The Ricardian equivalence proposition is an economic hypothesis holding that
consumers are forward looking and so internalize the government's budget
constraint when making their consumption decisions. This leads to the result
that, for a given pattern of government spending, the method of financing that
spending does not affect agents' consumption decisions, and thus, it does
not change aggregate demand. Thus, this theorem is used as an argument against
tax cuts and spending increases aimed to boost aggregate demand.
Introduction Governments can finance their
expenditures either through taxes or by issuing bonds. Since bonds are loans,
they must eventually be repaid—presumably by raising taxes in
the future. The choice is therefore "tax now or tax later."
Suppose that the government finances some extra spending through deficits;
i.e. it chooses to tax later. According to the hypothesis, taxpayers will
anticipate that they will have to pay higher taxes in future. As a result they
will increase their savings to pay the future tax increase; i.e. they reduce
their current consumption to do so. The effect on aggregate demand would be the
same as if the government had chosen to tax now.
David Ricardo was the first to propose this possibility in the early nineteenth
century; however, he was unconvinced of its empirical relevance. Antonio De Viti
De Marco elaborated on Ricardian equivalence in the 1890s. Robert J.
Barro took the question up independently in the 1970s, in an attempt to give the
proposition a firm theoretical foundation.
Ricardo and war bonds In "Essay on the Funding System" Ricardo
studied whether it makes a difference to finance a war with £20 million in
current taxes or to issue government bonds with infinite maturity and annual
interest payment of £1 million in all following years financed by future
taxes. At the assumed interest rate of 5%, Ricardo concluded that in terms of
spending the two alternatives amounted to the same value. However, Ricardo
himself doubted that this proposition had practical consequences. He followed
up the initial exposition with a claim that individuals do not actually
evaluate taxes in such a manner and, in particular, take myopic view of the tax
path. Ricardo–De Viti–Barro equivalence
In 1974, Robert J. Barro provided some theoretical foundation for Ricardo's
hesitant speculation. Barro's model assumed the following:
families act as infinitely lived dynasties because of intergenerational
altruism capital markets are perfect
the path of government expenditures is fixed
Under these conditions, if governments finance deficits by issuing bonds, the
bequests that families grant to their children will be just large enough to
offset the higher taxes that will be needed to pay off those bonds. Among his
conclusions, Barro wrote: ... in the case where the marginal
net-wealth effect of government bonds is close to zero ... fiscal effects
involving changes in the relative amounts of tax and debt finance for a
given amount of public expenditure would have no effect on aggregate demand,
interest rates, and capital formation. The model was an important contribution
to the New Classical Macroeconomics, built around the assumption of rational
expectations. In 1979, Barro defined the Ricardian
Equivalence Theorem as follows: ... shifts between debt and tax finance
for a given amount of public expenditure would have no first-order effect on the
real interest rate, volume of private investment, etc.
noting that "the Ricardian equivalence proposition is presented in Ricardo".
However, Ricardo himself was skeptical of this equivalence.
Criticisms Ricardian equivalence requires
assumptions that have been seriously challenged. The perfect capital market
hypothesis is often held up for particular criticism because liquidity
constraints invalidate the assumed lifetime income hypothesis.
International capital markets also complicate the picture. However, even in
a laboratory setting where all assumptions required are ensured to
hold, behavior of individuals is inconsistent with Ricardian equivalence.
In a 1976 comment, Martin Feldstein argued that Barro ignored economic and
population growth. He demonstrated that the creation of public debt depresses
savings in a growing economy. In the same issue James M. Buchanan also
criticized Barro's model, noting that "[t]his is an age-old question in public
finance theory", one already mooted by Ricardo and elaborated upon by De Viti.
In a response to the comments of Feldstein and Buchanan, Barro recognized
that uncertainty may play a role in affecting individual behavior with
respect to government finance. Nevertheless, he argued that "it is much
less clear that this complication would imply systematic errors in a direction
such that public debt issue raises aggregate demand."
In 1977, Gerald P. O'Driscoll stated that Ricardo, in expanding his treatment
of this subject for an Encyclopædia Britannica article, changed so many
features of it as to result in a Ricardian Nonequivalence Theorem; he
elaborated all the reasons why the proposition would not hold.
In 1989, Barro offered a number of defenses against various other
critiques. Empirical results
Ricardian equivalence has been the subject of extensive empirical inquiry.
Barro himself found some confirmation in post WW I years.
