The SaversSpenders Theory of Fiscal Policy

By N. GREGORY MANKIW*
The literature on the macroeconomic effects
of fiscal policy and, in particular, of government
debt is founded on two canonical models. The
purpose of this paper is to suggest that both
models are deficient and to propose a new
model to take their place.
The first canonical model is the Barro-Ramsey
model of infinitely-lived families (Robert Barro,
1974). According to this model, the governments
debt policy redistributes the tax burden among
generations, but families, who want to smooth
their consumption over time, reverse the effects of
this redistribution through their bequests. Government debt is completely neutrala proposition
called Ricardian equivalence.
The second canonical model of government
debt is the Diamond-Samuelson model of overlapping generations (Peter Diamond, 1965). In
this model, people smooth consumption over
their own lifetimes, but there is no bequest
motive. When the government issues debt, it
enriches some generations at the expense of
others, crowds out capital, and reduces steadystate living standards.
In this paper, I first discuss the facts that lead
me to reject these canonical models. I then
propose an alternative model and develop
briefly its implications for fiscal policy.

consumption over time. There is much reason to

be skeptical about this assumption.
A large empirical literature, starting with
Robert Halls (1978) seminal random-walk theorem, has addressed the question of how well
households intertemporally smooth their consumption. Although this literature does not
speak with a single voice, the consensus view is
that consumption smoothing is far from perfect.
In particular, consumer spending tracks current
income far more than it should.
In our 1989 paper, John Campbell and I considered a world populated with two types of
consumers, some following the permanentincome hypothesis and some following the simple rule-of-thumb of consuming their current
income. In this world, consumption does not
follow a random walk: predictable changes in
income lead to predictable changes in consumption, depending on the prevalence of rule-ofthumb behavior. We estimated that about half of
income goes to rule-of-thumb consumers.
Subsequently, various papers have confirmed
the great influence of current income on consumer spending. John Shea (1995) used microeconomic data to examine predictable changes
in wages resulting from union contracts and
found that a predictable increase in the wage of
1 percent leads to an increase in consumption of
0.89 percent. Jonathan Parker (1999 p. 969)
examined predictable income changes resulting
from Social Security taxes. He reported that
the elasticity of expenditures on nondurable
goods with respect to the predictable declines in
income that are studied is around one-half.
Nicholas Souleles (1999 p. 956) examined the
effect of predictable income tax refunds and
concluded that the response of total consumption was found to be at least 35 percent of
refunds within a quarter, up to over 60 percent.
There are various ways to view this rule-ofthumb behavior. One possibility is that consumers deviate from the assumption of fully rational
expectations. Perhaps some consumers naively
extrapolate their current income into the future;
or perhaps all consumers weigh their current

I. Why We Need a New Model

Three facts persuade me that neither the

Barro-Ramsey model nor the DiamondSamuelson model is adequate for analyzing fiscal policy.
A. Consumption Smoothing
Is Far From Perfect
Both the Barro-Ramsey model and the
Diamond-Samuelson model assume that all
households use financial markets to smooth

* Department of Economics, Harvard University, Cambridge, MA 02138.

