Academic journal article Economic Inquiry

Deadweight Losses and the Saving Response to a Deficit

Academic journal article Economic Inquiry

Deadweight Losses and the Saving Response to a Deficit

Article excerpt


Several recent empirical studies have challenged the conventional wisdom that deficits cause a higher interest rate. Many economists are, however, critical of the seemingly implied theoretical justification--that every individual fully recognizes the size of the deficit and the extent to which it increases future tax liabilities. This paper demosntrates that far weaker information assumptions are needed to obtain an aggregate savings response equal to the deficit: a reallocation of deadweight losses causes Ricardians to save more than their share of the deficit to keep consumption unaffected, allowing for a substantial fractrion of Keynesians, who save less than their share.


The saving behavior in the "Ricardian Equivalence Theorem" is often criticized for relying on perfect foresight; e.g., Buchanan [1976] and Evans [1985,85]. Even David Ricardo himself rejected what is nowadays termed the Ricardian Equivalence Theorem, on grounds that people are not sufficiently aware of future tax liabilities (see O'Driscoll [1977]).

This paper demonstrates that the saving response obtained by the Ricardian Equivalence Theorem--saving oing up by the deficit, with a constant interest rate--can be obtained with weaker rationality assumptions when deadweight losses associated with nonlump-sum taxation are accounted for. Deadweight losses have been overlooked in the deficit debate, possibly because the deadweight loss estimates in the public finance literature were rather small up until a few years ago; the first mention of deadweight losses we have found is the brief theoretical discussion of transactions costs in collecting taxes and issuing debt in Barro [1974,1109]. Deficits and welfare is an issue currently debated, but the question posed is usually the reverse of the one asked here; while we analyze how welfare losses affect the macro consequences of a deficit, recent studies have focused on whether deficits increase or decrease welfare. For instance, both Chan [1983] and Barsky et al, [1986] have studied whether deficits are desirable or not though analyzing how uncertainty of present and future after-tax income are affected.(1) Futher, a recent article by Hansson and Stuart [1987] estimated the losses from labor and capital taxes in a current and a future time period to evaluate the welfare consequences of a reallocation of taxes over time.

The theoretical argument made in this paper might be viewed as an obvious elaboration of the Ricardian Equivalence Theorem. Nevertheless, given current parameter estimates of deadweight losses, the argument turns out to be very important quantitatively. A simple illustration will demonstrate that far from everyone--perhaps less than half of the population--needs to have rational foresight about the deficit in order for a deficit to generate a one-to-one response in saving.

II. THE BEHAVIOR OF "RICARDIAN INDIVIDUALS" The Effect of Taxes Altering Efficiency and Deadweight Losses in Each of the Two Time Periods

The standard Ricardian Equivalence Theorem is arrived at assuming lump-sum taxation, with no deadweight losses accompanying taxation. According to the theorem, a deficit has the equivalent effect of current taxation, because people anticipate the future tax liability incurred with the deficit. These Ricardian individuals have no reason to alter their labor supply, the production techniques, or their consumption pattern. All that a deficit therefore results in is an increase in savings that is exactly equal to the deficit.

How would the analysis change if nonlump sum taxations is allowed for, and associated with deadweight losses? One shoudl have to analyze which particular tax is cut today and which is raised tomorow when the deficit is generated, and how both affect the desired levels of labor suplly, consumption, etc., today and in the future. …

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