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Stefano Toso- Ricardian Equivalence in retrospect: M od em Views and the Contri-
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Enrico Po t it o- 1 rapporti tra bilancio civile e dichiarazione nella normativa del testo unico delle imposte sui r e d d i t i ...
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E N R I C O P O T I T O
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rv
COLLANA DI FINANZA LOCALE
DIRETTA DA E. PROTETTI
CARMINE CLAUDIO DI ZENZO AN N A M A R IA M ANISCALCO G IU S E P P E M A R I A V IT A L E
I P R O C E D I M E N T I
DI ACCERTAMENTO,
DI RISCOSSIONE
E CONTENZIOSI
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La seconda riguarda gli accertamenti che devono essere eseguiti dai Comuni e dalle province e le procedure di accertamento: delibere, approvazioni del Ministero delle Finanze, controlli da parte dei Comi tati Regionali di Controllo.
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LE LEGGI PENALI
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A n n o ta te con la giu risp ru d en za
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D opo le decisioni della Corte Costituzionale n. 88 e 89/1982, infatti, il legislatore ha definitivamente abrogato la c.d. pregiudi ziale tributaria, che impediva l’ esercizio dell’ azione penale in materia di imposte dirette e di IV A . C iò ha fatto sorgere l’ esigenza di una complessiva rimeditazione dell’ intera materia per la defi nizione dei criteri ermeneutici di applicazione generale.
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---. . . . _______________________________________________________________ 330________________
VI
N ovità p er il manager e il professionista
ENRICO GUSTARELLI
LA GESTIONE D’IMPRESA
NELLA SUA
RAPPRESENTAZIONE CONTABILE
Volume I - Tomo II
I L P I A N O D E I C O N T IUn’indispensabile modello di riferimento per la
costruzione di un valido piano di contabilità-generale:
• Il sistema del reddito e il metodo della partita doppia
• La tecnica della formazione e della codificazione
• Il piano dei conti in edizione integrale e in versione
semplificata.
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COMMENTARIO DI LEGISLAZIONE AMMINISTRATIVA
C A R L O A N E L L I - F E R D IN A N D O I Z Z I - C A R L O T A L IC E
CONTABILITÀ PUBBLICA
Sommario:
Nozioni generali - I principi - L'informatica.
L'amministrazione del patrimonio.
Il bilancio dello Stato. v
Esperienze applicative e prospettive di riforma della legge
5 agosto 1978 n. 468. Le modificazioni introdotte con la
legge 23 agosto 1988 n. 362.
Controlli e responsabilità nelle gestioni dello Stato.
Il bilancio degli enti pubblici.
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V ili
SCHEDARIO
DEL DIRITTO
FALLIMENTARE
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Aggiornato al 30 giugno 1988
L o
Schedario
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• un IN D IC E -SO M M AR IO , che richiama l’ articolo e la «v o ce » ove la materia è collocata e che comprende anche una ricca rete di rinvìi e di richiami
• un INDICE DELLE FORM ULE • un INDICE GENERALE
La raccolta — 2428 schede in 5 raccoglitori con custodia in
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-4
MODERN VIEW S AND THE CONTRIBUTION OP THE ITALIAN TRADITION OF PUBLIC FINANCE (*)
S iiABY. 1' ^traduction. — 2. Ricardian equivalence and non equivalence mndAi mooer™ f ebatf : 21: Tbe analytical fram ew ork: a two-period “ „” 1. : 2:2f Different planning horizons for private and public sector: I K S l l i n° bequest motiva - 2-3- Imperfections in capital
Dl,S^ rtl,°naS taxation. — a. The contribution of the talian Tradition o f Public Finance. — 4. Conclusions. — References.
1. Introduction.
Few issues in economic theory are more controversial than the macroeconomic theory of public debt and, in particular, the differential incidence of debt and tax financing. This time-honoured controversy has recently been restated as «A re government bonds net w ealth?», «D o government deficits absorb private saving?», « Gan the burden of current government expenditure be shifted to future generations? » (1).
The « new classical macroeconomics » gives negative answers to these questions. Even though government spending is financed by issuing bonds instead of levying taxes, the burden of current government expenditure can not be shifted to the future generations; this is due to the fact that the present generation completely discounts the taxes that will be levied to pay the interest and increases its bequests so as to meet that future liability.
This theoretical view, summarized under the term of «debt neutrality », is generally labelled as Ricardian since it was Ricardo (1817, 1820) to point out the case of equivalence between the two alternative methods of financing (2). Since that classical contribution,
1nr 1 '"P t0 Professors V. Denicold, F. Giavazzi and R. Soazzieri 1 ^ their useful comments on an earUer version of M s paper. I owe a sneotal
T r Z s T n Z r M' MattmZZi fnr M8 W V & L i . AlTe^or* 7 1
BERN^ F a m 7)COmprehen8lVe SUrvey ° f the large body o t a « literature, see
— 4
the debate about differential incidence of tax financing and borrowing has resurfaced a number of times (3). The most recent revival of the controversy, restated as whether government bonds are considered as net wealth, is due to Barro (1974).
