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FALLACY 9 OF FINANCIAL FUNDAMENTALISM
William Vickrey, 1996 Nobel Awards in Economics
October 5, 1996

The negative effect of considering the overhanging burden of the increased debt would, it is claimed, cancel the stimulative effect of the deficit. This sweeping claim depends on a failure to analyze the situation in detail.
Analytical reality: This "Ricardian equivalence" thesis, while referred to by Ricardo, may not in the end have been subscribed to by him. In any case its validity depends crucially on the system of taxation expected to be used to finance the debt service.

At one extreme, in a Georgist economy making exclusive use of a "single tax" on land values, and where land values are expected to evolve proportionally over time, any debt becomes in effect a collective mortgage on the land parcels. Any increase in government debt to offset current tax reduction depresses the market value of land by an equal amount, aggregate wealth of individuals is unaffected, Ricardian equivalence is complete, and pure fiscal policy is impotent. A larger debt may still be desirable in terms of taking advantage of possibly lower interest rates available on government debt than on individual mortgages, and in effectively endowing property with a built-in assumable mortgage that facilitates the financing of transfers. And there may still be a possibility for stimulating the economy by tax-financed expenditures that redistribute income towards those with a higher propensity to spend.

In another scenario, if the main tax is one on all real estate, such as is common in American local finance, the effect is drastically different. In this case any investor erecting a building thereby assumes, for the time being at least, a share in the government debt, subject to some of this burden possibly being eventually taken over by further construction. Not only does this discourage construction, but if the debt overhang gets too great, this expectation of others taking up part of the burden may vanish rather suddenly, and all construction come to a grinding halt. Debt becomes a strong inhibitor of growth. While this result may resemble that claimed by the "crowding out" theory, the mechanism is not one of displacement but of disincentive.

With a sales or value-added tax as the mainstay, a deficit involving a reduction in tax rates today will have no depressing effect on capital values and will have a fully stimulating effect, through the increase in the aggregate supply of assets, possibly reinforced by anticipatory spending motivated by expectations that taxes may have to be higher at a later date to finance the debt service. There will be no Ricardian equivalence effect; if anything, anticipation of higher future taxes will encourage current spending, adding to the stimulus of the increased supply of securities.

The U.S. federal tax system is dominated by the income tax, for which the effect will be somewhat intermediate between taxes on savings and taxes on expenditure. In practice few individuals will have any clear idea of the taxes likely to be imposed in the future as a result of the existence of a larger debt, and it can be safely said that no reasoned Ricardian equivalence phenomenon will occur, though there may be some generalized malaise among the viewers with alarm, involving a kind of partially self-fulfilling prophecy.