Brookings Institution Budget Deficits, National Saving, and Interest Rates

ECONOMIC ANALYSIS OF the aggregate effects of fiscal policy dates back at least to the work of David Ricardo. Modern academic interest was reinvigorated by the work of Robert Barro and others and by the emergence of large U.S. federal budget deficits in the 1980s and early 1990s.1 The result was a substantial amount of research, which is summarized in sev-eral excellent surveys.2 The rapid but short-lived transition to budget sur-pluses in the late 1990s, followed by the sharp reversal in budget outcomes since 2000, has raised interest in this topic again. Economists tend to view the aggregate effects of fiscal policy from one of three perspectives. To sharpen the distinctions among them, it is helpful to consider a deficit induced by a lump-sum tax cut today followed by a lump-sum tax increase in the future, holding the path of government pur-chases and marginal tax rates constant. Under the Ricardian equivalence hypothesis proposed by Barro, such a deficit will be fully offset by an increase in private saving, as taxpayers recognize that the tax is merely postponed, not canceled. The offsetting increase in private saving means that the deficit will have no effect on national saving, interest rates