Ricardo’s undoubted originality in theorising the case of equivalence and the frequent, subsequent references to his analysis make the controversy interesting for a number of reasons. Firstly, it represents one of the oldest areas of theoretical inquiry. Secondly, its policy implications are of the utmost importance, since they deal with the effectiveness of a debt-financed tax cut as a sta bilization policy in the short run, and its effects on capital
accumulation in the long run. By denying that government bonds are perceived as net wealth, the « new classical macroeconomists » postulate both the short run ineffectiveness of fiscal policy and its irrelevance for the long run growth of private capital stock. In terms of theoretical respectability, the debt neutrality thesis represents, indeed, « a much more serious challenge to keynesian fiscal activism than previous discussions that focused on slopes of IS and LM curves » (Barro 1978: 571). The wealth effect of public debt is in fact a crucial element in the debate: according to con ventional keynesian theory (4) a shift from tax to debt financing, for a given level of government spending, raises perceived wealth and thereby causes an expansion of aggregate consumption. Higher interest rates, induced by the change in households’ portfolios and by higher desired consumption relative to saving, also reduce the fraction Of output which goes to private capital formation. On the contrary, in a world d la Barro both the effectiveness of debt financing as opposed to tax financing and the theoretical case for indirect crowding out disappear. The effect of fiscal policy is merely measured by the size of real public expenditure, regardless of how it is financed. In such a framework no problem of sustainability caused by the debt growth can eventually arise. Such far-reaching
Neesser (1961), for example, stressed Ricardo’s attention to the case of fiscal
illusion which implies the shifting of debt burden to the future. A more extreme position, according to which « Ricardo was not a Ricardian », has been supported by O ’Dr tsc o ix (1977), Butterand Tobin (1979) and Mu sg rave (1985),
On the relation between Ricardo’s analytical scheme and his policy approach to the public debt issue see also Asso and Ba r u o c i (1988).
(3) See Fe r g u so n (1964) and Tobin (1965) fo r a survey of the debate
in the 1960s.
(4) See for example Mo d ig lian i (1961), Blinder and So lo w (1973) and
policy implications explain why « the Ricardian view is as impalatable to fiscal conservative like Buchanan as to keynesians » (Tobin 1980 : 51). Unlike the modern re-discoverers of Ricardian equivalence, its opponents have argued that the required conditions clearly misrepresent reality. The effects of removing the basic assumptions of the theorem have been accordingly analyzed.
The most recent revival of the controversy, however, offers a further reason of interest, namely the opportunity of a retrospective reading of the current debate. It allows one to reconsider the contribution given by the Italian Tradition of Public Finance, at the turn of this century. In fact, it is not till the end o f the nineteenth and the early years of the twentieth century that we get a critical evaluation of the equivalence theorem and an exposition of its assumptions, which remained implicit in Ricardo’s formulation. This was accomplished by the work of some Italian scholars, namely Pantaleoni (1891), De Viti de Marco (1893), Griziotti (1917) and Borgatta (1918). Despite its remarkable contribution, the Italian Tradition of Public Finance has been almost completely neglected by the literature that followed.
The purpose of this paper is to suggest that a reconsideration of these classical analyses allows one to grasp some substantial anticipations of the current views of the debate. In particular, our aim is to suggest that a reading of the contribution of the afore mentioned Italian scholars, compared to that of some recent authors, as Barro (1974), Tobin (1980) and Blanchard (1984, 1985), highlights interesting analogies between the formers and the latters.
The outline of the paper is as follows. Section 2 shows an analytical framework (a two-period intertemporal model) which presents Ricardian equivalence theorem as reformulated in the recent revival of the controversy. Such a model also provides a unified framework to review the main criticism on that theorem. In section 3 the Italian scholars’ classical contribution to the theory of public debt is reconsidered. Section 4 offers some conclusions.
2. Ricardian equivalence and non equwalence in the modern debate.
2.1. The a'nalytirxil framework: a two-period model.
— 6 —
is linked to the subsequent one by a series of intergenerational transfers.
We shall here present Barro’s result in a slightly different analytical framework, that is in the context of a simple two-period model of the economy that consolidates the intertemporal budget constraints of the public and the private sectors (5). The choice of a two-period model to analyze such an issue may appear quite strange: an overlapping-generations model would be a more natural vehicle to handle the « entry » and the « e x it» of subsequent generations. However, our analytical framework is in fact no less appropriate than Barro’s: on the one hand, it will allow us a comprehensive consideration of the role of the basic assumptions of Eicardian equivalence, on the other hand, it provides a unified framework to
study the effects of their removing.
In our intertemporal model, periods 1 and 2 represent respectively the « present» and the « future », while time 0 accounts for initial conditions. Economic agents have a finite lifetime, i.e. a zero probability o f death at the end of the first period and a 100 % probability of death at the end of the second one. The intertemporal solvency condition for the government requires that the present discounted value of government expenditure plus initial financial liabilities must equal the present discounted value of tax revenue.
Let us assume that:
1) the economy is in a full employment stationary equilibrium (constant population with zero productivity growth),
2) the level and the nature of government expenditure is exogenously given,
3) private and public sector have the same planning horizon, 4) perfect competition prevails in capital markets,
5) lump-sum (i.e. non distortionary) taxes are available and there is no uncertainty about future expected income and wealth.
