Saturday, January 12, 2013

The Coming Empirical Test Of "Ricardian Equivalence"

Though "the fiscal cliff deal" meant that much of the planned tax increases or spending cuts in the U.S. were prevented or postponed, there will also be some tax increases taking effect already this month in the form of higher marginal income tax rates and limitations of deductions for the rich and the expiration of the payroll tax cuts for the middle class will in fact be implemented, something that in turn means that real disposable income will fall significantly this month.

When real disposable income falls, people have two choices: either they cut back on their spending or they reduce their saving. If people acted according to the Ricardian equivalence theory, income reductions due to higher taxes and/ or lower government spending, the result will simply be a reduction in the savings rate.

Based on previous experience it seems nearly certain that it will be a combination of the two choices: both the savings rate and consumer spending will fall. The exact proprtion to which savings will fall and consumption will fall is however a lot more uncertain. With the savings rate only about two percentage points above the lows of the housing bubble, it would however seem that there's not much room for big reductions in savings.