120

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MICROECONOMIC HETEROGENEITY IN MACROECONOMICS

income too heavily when looking ahead to their

future income because, as a psychologist might
explain, current income is the most salient piece
of information available (Amos Tversky and
Daniel Kahneman, 1973).
Alternatively, one can view the rule-ofthumb behavior as resulting from consumers
who face binding borrowing constraints. The
recent consumption literature on buffer-stock
saving (e.g., Christopher Carroll, 1997) can be
seen as providing a richer description of this
rule-of-thumb behavior. Buffer-stock savers are
individuals who have high discount rates and
often face binding borrowing constraints. Their
savings might not be exactly zero: they might
hold a small buffer stock as a precaution against
very bad income shocks. But the existence of
this small buffer does not alter the central result
that their current income has a large influence
over their consumption.
B. Many People Have Net Worth Near Zero
Examination of data on wealth holdings suggests that there are many households for which
saving is not a normal activity. One striking
comparison is between the income distribution
and the wealth distribution. According to the
U.S. Census Bureau, the lowest two quintiles of
the income distribution earn about 15 percent of
income. By contrast, Edward Wolff (1998) reports that the lowest two quintiles of the wealth
distribution hold only 0.2 percent of household
wealth.
A related and equally striking fact is the low
absolute level of wealth with which many
households operate. Wolff (1998) reports that
the mean net worth of the lowest two quintiles
of the wealth distribution is a mere $900. If we
exclude home equity on the grounds that it is
not always liquid, the mean for this group falls
to a negative $10,600, indicating that debts such
as credit-card balances exceed financial assets.
Net worth is zero or negative for 18.5 percent of
households; excluding home equity, the number
of households in the red rises to 28.7 percent.
Reflecting on these facts, one cannot help but
be drawn to a simple conclusion: many households do not have the financial wherewithal to
do the intertemporal consumption-smoothing assumed by much modern macroeconomic theory,
including the Barro-Ramsey and Diamond-

121

Samuelson models of fiscal policy. Acknowledging the prevalence of these low-wealth households
helps explain why consumption tracks current income as strongly as it does.
C. Bequests Are an Important Factor
in Wealth Accumulation
While many people have almost no wealth, a
few have much. The top 5 percent of the income
distribution has historically earned 1520 percent of all income. But the top 5 percent of the
wealth distribution holds 60 percent of the economys wealth and 72 percent of financial wealth
(i.e., wealth excluding home equity). This great
accumulation by a small part of the population
suggests that some households have motives
beyond normal life-cycle smoothing. A bequest
motive is the obvious candidate.
As a matter of accounting, each dollar of
wealth that a person holds will either be spent
during his lifetime or left as a bequest after he
dies. Laurence Kotlikoff and Lawrence Summers (1981) estimated the relative importance
of the two kinds of wealth. They concluded (p.
706) that intergenerational transfers account
for the vast majority of aggregate U.S. capital
formation. Any model that attempts to explain
how fiscal policy affects the economy must
come to grips with this fact.
II. A New Model

The three pieces of evidence I have just

discussed suggest that we need a new macroeconomic model of fiscal policy. Both the
Barro-Ramsey model and the DiamondSamuelson model are inconsistent with the
empirical finding that consumption tracks
current income and with the numerous households with near zero wealth. In addition, the
Diamond-Samuelson model is inconsistent
with the great importance of bequests in aggregate wealth accumulation.
A new model of fiscal policy needs a particular sort of heterogeneity. It should include both
low-wealth households who fail to smooth consumption over time and high-wealth households
who smooth consumption not only from year to
year, but also from generation to generation.
That is, there is a need for a model in which
some consumers plan ahead for themselves and

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AEA PAPERS AND PROCEEDINGS

their descendants, while others live paycheckto-paycheck. To see what might be learned from
such a model, I sketch a simple example in the
rest of this paper.
Imagine that the economy is populated by
two sorts of people. One group, which I will call
savers, has behavior that is described by the
Barro-Ramsey model: they have an operative
intergenerational bequest motive and, thus, infinite horizons. A second group, which I will
call spenders, consumes their entire after-tax
labor income in every period. This savers
spenders model of fiscal policy is extraordinarily simple (and its antecedents in my empirical
paper with Campbell are obvious). But its policy implications could not be more radical, as
the following propositions make clear.
PROPOSITION 1: Temporary tax changes have
large effects on the demand for goods and services.
In early 1992, President George Bush pursued a novel policy to deal with the lingering
recession in the United States. By executive
order, he lowered the amount of income taxes
that were being withheld from spenders paychecks. The order did not reduce the amount of
taxes that spenders owed; it merely delayed
payment. The higher take-home pay that spenders received during 1992 was to be offset by
higher tax payments, or smaller tax refunds,
when income taxes were due in April 1993.
What effect should this policy have? According to the logic of either the Barro-Ramsey or
Diamond-Samuelson model of fiscal policy,
consumers should realize that their lifetime resources were unchanged and, therefore, save the
extra take-home pay to meet the upcoming tax
liability. By contrast, President Bush claimed
that his policy would provide money people
can use to help pay for clothing, college, or to
get a new car. That is, he believed that consumers would spend the extra income, thereby
stimulating aggregate demand and helping the
economy recover from the recession.
Evidence supports Bushs conjecture. Shortly
after the policy was announced, Matthew Shapiro and Joel Slemrod (1995) asked people what
they would do with the extra income. Fiftyseven percent of the respondents said they
would save it, use it to repay debts, or adjust

