31.3 How Government Borrowing Affects Private Saving

Government Borrowing and Private Saving

When the government borrows money, does it change how much people save? The Ricardian equivalence theory says yes: households see government borrowing as taxes that have been postponed, so they save more now to cover the bill later. If this theory holds, it has big implications for whether fiscal policy can actually stimulate the economy.

Ricardian Equivalence Theory

The core idea is straightforward. If the government runs a deficit today, it will eventually need to raise taxes to pay off that debt. Forward-looking households recognize this and respond by increasing their savings now, setting aside money for the higher taxes they expect down the road.

The key predictions of Ricardian equivalence:

• Every dollar of government borrowing is offset by a dollar of increased private saving
• Because households save more rather than spend, fiscal policy becomes ineffective at boosting aggregate demand
• Government deficits do not crowd out private investment, since the extra private saving supplies the funds the government borrows

In other words, a tax cut funded by borrowing doesn't make people feel richer. They just stash the extra cash, knowing taxes will rise later. The stimulus never reaches the broader economy.

Graphical Analysis

Economists test Ricardian equivalence by plotting government borrowing against private saving rates.

• X-axis: Government budget balance (deficit to surplus)
• Y-axis: Private saving rate

If Ricardian equivalence holds, you'd see a positive relationship: as deficits grow, private saving rises alongside them.

The slope of the line tells you how strong the effect is:

• A slope of 1 means perfect Ricardian equivalence. Each $\$1$ increase in government borrowing produces exactly $\$1$ more in private saving.
• A slope between 0 and 1 means partial Ricardian equivalence. Households adjust their saving, but not enough to fully offset the deficit.
• A slope of 0 means no Ricardian equivalence at all. Government borrowing has zero effect on private saving behavior.

Most real-world data points to slopes well below 1, suggesting the theory captures something real but overstates the response.

Empirical Evidence

Research on Ricardian equivalence has produced mixed results. Some studies find a meaningful link between deficits and saving; others find little or none. Several factors explain why the theory often breaks down in practice:

• Liquidity constraints: Many households can't increase their savings even if they want to, because they have limited access to credit and are already spending most of their income on necessities.
• Myopia (short-sightedness): People tend to focus on their current financial situation rather than calculating future tax obligations years or decades away.
• Lack of intergenerational altruism: The theory assumes parents care enough about their children's tax burden to save on their behalf. In reality, many households don't plan that far ahead.
• Uncertainty about future tax policy: Even if households try to be forward-looking, they can't predict exactly when or how taxes will change, making it hard to adjust saving with any precision.

The theory also rests on some strong assumptions that don't always match the real world. It requires households to be rational and forward-looking, and it ignores the possibility that government spending itself could boost growth. A deficit used to fund productive infrastructure or education, for example, might raise future incomes enough to cover the debt without requiring painful tax increases.