Free Lunch For Everyone

Guess what is happening in the USA at the moment? The Trump administration is introducing massive tax cuts and increasing domestic government spending to stimulate the economy. But could that actually work?

Is a tax-cut a free lunch? According to the Ricardian equivalence theorem, no. The theory was formed by the Great Master of comparative advantage and international trade, David Ricardo.

The Ricardian equivalence theorem suggests that when the government is introducing tax-cuts or stimulating the economy by more debt-financed government spending, the aggregate demand in the economy doesn't change, thus no economic growth is achieved from these actions. This is because the consumers expect the government to finance its increased debt-burden by raising the tax rates in the future. Because of these expectations, the consumers are more willing to save their extra income instead of spending it into goods and services.

The theorem relies on few assumptions. First of all it assumes that the credit markets are perfect (which they duh). We assume that the interest rate on which a consumer can both lend and borrow are identical and it is always possible the borrow money with this interest rate. As I wrote earlier, usually the interest rate on your savings and loans is very different and your solvency decides whether or not your bank thinks you are credit-worthy to get your loan.

Additionally we assume that the consumers save their extra income, even if the hiking tax rates aren't expected to come during their lifetime. Because of these unrealistic assumptions, the Ricardian equivalence theorem has been criticized throughout the years, especially by the Keynesian economists.

But if tax cuts seem a highly popular way of achieving economic growth, could the Ricardian equivalence theorem be true? Are people really saving their extra income and wait for the tax rates to rise again to offset the debt taken during the tax cuts?

We have to remember that we live in a historical time. We live in the time where the interest rates are negative and debt investments offer practically zero profit for investors. The interest rates on the loan that you can get from your bank are historically low. Could this make a difference toe the situation?

Interesting evidence can be found from the time of the financial crisis in 2008. Studies show that the within the European Union these seemed to be a correlation between the increase in the government debt and the capital flow to financial assets (stocks, funds etc) accumulated for 12 of the 15 countries within the union. This suggests that consumers were really saving for the day when the government spending decreases and the tax rates are expected to rise.

On the other hand, this flow of capital to financial assets can be explained by other factors as well. During 2007-2008 the financial markets were booming and more and more capital was flowing to the financial markets before the crisis. During this same time, governments might have had the incentive to take more debt to finance more government spending. It just might be that the the increasing flow of capital to financial assets might not be the causality from the increased government debt. More data is required to investigate this. Inflation rate in 2007 was almost 3,5 %, way above the goal of the European Central Bank. This might also brought its spice to the situation.

So, could the Ricardian equivalence theorem exist in the real-life? Not any conclusions here.... yet.

The reason I'm writing these points down is because I'm soon in the situation where I have to face my greatest fear, my Master's Thesis. The existence and evidence for and against the Ricardian equivalence theorem is very interesting and currently the number 1 topic at the moment. I probably need to investigate this further and gather more data so that I would have sufficient material for my thesis. Then you can hopefully read my 100 pages of whether this theorem exists in real-life or not.