These assumptions describe a very specific fiscal regime. Firstly, they imply that government debt is fully backed by taxation, i.e. an increase in government bonds hold by the private sector brings about an increase in future tax collections, whose present value exactly matches the value of existing government bonds. Secondly, the time path of government spending is assumed as given, i.e. any change in the debt-tax ratio is treated as signalling no future changes
On the contrary, we could refer to an alternative scenario bonds are backed by implicit inflationary taxation in the for money creation (6). Furthermore, changes in taxes and debt in fact cause changes in future government spending, which turn may induce some kind of reaction in the private sector (7).
The government budget constraint for the two periods, in nominal terms, is the following:
^1 — Ti + ig Bg = _Z>j — D 0 T2 + ix B 1 — — B x
(1) (2)
where G is the government expenditure, T is the lump-sum tax revenue, D is the public debt and i is the nominal interest rate. Equation (2) implies that all the debt is paid off, i.e. D2 = 0.
Equations (1) and (2) can be expressed in real terms (8) and consolidated in a single intertemporal government budget constraint. Denoting by P and r, respectively, the price level and the real rate of interest, we get the following equation:
9i + 92 (1 + rx) 1 + (1 + r0) d0 = Tl + r2 (1 + r,)-* (3)
where g, d and ~ indicate the real value of the corresponding nominal variables G, D, T and
(1 + r j = (1 + H) (P ,/P 2), (1 + r0) = (1 + i0) (PJPJ.
Equation (3) simply makes explicit the intertemporal solvency requirement for the government.
If, for the sake of simplicity, we assume a closed economy without physical capital, the private sector budget constraint in period 1 and 2 can be expressed in nominal terms as follows
C1 = Y 1 - B i + ( 1 + i0) B a - Tx {4)
C'2 = Y2 + (1 - f ij) Dj — t2 (5)
where Y is the income from human capital and D is private wealth. 6
(6) See fo r example Sabgent and Wallace (1981).
^ 1f SUe of the f a l l i n g role of fiscal behaviour has not yet ciocJi pai?icular attention ; some exceptions are Feldstein (1982), Hibbchhobn
(1984) and Leidebman and Blejee (1988).
nKo J Î L i t n y J ,r^ 1T lu 0Îj 1nÎLiiti<m a<Uustment is left out in the particular
— 8 —
Equations (4) and (5) can be expressed in real terms and consolidated in the intertemporal private sector budget constraint:
Ci + c2 (1 + iq)- 1 = y 1 + y i ( 1 + r j - 1 - - t2 (1 + u ) - 1
+ (1 + r0) d0, (6)
where y and d indicate the corresponding real values for 7 and D. Equation (6) shows that the present discounted value of private sector consumption must be equal to the present discounted value of disposable income, plus the initial wealth. Private sector’s optimal consumption plans are obtained by solving the intertemporal utility maximization problem subject to the budget constraint represented by equation (6).
Given our assumptions, private sector internalizes the inter temporal budget constraint of public sector in order to fully
evaluate the consequences of government activities for its welfare levels. In fact, modelling private sector consumption without taking into account the above aspect would involve a rather asymmetric behaviour with regard to fiscal policy. Private sector would be forward-looking in its assessment of income and taxes, but government bonds would still be included as part of private wealth. This myopia regarding the extra taxes required to pay off the principal and the interest appears rather inconsistent with an approach that embodies perfect foresight. In our model therefore, private sector behaviour is assumed to depend on total resources available to the economy, i.e. on national income net of government absorption, rather than on disposable income.
Ricardian equivalence emerges by substituting equation (3), the intertemporal government budget constraint, into the private sector one, equation (6), The substitution yields:
Sncli striking result depends on three key assumptions, in particular: identical planning horizons for private and public sector, perfect capital markets, and lump-sum taxation. We now consider the main criticism on these assumptions in the modern literature.
2.2. Different planning horizons for private and public sector: uncertain lifetime with no bequest motive.
Three main deviations from the basic hypotheses of the equivalence theorem have been considered in the recent revival of the debate: different planning horizons for private and public sector, imperfection^ in capital markets, non lump-sum taxation along with uncertainty about future income and wealth. Let us consider each of them separately.
Ricardian equivalence requires that both the private and the public sector have the same planning horizon and the same rate of time preference. In an overlapping-generations model, where each individual has a finite lifetime of two periods, this assumption requires agents to act as if they had infinite horizons. In this respect, Barro (1971) assumes that each finite-lived generation is linked to the subsequent generation by a series of voluntary transfers (bequests, gifts, etc.). In this intergenerational altruism model, the process of bequests makes finite-lived individuals act like infinite- lived ones. Therefore, as long as no change in the budget constraint of the current generation occurs, there is no reason to change inter temporal consumption. The equivalence of tax and debt financing is thus established.
— 10
With regard to the first component, Drazen (1978), Laitner (1979) and Weil (1987) have argued that, under plausible assumptions about preferences, many parents will bequeath nothing to then- children. Models which allow for both gifts (from children to parents) and bequests (from parents to children) have also been studied. These studies show that there is a range of parameter values where transfers flow in neither direction.