MAY 2000

their withholding in order to reverse the effect

of Bushs executive order. Forty-three percent
said they would spend the extra income. Thus,
for this policy change, most people were planning to act as standard theory posits, but many
planned to spend the extra income. This result is
easily explained by the saversspenders model
of fiscal policy.
PROPOSITION 2: Government debt need not
crowd out capital in the long run.
Although the saversspenders model gives
fiscal policy a strong influence in the short run,
it renders it less potent in the long run. In
particular, if taxes are lump-sum (or if they are
levied entirely on inelastically supplied labor),
then government debt does not influence the
steady-state capital stock. In a limited sense,
debt neutrality holds in the long run, even if
not in the short run. As Kent Smetters (1999)
puts it, Ricardian equivalence is a long-run
leviathan.
This result follows from the standard steadystate condition: f (k) . In the long run, the
marginal product of capital must equal the savers rate of time preference. (Including exogenous technological progress in the model would
alter this condition, but not in any important
way.) This equation pins down the steady-state
capital stock, regardless of the level of government debt.
How can the governments debt policy have a
strong short-run effect but no long-run effect?
Imagine that the government gives everyone a
one-time tax cut, financed by a permanently
higher level of debt (and thus higher taxes to
finance the interest payments). The initial response of the savers is to do nothing: They are
Ricardian in looking ahead to their future tax
liabilities. The spenders, however, immediately
consume their tax cut. This extra consumption
reduces investment, which in turn raises the
marginal product of capital and thus the interest
rate. The higher interest rate, in turn, induces
savers to save more. Their higher saving continues until the marginal product of capital is
driven back down to their rate of time preference. Hence, the debt-financed tax cut temporarily crowds out capital accumulation, but the
permanently higher level of debt does not depress the steady-state capital stock.

VOL. 90 NO. 2

MICROECONOMIC HETEROGENEITY IN MACROECONOMICS

PROPOSITION 3: Government debt increases

steady-state inequality.
Although Proposition 2 says that government
debt does not affect the steady-state capital
stock and national income, government debt
does influence the distribution of income and
consumption in the saversspenders model.
(For a similar result in a somewhat different
model, see Kevin Fletcher [1999 Ch. 2]). A
higher level of debt means a higher level of
taxation to pay for the interest payments on the
debt. The taxes fall on both spenders and savers,
but the interest payments go entirely to the
savers. Thus, a higher level of debt raises
the steady-state income and consumption of the
savers and lowers the steady-state income and
consumption of the spenders. The spenders,
however, already had lower income and consumption than the savers (for only the savers
earn capital income). Thus, a higher level of
debt raises steady-state inequality in income
and consumption.
PROPOSITION 4: Substantial long-run crowding out can occur if taxes are distortionary.
Proposition 2 regarding long-run debt neutrality holds if taxes are lump-sum. As in the
standard Barro-Ramsey model, things change
dramatically if taxes are distortionary. To see
how, suppose that taxes are raised with a proportional income tax with rate . The following
equations describe the steady state:
y fk

y rD g
r f k
1 r
where the notation is standard. The first equation is the production function. The second
equation states that tax revenue ( y) equals the
interest on the debt (rD) plus government
spending ( g). The third equation states that the
interest rate (r) equals the marginal product of
capital. (Both interest income and capital income are assumed to be taxed at the same rate,
so the tax does not affect this equation.) The

