the risks about individual disposable income to a greater extent. It follows that the results are opposite to those found before; namely, a budget deficit tends to raise current consumption and hence, to raise private saving by less than the tax cut Overall, the conclusions depend on the net effect of higher mean future tax collections on the uncertainty associated with individuals' future disposable incomes Desired national saving tends to rise with a budget deficit if this uncertainty increases and vice versa The Timing of Taxes Departures from Ricardian equivalence arise also if taxes are not lump xample, with an income tax. In this situation, budget deficits change the timing of income taxes, and thereby affect people's incentives to work and produce in different