With respect to the second component (bequests motivated only by intergenerational altruism), some authors have suggested that bequests can rather be the outcome of a taste for generosity (Tobin (1980)), the effect of lifetime uncertainty (Abel (1985)) or, still, the result of future earnings uncertainty (Feldstein (1988)).
On a priori ground, Tobin (1980) argues, on the one hand, that Barro’s dynastic model which assumes families as perfectly harmo nious units is extremely restrictive; and, on the other, that the preferences of distinct generations may sensibly conflict.
Abel (1985) presents an overlapping-generations model with precautionary saving and accidental (i.e. involuntary) bequests caused by lifetime uncertainty (9). The key assumptions are: consumers live for either 1 or 2 periods, no bequest motive, no private markets for annuities (10). In Abel’s model, a precautionary demand for saving arises since each individual never knows ex ante the date o f his death. Therefore, when that time occurs, the individual is likely to hold some wealth that will be passed on to his heir in the form of accidental bequests. In such a framework, a tax-to-debt switch does not imply that future generations inherit a monetary amount just equal to the future taxes for the debt service.
Feldstein (1988) obtains the same result in a similar framework where the crucial hypothesis is that current generation in the first half of its lifetime is uncertain about the second-period income, i/2. The focus is on the effect induced by that uncertainty on the desired bequest. Because of the stochastic nature of second-period earnings, individuals choose their current consumption, ci, without knowing whether they will be able to make a bequest in period 2. Furthermore, due to precautionary saving, c2 may be substantially less than it would be under conditions of full certainty. In such a context, the
(9) The effect of lifetime uncertainty on individual consumption were first examined formally in a seminal paper by Yaari (1965). His model represented the common framework for most subsequent works.
ultimate effect of uncertainty about future earnings is to « shorten » the present generation’s horizon, which implies that a shift from tax to debt financing will raise current consumption.
Let us consider now the implication of lifetime uncertainty for Ricardian equivalence in our two-period model. Let us assume that, contrary to the case of equal planning horizon for private and public sector, each economic agent at time 1 is given the same constant probability o f dying, p, before the start of the second period (0 < p < 1). A ll the other hypotheses of the model are the same (11).
Because of uncertainty of survival, individuals discount the future more heavily. The effective interest rate facing the consumers- taxpayers is therefore f= (1 + rx) / (l — p) _ i , where r3 is the real interest rate if probability of death is nil.
Whereas the government budget constraint is the same as before, the new private sector budget constraint is the follow ing:
ci + c2 (1 -f- B J -1 = Pi + y2 (1 + -BJ- 1 — Tj — -r2 (1 + R j)-1
+ (1 + -Bo) i (8)
where
(1 + r j / (1 - p) - 1 = [(l + ij) / (1 - p) - l ] (PJPt).
Since private sector internalizes the intertemporal government budget constraint, substituting (3) into (8) yields:
ci + c2 (! + -Ba)-1 = Vi + p2 (1 + B J -1 — sq — g2 (1 + rj) - 1 +-(B 0 - r„) d0 + p t2 [(1 - p) ( 1 + R :)]-1. (9)
Equation (9) shows that a current tax cut (<l Tl < 0) that is matched by an increase in future taxes (d t2 > 0) raises consumers’ perceived wealth and consumption. To the extent that individuals have a strictly positive probability of death before the start of time 2 (p > 0), the departure from equivalence theorem occurs since
(11) Macroeconomic models incorporating agents with uncertain lifetime and no bequest motive were first established by Bl a n o h a b d (1984, 1985).
— 12 —
the current tax cut involves a less than one-to-one increase in the present value of future taxes. In fact, it is as if a tax-to-debt swap at time 1 presents individuals with the opportunity to extract funds
from the « future » (time 2).
Yaari-Blanchard’s approach, in which the horizon of agents is a parameter that can be chosen arbitrarily, is extremely flexible. If p goes to zero equations (9) and (7) coincide: Barro’s model is obtained as a special case (12).
Two considerations are required at this stage in order to avoid misleading conclusions. Firstly, the wealth effect of public debt in Yaari-Blanchard’s model does not depend on the randomness of lifetime in itself, but on the fact that lifetime uncertainty << shortens » the horizon of risk-averse agents. Such a consideration may look trivial: in our two-period model uncertain lifetime implies necessarily a shorter horizon. Generally speaking, however, it cannot be excluded that a random lifetime causes an agent’s horizon to be longer than that of an agent with certain lifetime. In this case, as argued by Levhari and Mirman (1977), two elements act in opposite directions: the desire of a risk-averter to provide for a longer life together with the desire for more certainty. The final effect on current consumption cannot be established a priori.
The second remark, due to Buiter (1988), is that, in the case of lifetime uncertainty, debt non-neutrality hinges on the implicit assumption of a positive birth rate. In other words, as long as there is a zero birth rate, uncertain lifetime (represented by a positive constant probability of death) does not destroy debt neutrality. The intuition behind the result is that, with a zero birth rate, to postpone lump-sum taxes fails to redistribute income or wealth over tim e: while the probability to survive to pay the future taxes declines, the per capita tax burden of the survivors increases (13). This qualification is consistent with our two-period model. Given the hypothesis of constant population, to assume a constant probability of death before the start of period 2, necessarily implies a positive birth rate.
