Ricardian Equivalence

There\’s an interesting little economic theory out there. Sure, you can cut taxes in order to try and boost demand. But if people know that taxes will rise in the future to pay back the borrowing then they\’ll not spend the money, they\’ll save it. Save it to pay the future higher taxes.

Thus your tax cut doesn\’t in fact boost demand.

Now, there\’s a certain controversy over whether this actually holds. David Ricardo, who first considered it, thought it didn\’t and people have been arguing ever since.

But whether it does or it doesn\’t hold depends rather on what people believe. Is this a permanent tax cut? Or just a short term one which will have to be paid for?

Lord Mandelson, the new Business Secretary, said that there would need to be "a medium term adjustment some years ahead" to pay for a "fiscal stimulus" now to revive Britain\’s ailing economy.

His remarks were seized on by David Cameron, who warned that a tax "bombshell" was being stored up.

In a Commons exchange with Gordon Brown following the G20 summit in Washington, he told the Prime Minister that "discretionary borrowing now" would mean "higher taxes later."

The Tory leader said: "Isn\’t it the case that Labour\’s borrowing bombshell will soon become a tax bombshell? And let\’s be clear about what that means. Borrowing £30 billion now will mean an income tax bill for the average earner of nearly £1,500 later.

Oh, well done everybody. If you\’re going to remind everybody that these cuts will need to be paid for then you won\’t in fact get any boost to the economy from the tax cuts in the first place.

Don\’t these people that we hire to administer parts of the economy know any economics at all?

9 thoughts on “Ricardian Equivalence”

  1. Come the next election the Tories will save a fortune on Ad campaigns. They can just rerun those from year gone-by: “Labour Is’nt Working”, “Tax Bombshell”,…

  2. So you’re saying that politicians should lie in an attempt to hoodwink the public? And this is backed up by economic theory? If you can see through it, surely anyone else can?

    Tim adds: Tsk….no, of course not everyone can see through it. I am, after all, blessed with an unusual perspicacity, as, of course, are you, as a reader here.


  3. But if the stimulus works and the economy recovers won’t the tax take increase anyway?

    And if they are bringing forward spending on capital projects doesn’t this mean that future spending requirements will be reduced and therefore lower taxes needed to meet capital spending?

  4. I am not sure if Grabber is just setting the Tories up for a very painful few years in office, or he thinks he will win in 2010 and just throw our lot in with the Eurozone. Tories might even do that, considering the flaccidity of the leadership.

    We need a huge spending cut and to cut taxes enormously. Three figure billions.

    Any household knows this. Why Gordon thinks his budget is so very special is beyond me. His fistall policy is self-serving and aims, AFAICT, to prop up is paymasters and bring more control of the economy into his grasping hands.

  5. Roger, a Stalinesque purge of Gordon’s Turkey Army is long overdue. It would have the salutary effect, apart from saving lots of money, of reducing the number of prodnosed commissars that take such delight in their pettifogging interference in our lives.

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