Ricardo Rules OK?

This week’s newspaper headlines have been dominated by the £2.7 bn tax bribe (whoops .... tax adjustment) announced by the embattled Chancellor Alastair Darling to compensate for the fiasco over the abolition of the 10% starting rate of income tax. The FT this morning linked the economic effects of this tax cut to one of the most celebrated and controversial ideas of moden macroeconomics - Ricardian equivalence theory ..... how sexy does macroeconomics get!

Do taxpayers increase their consumption of goods and services when the government offers a tax rebate or tax reduction that boosts their disposable income?

This question is of real relevance to the economic issues of the moment. In the United States, the Bush administration has introduced a $150bn tax rebate scheme designed to bolster domestic demand during the fallout from the credit crunch and sub-prime crisis. And in the UK, Darling has injected a more modest £2.7bn by announcing a £600 increase in the value of the income-tax free allowance. Estimates are that the tax giveaway will cause anyone earning up to £40,835 to gain £120 this year. This is worth around 0.3% of household incomes.

Some economists are deeply sceptical that such fiscal measures have much impact on domestic demand for goods and services. What might happen if people regard these tax cuts as merely temporary and expect them to be reversed or clawed back pretty quickly? Darling has said that the extra £2.7bn will be funded by a rise in government borrowing (a higher than expected budget deficit) - but do unfunded tax cuts actually work?

Not according to the Ricardian equivalence theory.

As an article by Chris Giles in the FT states:

“The theory, although more closely associated with professor Robert Barro in the 1970s, suggests that unfunded tax cuts will have no effect on spending because the public know they will be taxed in future to pay for current government largesse.”

Windfall gains are just that - one-off reductions in our tax bills that will not be repeated year-in-year-out. Canny taxpayers will expect the government to claw back the revenue in other ways - there are plenty of new or existing stealth taxes they can tweak. And in the current climate, with rising food and utility bills and falling house prices, much of the extra income will disappear either in meeting double-digit increases in energy prices. Or in saving a little more to repair household finances that are coming under intense pressure.

The rest of the FT article is here