Debates about how to finance government date back for centuries. The great classical economist David Ricardo (1772-1823) analyzed public debt and deficits as if people regarded public debt as equivalent to private debt. The Ricardian equivalence theorem as he elaborated it stated:
When for the expenses of a year's war, twenty millions are raised by means of a loan, it is the twenty millions which are withdrawn from the productive capital of the nation . . . . Government might at once have required the twenty millions in the shape of taxes; in which case it would not have been necessary to raise annual taxes to the amount of a million. This, however, would not have changed the nature of the transaction. An individual instead of being called upon to pay £100 per annum, might have been obliged to pay £2000 once and for all.Ä
Recently, Robert Barro,¨ has resurrected Ricardo's view that public debt and taxes are equivalent. According to Barro, if government borrows more today (issues bonds), taxpayers realize that higher future taxes will be required to pay interest on the debt and eventually repay it, so our current saving rates should rise as we bank funds to pay these future tax bills.
Barro's version of Ricardian equivalence essentially treats the burden of paying for government spending as unaffected by the mode of finance---citizens adjust to taxes, public debt, or new monetary base as mechanisms that simply transfer parts of gross private saving to use by the public sector. Ultimately, nominal variables such as the price level or the monetary rate of saving or interest will reflect how government budgets are financed, but real macroeconomic variables---employment, output, and National Income---would be unaffected.
An intriguing historical footnote is that before he confronted the dilemma posed by the Great Depression with his General Theory, John Maynard Keynes's views on the irrelevance of the mode by which government finances its spending appeared quite classical, differing little from those of Ricardo---or Barro. In 1923, Keynes observed that:
It is common to speak as though, when a government pays its way by inflation, the people of the country avoid taxation. We have seen this is not so. What is raised by printing notes is just as much taken from the public as is beer-duty or an income-tax. What a government spends the public pays for. There is no such thing as an uncovered deficit. But in some countries it seems possible to please and content the public, for a time at least, by giving them, in return for the taxes they pay, finely engraved acknowledgments on water-marked paper. The income tax receipts which we in England receive from the surveyor, we throw into the wastepaper basket; in Germany they call them bank-notes and put them into their pocketbooks; in France they are termed Rentes and are locked up in the family safe.*
According to these classical perspectives, we gain nothing by piling up public debt or issuing monetary base instead of financing government through taxes. We might as well balance the budget annually. Naturally, Keynes's views on this issue changed sharply when, in the 1930s, he tried to address the challenge of economies plagued by idle capital and unemployed labor.
One important assumption of Barro's model is that taxpayers have an infinite time horizon because they are concerned about the effects of present debt on their children and future generations. This seems unlikely. Moreover, predictions based on Ricardian equivalence have not been borne out. Tax cuts and swelling deficits did not stimulate higher saving rates in the 1980s. In fact, saving rates fell. Rising saving during 1985--1990 might seem to support Barro, but his model is inconsistent with such lags. This increased saving is, however, consistent with Keynesian theory (rising income during the 1983--1989 recovery stimulated saving) or with demographic changes (baby boomers are outgrowing the high consumption period of young family formation and are beginning to save for retirement).
Ä D. Ricardo, "Principles of Political Economy and Taxation," Works and Correspondence, Vol. 1, Cambridge, 1951 (reprint).
¨ R. Barro, "Are Government Bonds Net Wealth?," Journal of Political Economy, Dec. 1974.
*J. M. Keynes, Monetary Reform (NY: Harcourt Brace, 1924), pp. 68--69.