Ricardo-Barro Effect

What Is the Ricardo-Barro Effect?

The Ricardo-Barro effect, also known as Ricardian equivalence, is an economic theory that suggests that when a government tries to stimulate an economy by increasing debt-financed government spending, demand remains unchanged, because the public increases their saving to pay for expected future tax increases that will be used to pay off the debt.

Understanding Ricardo-Barro Effect

While the Ricardo-Barro effect was developed by David Ricardo in the 19th century, it was revised by Harvard professor Robert Barro into a more elaborate version of the same concept. His theory stipulates that a person's consumption is determined by the lifetime present value of his after-tax income—their intertemporal budget constraint.

So government cannot stimulate consumer spending since people assume that whatever is gained now will be offset by higher taxes due in the future. It also implies that no matter how a government chooses to increase spending by borrowing or raising taxes, demand will remain unchanged, because debt-financed public spending will "crowd out" private spending.

Arguments Against the Ricardo-Barro Effect

The major arguments against the Ricardo-Barro effect are due to what are perceived as the unrealistic assumptions on which the theory is based. These assumptions include the existence of perfect capital markets and the ability for individuals to borrow and save whenever they want. Additionally, there is the assumption that individuals are willing to save for a future tax increase, which they may not see it in their lifetime.

There is no evidence that the Ricardo-Barro effect changed saving when the Reagan administration cut taxes and hiked military spending between 1981-85. In fact, net private savings as a percentage of GNP fell to 7.47% during the 1981-86 period, from 8.5% in 1976-80.

This also does not ring true today, when U.S. personal saving rate has fallen to multi-decade lows, even as U.S. government borrowing soars. People just don’t seem to behave in a way that is consistent with Ricardian equivalence.

The Eurozone Provides Some Evidence of Ricardian Equivalence

There is no evidence that the Ricardo-Barro effect changed saving when the Reagan administration cut taxes and hiked military spending between 1981-85. In fact, net private savings as a percentage of GNP fell to 7.47% during the 1981-86 period, from 8.5% in 1976-80.

The eurozone financial crisis has provided some evidence to support Ricardian equivalence. Based on data from 2007, there is a strong correlation between government debt burdens and changes in households’ financial assets for 12 of the 15 countries within the union.