Classical or Ricardian?

Many macroeconomists have always believed that a tax cut will boost consumption while a tax rise will reduce consumption. This widely accepted theory appears to be very close to the heart of our world leaders as well, as can be seen from the way they use fiscal policy to respond to the current downturn. Many countries, both developed and developing, have resorted to tax cuts in order to boost consumption and hence aggregate demand. Latest data has shown that those moves have indeed produced some positive results. Numerous sources have reported the emergence of green shoots in several economies. However, does it mean that we should forget altogether about another theory known as Ricardian Equivalence?

Ricardian Equivalence is named after a guy named Ricardo who ironically didn’t buy the theory that now bears his name. Broadly, it states that tax cuts have no impact on current spending/consumption and therefore aggregate demand because rational people know that a tax cut now would have to be compensated with a tax rise sometimes in the future, particularly so if government doesn’t make any effort to trim its existing expenditures. Hence, these people would save whatever additional money they obtain from the tax cut in order to pay for the future tax rise.

This theory makes perfect sense to me because throughout my life, I have seen a couple of people with such kind of thought. In fact, both my grandparents and my dad practice it. Whether there’s a tax cut or not, they just spend on basic necessities and save the rest for future generations or as they like to say, for rainy days. You may then ask: if that’s really the case, why is it that tax cuts still work?

Well, 3 good and valid reasons for that. Firstly, not everyone is as far-sighted as some people. They don’t think far. Even if they do, their response would be “let’s think about the solution when government really raise the tax.” Secondly, some people would like to spend beyond their means but in order to do so, they need to borrow. However, due to borrowing constraints, they aren’t able to do so. Tax cuts is one of those methods that will allow them to bypass the borrowing constraints put in place by banks or other institutions. Lastly, many believe that a tax rise sometime in the future will probably affect their children, grandchildren or even great-grandchildren and couldn’t care less about them. So which theory should we adhere to?

There is no right or wrong about the two theories. Each has its own strengths and weaknesses. But if I may, I would like to be somewhere in between because depending on how you argue it, each is valid. On the other hand, too much or too little of either one is not good as well. Too much of the classical theory would mean a selfish society who doesn’t really care about the well-being of the future generations. Too much of Ricardian would mean that the fiscal policy of many governments would effectively be useless in moderating the economy.