(12) Yaari-Blanchard’s model allows for radically divergent implications: a role fo r short run stabilization policy when agents have finite, horizons ( p > 0 ) , debt neutrality when they display infinite horizons (p = 0). Since Bixnohabd (1984, 1985), the hypothesis of finite horizons’ agents has been the standard approach to build a role for deficit-spending policies.
2,3. Imperfections in capital markets.
Another important channel leading to deviations from Eicardian equivalence is given by imperfections in capital markets.
It has recently been contended that the issue of agents’ horizon along with the bequest motive is not likely to be empirically relevant. Hubbard and Judd (1986) and Poterba and Summers (1987) for example point out that under a variety of plausible deficit scenarios, a substantial fraction of the deferred tax burden is not shifted upon future generations. These authors conclude that factors such as liquidity constraints may have a much larger bearing on the controversy.
Indeed, the belief that imperfections in capital markets are empirically relevant also explains the large body of recent work designed to identify liquidity constraints from consumption data (14).
Given all the other assumptions of Eicardian equivalence, let us consider the case of imperfect capital markets in our simple two-period model.
Let us suppose that private sector faces higher borrowing rates than government does. The higher private borrowing rate could reflect government superiority in the intermediation process as long as costs of verifying credit-worthiness, of monitoring the borrower, and expected default costs are lower for the public sector than for the private.
In particular, let us assume that the interest rate facing private sector is (1 -f- <I>) i, where i is the nominal rate of interest that applies to government borrowing and <3> is the premium reflecting the relative inefficiency of private sector in arranging loans.
The government budget constraint [equation (3)] is not affected by the new assumption. On the contrary the intertemporal budget constraint of the private sector has to be reformulated as follows:
ci - f c2 [1 + (1 + Oj) r j - 1 = y t — Vi - f (2/a — t2) [1 + (1 + Oj) r j - 1
+ [1 + (1 + <E>0) r0] do , (10) where
i + (i + d y r, = [i + (i + d g y (p x/ p 2).
— 14 —
Since private sector internalizes the government budget constraint, equation (10) can be rewritten a s:
ci + c2 [1 + r-y (1 + Oj)]“1 = y 1 + f 2[l + (l + i>x) »q]-1 — gy— g2( 1 + rq)-1
+ r0 d0 + a rt t2 , (11)
where
« = (!■+. »i)“ 1 [1 + (1 + ®i) ry]-\
Equation (11) shows that, as long as cjq > 0, a current shift from tax to debt finance (that is matched by an increase in future taxes, d t2 > 0) increases private sector consumption. Economic agents are no longer indifferent to the opportunity to postpone tax payments: « Even if they themselves must pay the taxes later, they will increase their consumption now. In effect the government lends to them at its borrowing rate of interest, an option not otherwise available in the credit market» (Tobin 1980 : 57). The result crucially depends on the assumed government superiority in the intermediation process. If its ability to enforce tax payments is as great as private lending institutions’ ability to enforce debt repayment, any rate differential disappears (<E>0 = <iq = 0) and equations (11) and (7) coincide. The equivalence theorem is thus restated.
Imperfection in capital markets can also take the form of credit rationing. For those individuals whose borrowing constraints are binding, the tax-cut represents a slack in the constraint itself. They may consequently choose to revise their portfolio decisions by increasing present consumption. In fact, a tax-to-debt swap can be thought of « as the public sector borrowing from low borrowing cost individuals (those whose borrowing constraints are not binding) and lending to high cost individuals (those with binding constraints) » (Chan 1983 : 370).
Unfortunately, the basic premise that the government is more efficient than the private market in arranging loans seems weak on a theoretical ground. Furthermore, liquidity constraints are assumed as exogenously given.
private financial markets. As regards public debt controversy, the question arises as to whether models of informationally imperfect markets provide a sound theoretical base for debt non-neutrality.
In this respect, neither Hayashi (1987) nor Yotsuzuka (1987) provide clear-cut answers: unless the exact nature of market imperfection and the extent to which information is shared among lenders are clearly specified, adverse selection in capital markets does not seem to violate Eicardian equivalence. Apart from these preliminary results, which do not imply, as Yotsuzuka h im s e lf
states, « that capital market imperfections do not m atter», the microfoundations of imperfect capital markets seem an interesting issue on which future theoretical work could concentrate.
2.4. Distortionary taxation.
A third important source of debt non-neutrality is the non lump-sum nature of the tax system: by inducing intertemporal substitution effects, distortionary taxes affect the allocative decisions of private sector. Under these circumstances, debt financing is no longer perceived as a mere « tax postponement ».
Most of the current debate has not paid attention to the crucial role played by the assumption of lump-sum taxation. Since Barro (1974), as previously argued, the main focus has been by far on the role of voluntary private intergenerational transfers (bequest motive).
16 —
The ease of distortionary taxation can also be easily illustrated in our two-period model. Let us consider, for example, an open economy with perfect capital mobility, such that the domestic real interest rate, r, is equal to the international rate, r*, which applies to borrowing from abroad. All borrowing, both by public and private sector, comes from foreign lenders. While lump-sum taxes are not available, taxes on interest payments against foreign borrowing by the private sector are levied. All the other assumptions of Ricardian equivalence are satisfied.
