What Is Ricardian Equivalence?
Ricardian equivalence is an economic theory that says that financing government spending out of current taxes or future taxes (and current deficits) will have equivalent effects on the overall economy.
This means that attempts to stimulate an economy by increasing debt-financed government spending will not be effective because investors and consumers understand that the debt will eventually have to be paid for in the form of future taxes. The theory argues that people will save based on their expectation of increased future taxes to be levied in order to pay off the debt, and that this will offset the increase in aggregate demand from the increased government spending. This also implies that Keynesian fiscal policy will generally be ineffective at boosting economic output and growth.
This theory was developed by David Ricardo in the early 19th century and later was elaborated upon by Harvard professor Robert Barro. For this reason, Ricardian equivalence is also known as the Barro-Ricardo equivalence proposition.
- Ricardian equivalence maintains that government deficit spending is equivalent to spending out of current taxes.
- Because taxpayers will save to pay the expected future taxes, this will tend to offset the macroeconomic effects of increased government spending.
- This theory has been widely interpreted as undermining the Keynesian notion that deficit spending can boost economic performance, even in the short run.
Understanding Ricardian Equivalence
Governments can finance their spending either by taxing or by borrowing (and presumably taxing later to service the debt). In either case, real resources are withdrawn from the private economy when the government purchases them, but the method of financing is different. Ricardo argued that under certain circumstances, even the financial effects of these can be considered equivalent, because taxpayers understand that even if their current taxes are not raised in the case of deficit spending, their future taxes will go up to pay the government debt. As a result, they will be forced to set aside some current income to save up to pay the future taxes.
Because these savings necessarily involve forgone current consumption, in a real sense they effectively shift the future tax burden into the present. In either case, the increase in current government spending and consumption of real resources is accompanied by a corresponding decrease in private spending and consumption of real resources. Financing government spending with current taxes or deficits (and future taxes) are thus equivalent in both nominal and real terms.
Economist Robert Barro formally modeled and generalized Ricardian equivalence, based on the modern economic theory of rational expectations and the lifetime income hypothesis. Barro’s version of Ricardian equivalence has been widely interpreted as undermining Keynesian fiscal policy as a tool to boost economic performance. Because investors and consumers adjust their current spending and saving behaviors based on rational expectations of future taxation and their expected lifetime after-tax income, reduced private consumption and investment spending will offset any government sending in excess of current tax revenues. The underlying idea is that no matter how a government chooses to increase spending, whether through borrowing more or taxing more, the outcome is the same and aggregate demand remains unchanged.
Arguments Against the Ricardian Equivalence
Some economists, including Ricardo himself, have argued that Ricardo's theory is based upon unrealistic assumptions. For instance, it assumes that people will accurately anticipate a hypothetical future tax increase and that capital markets function fluidly enough that consumers and taxpayers will be able to easily shift between present consumption and future consumption (via saving and investment).
Many modern economists acknowledge that Ricardian equivalence depends on assumptions that may not always be realistic.
Real-World Evidence of Ricardian Equivalence
The theory of Ricardian equivalence has been largely dismissed by Keynesian economists and ignored by public policy makers who follow their advice. However, there is some evidence that it has validity.
In a study of the effects of the 2008 financial crisis on European Union nations, a strong correlation was found between government debt burdens and net financial assets accumulated in 12 of the 15 nations studied. In this case, Ricardian equivalence holds up. Countries with high levels of government debt have comparatively high levels of household savings.
In addition, a number of studies of spending patterns in the U.S. have found that private sector savings increase by about 30 cents for every additional $1 of government borrowing. This suggests that the Ricardian theory is at least partially correct.
Overall however, the empirical evidence for Ricardian equivalence is somewhat mixed, and likely depends on how well the assumptions that consumers and investors will form rational expectations, base their decisions on their lifetime income, and not face liquidity constraints on their behavior will actually hold in the real world.