Definition of Ricardian equivalence This is the idea that consumers anticipate the future so if they receive a tax cut financed by government borrowing they anticipate future taxes will rise. Therefore, their lifetime income remains unchanged and so consumer spending remains unchanged.
Similarly, higher government spending, financed by borrowing, will imply lower spending in the future.
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.
Assumptions of Ricardian equivalence
- Income Life-cycle hypothesis – 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.
- Rational expectations on behalf of consumers. Consumers respond to tax cuts by realising it will probably mean future taxes have to rise.
- Perfect capital markets – households can borrow to finance consumer spending if needed
- Intergenerational altruism – Tax cuts for present generation may imply tax rises for future generations. Therefore, it is assumed that an altruistic parent would respond to current tax cuts by trying to give more wealth to their children so they can pay the future tax rises.
Impact of tax cuts under Ricardian Equivalence
The principle behind Ricardian equivalence can be illustrated by this simple trade-off.
If tax cuts, increase disposable income in the short-term, then it reduces disposable income in the long-term. Therefore, a rational consumer believes their lifetime income is unchanged by a tax-cut.
But, even Ricardo himself was suspicious of his findings.
Does it matter if governments finance spending through debt or taxation?
David Ricardo in”Essay on the Funding System” (1820) investigated whether it made a difference to finance a war through issuing government bonds or raising taxation. Ricardo concluded it probably made no difference.
In 1974 Robert Barro reinvestigated the idea and argued that under certain conditions, financing government spending by bonds was the same as raising taxes. He concluded public debt issuance and tax were largely equivalent
Problems with Ricardian equivalence
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. Many households do not project future budget deficits and predict future tax increases.
If the economy is at Point A – a rise in government spending can lead to a fall in private sector spending. There is crowding out. But, if the economy is at point C (inefficiency) Then it is possible to increase government spending without a fall in private sector spending.
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.