The hypothesis of distortionary taxation modifies the original intertemporal government budget constraint [equation (3)] as follow s:
9i + g2 (1 4: »q) - 1 + (1 + r0) d0 = e0 r0 b0 + jL r1 b, (1 - f jq)- 1 (12)
where b is the private sector debt in real terms and e is the tax rate applied to private sector interest payment on foreign borrowing to be paid at time (t -j- 1). The private sector intertemporal budget constraint is the following:
ci + c2-[l + (1 -h £i) ^i]“ 1 = Vi + y2 [1 + ri (1 + Si)]-1
— P 4” ro (1 + ®o)] K • (1 3 )
Substituting (12) into (13) gives the intertemporal budget constraint facing rational economic agents:
¿i 4 e2 [1 4 4 (1 + Si)]“ 1 = yx + y2 [1 + (1 4 |j.) r,]“ 1 — gq - 92 (1 + n )“ 1 - (1 + r0) (60 + d0)
g j f t h (1 -rh l l 1- (1 4 )
The first four addenda on the RHS are the present value of real resources available to the private sector, while the other two addenda represent the initial value of the economy’s external debt commitment. The higher the value of external debt commitment, the lower the level of wealth and o f private consumption will be.
- (i + r0) (b0 + d0), the government’s foreign borrowing has no effect on private consumption. This is affected only by the amount of public expenditure, g, + gA l + r j - i , and not by the form o f financing. On the contrary, when Sl 4 = o, a current tax cut (dt0 < 0> followed by a future increase (d£] > 0) implies both substitution and wealth effects. A current tax cut can alter the relative price of present consumption in such a way that consumers-taxpayers will be induced to substitute away from future towards current con sumption.
* Al0Ilg Wlth tbe debate 011 Ricardian equivalence, the implications, oi assuming distortionary taxes have also been analyzed by the «optimum debt» theory (15). The starting point is that, even though taxpayers display infinite horizons and capital markets are perfect tax-to-debt swaps are not irrelevant as far as some welfare cost is associated with collecting distortionary taxes.
Given the intertemporal government budget constraint, the- problem is to derive the time pattern of taxes which minimizes the- excess burden induced by non lump-sum taxation. This is a dynamic application of the theory of optimal taxation to the study of fiscal policy. In this respect the theory of optimal taxation becomes a t eory of optimal public debt since borrowing is viewed as a device to redistribute tax distorsions over time. The basic result is that it is optimal to smooth planned tax rates relative to planned govern ment spending. This implies that debt financing should be used either in the case of exceptionally high expenditures (such as during wars) or when tax receipts are temporarily low (such as during recessions) (16).
•1. The contribution of-the Italian Tradition of Public Finance.
A survey of the main criticism on the equivalence theorem has shown the extremely restrictive conditions on which the irrelevance
Stok w% 83). “ particuIar Baebo <1979> 198°)> B u r im (1983), Lucas and follow his ^ 1Tent ?-0U7 maker “ commit lts successors to. ronow ms optimal plan, the application o f the optimal taxation theorv to framework does n° t originate any time-consistency problem. However since it is more sensible to think o f tax rates as being set over time bv a
F E X r S * 1 a M ity t0 bind future tax decisions, an incentive
to deviate from previously announced policy may arise. On the issue of T> optIm al flscai policy see Lucas and Stokisy (1983) Lucas
18 —
of alternative government financing rules can be maintained. Nevertheless, that criticism has not faulted the logic inherent in the theorem. Therefore it seems that the controversy can be settled only on empirical grounds (17).
However, as far as the economic theory of public debt is concerned, many of the current views were already contained in old strands of the literature. In particular, an original contribution was given, at the turn of this century, by some exponents of the Italian Tradition of Public Finance. Spelling out the key assump tions of the Ricardian equivalence theorem, which remained implicit
in Ricardo’s exposition, they made evident the logic of the theorem. In this way, they laid down a basis for a definite settlement of the controversy. Such remarkable contribution, however, has been sub stantially neglected by the subsequent literature (18).
Let us reconsider, therefore, the main points of the Italian debate at the turn of the century in order to highlight some interest ing anticipations of the modern views.
Before the appearance of the works by Pantaleoni (1891) and De Yiti de Marco (1893), the Ricardian equivalence theorem found scarce approval in the Italian literature. The prevailing view argued for the differential incidence of the two alternative means of financing: whereas levying an extraordinary tax placed the burden of providing for the government expenditure on the present genera tions, debt finance shifted the burden on the future ones. Most authoritative Italian scholars either supported the ‘ shifting view ’ or, more often, stated contradictory views which appeared to reject it as much as to approve it (19).
The author generally viewed as reflecting the doctrinal turning- point is Be Yiti de Marco (1893). Along with him, the main 17 18 19
(17) Several econometric works have attempted to quantify the wealth effect o f public debt. Rather than solving the controversy, the bulk of existing work has been proved substantially inconclusive. A support to Ricardian equivalence can be found in Koch in (1974), Tanner (1979), Ca r m ic h a e l (1982).
