Definition of Ricardian equivalence This is the idea that increased government borrowing may have no impact on consumer spending because consumers predict tax cuts or higher spending will lead to future tax increases to pay back the debt.
If this theory is true, it would mean a tax cut financed by higher borrowing would have no impact on increasing aggregate demand because consumers would save the tax cut to pay the future tax increases.
This is related to two factors:
- Income Life-cycle hypothesis
- Rational expectations on behalf of consumers.
It is argued that if the government borrows money to fund a tax cut, rational consumers realise in the future taxes will have to rise to finance the borrowing. Therefore, they save the extra income so that they can pay future tax rises.
Consumers wish to smooth their consumption over the course of their life. Thus if consumers anticipate a rise in taxes in the future they will save their current tax cuts to be able to pay future tax rises.
This has implications for fiscal policy. If true, it makes fiscal policy redundant. But, even Ricardo himself was suspicious of his findings.
There are various problems with this theory of Ricardian equivalence
1. Consumers are not rational. Many would not anticipate that tax cuts will lead to tax rises in the future.
2. The idea tax cuts are saved is misleading. In a recession, average propensity to consume may decline. But, this is different to the marginal propensity to consume. Evidence suggests that people do spend some of the tax cuts, even if their average propensity to save rises.
3. Tax Cuts can boost growth and diminish borrowing requirements. In a recession, government borrowing rises sharply because of automatic stabilisers (lower tax revenue, higher spending on unemployment benefits). If tax cuts boost spending and economic growth, the increased growth will help improve tax revenues and reduce government borrowing. Therefore stimulus packages of say $800bn, do not necessarily mean taxes have to rise by $800bn. If growth is increased and the economy gets out of recession this will improve the government’s fiscal position.
4. No Crowding out in a recession. In a recession, private sector saving rises because of lack of confidence. Expansionary fiscal policy is a way of causing the private sector saving to be utilised. It is argued higher government spending financed by borrowing causes lower private sector spending. But, this isn’t the case. The government is not preventing private sector spending but using private sector savings to increase aggregate demand.
5. Multiplier effect. The initial increase in government spending may cause a further rise in spending in the economy causing the final increase in GDP to be bigger than the initial injection into the economy.
Ricardian equivalence is also known as the Barro-Ricardo equivalence proposition because Barro extended the use of this idea in the twentieth century.