123

fourth equation states that the after-tax interest

rate equals the savers rate of time preference
(). Given these equations, it is straightforward
to see how an increase in government debt
affects the economy. Higher debt leads to
higher debt service; a higher debt service requires a higher tax rate; a higher tax rate leads
to a higher before-tax interest rate; and a higher
interest rate leads to a smaller steady-state capital
stock. As in the Diamond-Samuelson model, government debt crowds out capital, although the
mechanism here is completely different.
It is possible to calibrate the magnitude of this
effect. By differentiating this system of equations,
one can solve for an expression to show how
much debt crowds out capital:
dk/dD Df /f
1 ff / f 2 1 .
If the production function is Cobb-Douglas y
k , this becomes:
dk/dD 1 D/k
1 1 / 1 .
For the U.S. economy, taxes are about one-third
of income ( 13), capital earns about onethird of income ( 13), and the government
debt equals about one-sixth of the capital stock
(D/k 1 6 ). For these parameter values, dk/
dD 1.125. That is, an extra dollar of
government debt reduces the steady-state capital stock by slightly more than one dollar. Naturally, this numerical result is sensitive to
various assumptions. (Introducing depreciation,
so that the production function is f(k) k
k, reduces crowding out as measured by dk/
dD, whereas taking a broad view of capital, so
that is larger than 13, raises it.) Nonetheless,
this example shows that substantial steady-state
crowding out can occur simply because of distortionary taxation.
PROPOSITION 5: The optimal steady-state
capital tax from spenders standpoint is zero.
Suppose that spenders are in the majority and
therefore control tax policy. They have to pay
for an exogenous level of government spending

124

AEA PAPERS AND PROCEEDINGS

g, which can either be a public good or a

transfer payment. The choice this majority faces
is how much to tax labor income and how much
to tax capital income. In making this choice,
the goal is to maximize after-tax wages. Thus,
the spender majority ignores the welfare of the
saver minority.
To keep things simple, I start by comparing
alternative steady states. The issue of tax policy
then boils down to the following optimization
problem:
maximize 1 w
,

subject to
w fk f kk

w f kk g
1 f k .
The objective here is simply to maximize the
after-tax wage, (1 )w. In pursuing this goal,
the spender majority faces three constraints.
The first constraint says that labor earns its
marginal product, which by Eulers theorem
equals output left after capital is paid its marginal product. The second constraint is a government budget constraint, which says that
revenue from labor taxes plus revenue from
capital taxes must equal government spending.
The third constraint is the steady-state condition
stating that the after-tax marginal product of
capital equals the savers discount rate.
I will skip the details of the solution and go
straight to the result: 0. That is, the optimal
tax on capital income is zero. This is true even
though I have been doing the optimal tax problem from the standpoint of the spenders, who
hold no capital.
Why do spenders want to exempt capital income from taxation? The reason is that the
supply of capital is highly elastic in this model.
In the long run, it is infinitely elastic at rate .
When capital is taxed, the quantity falls, which
in turn depresses the real wage. This effect is
large enough to make any tax on capital income
undesirable, even from the perspective of people who own no capital.
In light of this result, one might wonder why
the populace is not clamoring to eliminate the

MAY 2000

taxation of capital income. One answer is that

people are not focused only on the steady state.
In the short run, spenders are tempted to confiscate all capital and enjoy a temporary consumption binge. Indeed, the same high rate of
time preference that induces spenders not to
save may lead them to favor capital taxation,
despite its adverse long-run effects. Of course,
the usual issues of time-consistency also arise
here, as in any analysis of capital taxation.
III. Conclusion

Economists use simple models to develop

and hone their intuition. For the macroeconomic
analysis of fiscal policy, the two dominant
models have been the Barro-Ramsey model of
intergenerational altruism and the DiamondSamuelson model of overlapping generations.
In my view, neither is satisfactory. A better
model would acknowledge the great heterogeneity in consumer behavior that is apparent in
the data. Some people have long time horizons,
as evidenced by the great concentration of
wealth and the importance of bequests in aggregate capital accumulation. Other people have
short time horizons, as evidenced by the failure
of consumption-smoothing and the prevalence
of households with near-zero net worth. The
saversspenders theory sketched here takes a
small step toward including this microeconomic
heterogeneity in macroeconomic theory, and it
yields some new and surprising conclusions
about fiscal policy.
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