Ko r m en d i (1983), Seater and Mariano (1985)' and Evan s (1988). For an empirical rejection see, fo r example, Rotter and To b in (1979), Fe ld stein (1982),
Ba r t h, Iden and Rtjssek (1985) and Modiglian i and Ster lin g (19S6).
(18) An exception is Bu c h a n a n (1958, 1960). For an overview of the
Italian debate on public debt at the turn of the century see also Chiancone
(1985) and Ma t t e u z z i and Sih o n a z z i (1988).
contributors to the debate are Pantaleoni (1891), Griziotti (1917) and Borgatta (1918). Their works focus on the assumptions of the theoretical case stated by Ricardo. A clear understanding of those conditions is of crucial significance for two reasons : to bring out the limited extent of validity of equivalence theorem, and to show that the contrasting views about it merely depend on the rejection of some of the assumptions themselves. In particular the focus is on the issues of agents’ horizon and on capital market imperfections.
The role played by the assumption that, in modern terms, is better known as ' bequest motive’ is first emphasised by P antaloni (1891). He points out that, if the present generation owns a capital stock sufficient to finance the extraordinary expenditure, the two alternative modes of financing lower private wealth by the same amount. It is in fact perfectly equivalent for future generations to inherit either a capital stock reduced by the extraordinary tax or a greater capital stock along with the annual tax liability for the debt service.
If, on the other hand, the current generation owns capital asse s which are less than the required financing, it will be unpossible to levy an extraordinary tax and the only way o f finance is the external debt. In this case the debt burden will be shifted on future generations since they « inherit » the tax liabilities but not an asset to meet them. Pantaleoni sets out the non-equivalence case as follows :
« se la generazione che contrattò il debito aveva soltanto un patrimonio inferiore al debito assunto, o non ne aveva alcuno, potrà essere cagione di meraviglia che essa abbia ot tenuto del credito, ma non può essere dubbio che gli inte ressi perpetui di cui saranno gravate le generazioni avvenire' saranno pagati in parte, o in tutto, con le fatiche di queste istesse . . . . il punctum saliens sta nell’essere, o non essere, stato trasmesso alla generazione posteriore, insieme con il carico dell’annualità, eziando il capitale di cui quello è il corrispettivo » (1891 : 48, 49).
— 2 0 —
de Marco generalises this result by extending it to those subjects (professionists, workers) who have only non-asset income.
The crucial point of his analysis is the assumption that genera tions are linked together by an ‘ intertemporal continuity of interests Given this hypothesis, the father fully discounts to the present any future tax liability on his son, whether he has some capital assets or only labour income. In the latter case the son will ‘ inherit like the individual receiving real capital assets, a human capital (in terms of his father’s ability, knowledge, etc.) to meet the future tax liabilities for the debt service.
The assumption of continuity of interests among generations in De Viti’s analysis follows from his general approach to public economics, and it would go beyond our present purpose to consider it in detail. It is however relevant to notice that De Viti’s logical extension of the ' bequest motive ’ to individuals who do not own real capital assets anticipates the idea that economic agents have
infinite horizons.
That assumption was strongly questioned by Griziotti (1917), who took exactly the opposite stance with respect to De Viti de Marco and rejected the idea of an intertemporal fiscal solidarity. Since individuals do not act as if they live forever, different generations cannot be treated as a unique generation with infinite horizons.
The implications for the equivalence theorem are straightfor ward : the alternative burden to the extraordinary tax the taxpayer faces is no longer a perpetual annual tax of equal present discounted value but, rather, it is an annual tax to be paid only as long as he lives. Each individual does not evalutate the infinite stream of annual taxes, required to match interest payments, but a stream that is limited by his own life expectation. Therefore he will prefer the case of debt finance because the present discounted value of future taxes for the debt service is less than the value of the extraordinary tax,
« Avanti di discutere se l’imposta straordinaria e il prestito esercitano un’influenza uguale o differente sulle generazioni presenti e future, occorre dirimere il dubbio se è legittimo parlare di generazioni cbe si seguono e che pos sono avere interessi divergenti o se invece si deve assumere come premessa logica e di fatto del ragionamento finanziario il principio della continuità tra generazioni di cittadini. Infatti, se si concede cbe il figlio subentra nella posizione del padre senza soluzione di continuità e si ammette cbe nella società nel suo complesso non si può distinguere il momento in cui una generazione finisce e l’altra comincia, si potrebbe convenire col De Viti de Marco cbe la questione della ripartizione del costo dei servigi pubblici, fra genera zioni presenti e generazioni future, cesserebbe d’esistere in questi termini come questione a sé, per rientrare in una questione più generale, che potrebbe chiamarsi del ' valore nel tempo ’ » (1917 : 218).
