On Ricardian Equivalence in Local Public Finance

Abstract

The Ricardian Equivalence Theorem establishes a set of conditions under which the form of finance of a public program (tax or debt finance) has no effects on any substantive outcomes. Following Barro (1974), the theorem has typically been formulated in the context of a national government in an intergenerational model of altruistic individuals, in which the impact of debt finance is offset by increased private saving. However, Ricardian equivalence can also be established in a setting of local public finance. Here, its rationale is entirely different. It results not from altruistic behavior, but from the operation of local land markets under which local fiscal differentials are capitalized into local property values. In this paper, we provide a proof of this latter form of Ricardian equivalence in terms of a simple multi-period model of local government finance. We then explore its relevance to local public finance. We find that it is quite restrictive in certain respects. In particular, in the U.S, context, where the interest income from state and local bonds is exempt from federal income taxation, we argue that rational behavior may be inconsistent with Ricardian equivalence. Finally, after reviewing some earlier evidence, we present some new findings from an econometric analysis of local referenda in the U.S. for the conservation of open space that reveal a preference on the part of electorate for local bond finance over tax finance.