Controversy Research by Chris Carroll, James Poterba
and Lawrence Summers shows that the Ricardian equivalence hypothesis is
refuted by their results. In the Ronald Reagan era, the US government had a
historically large budget deficit due to the Reagan administration introducing
several tax cuts and increasing military spending. During 1976-80, the government
revenue was 10.01 percent of the potential GNP, and it declined to 8.86
percent during 1981-1985. The ratio of the US government's budget deficit to
its potential GNP did not exceed 4 percent from the World War Two to 1981,
and exceeded 4 percent after 1981. The ratio of an inflation- and
cycle-adjusted deficit to the potential GNP was 2.56 percent during 1981-1986,
and this ratio was the largest between 1958 and 1986. If the Ricardian
equivalence hypothesis is true, the rational consumers, who expect the
government to raise taxes, in the country try to reduce their consumption
and increase their savings. The reality was that the net private saving as a
percentage of GNP was 8.55 in the 1976-1980 period, and it decreased to
7.47 percent in the 1981-1986 period. The ratio of consumption to GNP was
62.96 percent in the 1976-1980 period, and slightly increased to 64.72 percent
in the 1981-1986 period. The facts about private saving,
government saving and consumption in the US are shown in Table 1. Their finding
is that increases in government deficits is followed by decreases in private
saving. They see the increase in the consumption-to-GNP ratio during 1981-86,
when the governmental dissaving is accelerated by Reaganomics. Their
results refute the Ricardian equivalence hypothesis.
An argument for countercyclical fiscal policies
Ricardian equivalence has a crucial importance in the fiscal policy
considerations of new classical macroeconomics. When assessing Ricardian
equivalence or any of the new classical doctrines, one should bear in mind the
conditional character of these theses. Thus the equivalence theorem should not
be separated from the assumptions on which it is based. In other words,
Ricardian equivalence does not mean the failure of any countercyclical efforts,
but underlines the necessary conditions for this failure and, naturally, for the
success at the same time. Governments do not have any potential to exert
countercyclical efforts if the path of government expenditures is fixed and if
agents form rational expectations. If these conditions hold, cuts in taxes
imply a later pressure to rise taxes, since government has to fill the
resource gap in the budget which is the result of the initial tax cut. So,
rational agents treasure up the additional income from the tax cut and
consumption does not rise. In this story, public operations should stand in
the focus of reasoning: if these processes can be changed by the
government, or, in any way, the additional income can be believed not to
be withdrawn later, the initial tax cut will induce a rise in public consumption
expenditures. So, if any of the conditions necessary
for the equivalence does not hold, countercyclical fiscal policy can be
effective. Controlling the real economy is possible perhaps even in a Keynesian
style if government regains its potential to exert this control.
Therefore, actually, new classical macroeconomics highlights the conditions
under which fiscal policy can be effective and not the inefficiency of
fiscal policy. Countercyclical aspirations need not to be abandoned,
only the playing-field of economic policy got narrowed by new classicals.
Keynes urged active countercyclical efforts of fiscal policy and these
efforts are not predestined to fail not even in the new classical theory, only
the conditions necessary for the efficiency of countercyclical efforts
were specified by new classicals. Ricardian equivalence underlines the
importance of fiscal reforms, since such reforms are needed in order to change
the path of government expenditures. When implementing comprehensive fiscal
reforms which make public sector more efficient governments do not exert
countercyclical efforts of course, but form the necessary conditions for
regaining countercyclical potential. In this respect, Ricardian equivalence
clarifies the exact conditions necessary for countercyclical fiscal policies.
See also Public finance
Government debt Policy Ineffectiveness Proposition
Say's law References
Further reading Blanchard, Olivier Jean; Fischer,
Stanley. "Fiscal Policy: Debt and Deficit Finance". Lectures on
Macroeconomics. Cambridge: MIT Press. pp. 126–135. ISBN 0-262-02283-4.
Galbács, Peter. The Theory of New Classical Macroeconomics. A Positive
Critique. Heidelberg/New YorkLondon: Springer. ISBN 978-3-319-17578-2.
Hoover, Kevin D.. "Ricardian Equivalence". The New Classical
Macroeconomics. Oxford: Basil Blackwell. pp. 139–149. ISBN 0-631-14605-9.
Seater, John J.. "Ricardian Equivalence". Journal of Economic
Literature 31: 142–190. JSTOR 2728152. External links
Does It Matter How You Pay for a State Dinner? A Lesson on Ricardian
Equivalence by Morgan Rose, at the Library of Economics and Liberty
Biography of David Ricardo