An interesting comment to Griziotti (1917) is made by Borgatta (1918). According to him the assumption o f finite horizons is inconsistent with the argument that, even in the absence of any extraordinary expenditure, each taxpayer accumulates for some reason a capital stock that will survive him. This behaviour satisfies the subjective need ’ to pass to the future what has been saved during a lifetime. Borgatta states that this was the case of the Bicardian taxpayer, who faced the problem of providing for the extraordinary government spending. The choice problem between the two alternative modes of financing should be accordingly referred to a context of intertemporal utility maximization, where individuals discount to the present not only the future taxes to meet during their lifespan but also those charged on their sons. Borgatta remarks :
hanno i bisógni futuri in questo sistema? Per valutare il sacrificio che la l a generazione fa coi due procedimenti; per valutare che cosa lascerebbe di capitale effettivo e che cosa non lascia pel fatto del sistema adottato, l’essenziale è conoscere il sistema dei bisogni nel tempo della prima e delle successive generazioni » (1918 : 29).
The recognizing of the logical consistency of the equivalence theorem does not prevent the mentioned Italian scholars from rejecting it on the ground of its evident misrepresentation of real world. Borgatta himself states that
« La teoria di Ricardo costituisce, più che una concreta formulazione della realtà, un lucidissimo schema teorico, ipotetico, esatto nei limiti delle ipotesi cui si riferisce e dal quale si può utilmente partire neltinterpretare la realtà storica, introducendo cioè le diverse condizioni concrete da questa contenute in confronto dell’ipotesi ricardiana, e da queste deducendo le diverse pressioni che i due metodi possono presentare » (1918 : 34, 35).
The awareness of the trade-off existing between the logic inherent in the theorem and its empirical relevance is remarkable. This holds even if it is compared to the abstract, though elegant, analyses in the modern debate.
Let us recall, for example, Griziotti’s view concerning the problem of economic agents’ horizon. The practical relevance of the theorem is also questioned by De Viti de Marco. In particular, he casts doubts on the empirical relevance of the assumption of perfect capital markets. De Viti underlines the government superiority in the intermediation process, which comes from its ability to tax and, consequently, from its lower risk of default if compared with private agents’ one. In fact, as far as market imperfections are concerned, an individual with bad collaterals
« o non troverà credito o lo troverà a condizioni troppo- onerose » (1934 : 399)
on behalf of private agents. Indeed, De Yiti de Marco ascribes the main economic rationale of public debt to capital market imperfections. The abstract nature of the equivalence theorem was also questioned by Borgatta. Notwithstanding his criticism to Griziotti, Borgatta clearly supports the non equivalence thesis. He argues that the differential incidence of the two financing modes depends on the variability of various elements, such as fiscal legisla tion, income and wealth distribution, and rates of interest. Uncertainty about the path of future taxes and incomes weakens the practical relevance o f the equivalence theorem even more (20).
4. Conclusions.
The main purpose of this paper has been to provide a retrospective reading of some recent theoretical studies in the macroeconomic theory o f public debt.
The protracted controversy can be traced to Ricardo’s (1817, 1820) classical contribution, according to whom debt and taxes arj perfectly equivalent as alternative government financing rules. Substitution of debt for taxes has no impact on private sector wealth and consumption.
Since Ricardo the dispute has resurfaced a number of times, the last stage of it being the question of whether government bonds are net wealth [Barro (1974)]. Its most recent revival has pointed out that the controversy can be settled only on empirical grounds: Ricardian equivalence is perfectly consistent within the framework of its key assumptions (infinite horizons’ agents, perfect capital markets, lump-sum taxation). The non equivalence case emerges in fact from the rejection of some of those assumptions.
Our reproposal of Ricardian equivalence has been carried out, rather than by the standard device of an overlapping-generations model, by a two-period model that consolidates the intertemporal budget constraint of the public and the private sector. Such a
— 24 —
framework, besides clearly displaying tbe crucial conditions of the equivalence theorem, provides also a unified scheme to study the effects of their removing.
Along with the exposition of the main deviations from Ricardian equivalence which have been emphasised in the modern literature (lifetime uncertainty with no bequest motive, imperfections in capital markets, distortionary taxes), our focus has been on the theoretical clearness in tackling the issue of some Italian scholars at the turn o f this century. By making clear the conditions required by the logic inherent in Ricardian equivalence theorem, their analysis provides an original and clear-cut contribution. This did not prevent those classical authors, namely Pantaleoni (1891), De Viti de Marco (1893), Griziotti (1917) and Borgatta (1918), from stressing the evident misrepresentation of real world embedded in
the assumptions of the theorem.
Such remarkable contribution has been almost completely neglected by the subsequent literature. Not only did the issue of differential incidence of debt versus tax financing resurface à number of times, but even the most recent views appeared sub stantially anticipated by those classical studies. Let us recall, for example, Pantaleoni’s emphasis on the device that makes the two financing modes equivalent (the son receives, along with the tax liability for the debt service, also an asset to meet the liability itself) vis-à-vis Barro’s view in which debt finance is simply perceived as a stimulus to increase intergenerational income transfers. Let us still consider Borgatta’s work where the choice problem of the individual is depicted in a context of intertemporal utility maximiza tion or, again, Griziotti’s focus on the issue of agents’ horizon compared with Blanchard-type models. Even Tobin’s remarks on credit rationing do not sound new if compared to what De Viti de Marco argued with regard to imperfections in capital markets.
Indeed, quite apart from any historical interest, the comparison between modern and classical strands of thought in the Ricardian equivalence debate seems to show the frequent recurrence of old paths of theoretical inquiry in the development of our discipline.
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