The Ricardian equivalence proposition (also known as the Barro–Ricardo equivalence theorem) is an economic hypothesis holding that consumers internalize the government's budget constraint: as a result, the timing of any tax change does not affect their level of spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, because the effect on the total level of demand in the economy is the same.
The hypothesis proposes that governments can raise money 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. This action might suggest to taxpayers that they will have to pay higher taxes in future. Taxpayers would put aside savings to pay the future tax rise; i.e. they would willingly buy the bonds issued by the government, and would 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 it. Antonio De Viti De Marco elaborated on Ricardian equivalence starting 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.
Later economists counter that the hypothesis ignores factors such as economic and population growth which bring in higher tax revenue, and inflation which erodes debt. For those reasons the proposition remains controversial.
Ricardo and war bonds
In "Essay on the Funding System" (1820) 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 point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever, or £1,200,000 for forty-five years are precisely of the same value.
However, Ricardo himself doubted that this proposition had practical consequences. He continued:
- But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly. We are too apt to think that the war is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes. It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1000.
In other words, if people had rational expectations they would be indifferent between the two systems, but since they do not have them, they are subjected to a "Fiscal Illusion", which alters their decisions.
In 1974, Robert J. Barro provided some theoretical foundation for Ricardo's hesitant speculation (apparently in ignorance of Ricardo's earlier notion and De Viti's subsequent extensions). Barro's model assumed the following:
- families act as infinitely lived dynasties because of intergenerational altruism
- capital markets are perfect (i.e., all can borrow and lend at a single rate)
- 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.
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 "[t]he Ricardian equivalence proposition is presented in Ricardo". However, Ricardo himself was skeptical of this equivalence.
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.
In that same year, James M. Buchanan also faulted 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 particular, he criticized Barro for:
- failing to compare the differential impacts of taxation and debt issue;
- "superimposing" an issue of public debt without offsetting or compensating changes;
- erring in assuming the equivalence of the "helicopter drop" to currently old households and the sale of bonds on a competitive capital market, with the proceeds of this sale used to effect a lump-sum transfer to generation 1 household;
- not providing empirical evidence about the full discount of future taxes;
- not considering that, under his hypothesis, there should be roughly indifferent public reactions to a fully funded and to an unfunded pension system;
- not considering the political consequences of the equivalence.
In 1977, Gerald P. O'Driscoll opined 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.
In 2009, Paul Krugman ignited a debate among notable blogging economists and financial journalists when he grouped Barro with "first-rate economists [who] keep making truly boneheaded arguments against [organizing Keynesian stimulus]".
In 1976, Barro recognized that uncertainty may play a role in changing individual behavior. Nevertheless, he argued,
- ...it is much less clear that this complication would imply systematic errors in a direction such that public debt issue raises aggregate demand.
In 1989, Barro offered a number of defenses against various other critiques.
- Public finance
- Government debt
- Prisoner's Dilemma
- Fiscal theory of the price level
- Policy Ineffectiveness Proposition
- Say's law
- Treasury View
- Buchanan, James M. (1976). "Perceived Wealth in Bonds and Social Security: A Comment". Journal of Political Economy 84 (2): 337–342.
- David Ricardo, "Essay on the Funding System" in The Works of David Ricardo. With a Notice of the Life and Writings of the Author, by J.R. McCulloch, London: John Murray, 1888
- Handbook of public economics, Martin Feldstein, Alan J. Aurbach, eds., North Holland (August 1, 1985) ISBN 978-0-444-87612-6
- Barro, Robert J. (1974). "Are Government Bonds Net Wealth?". Journal of Political Economy 82 (6): 1095–1117. doi:10.1086/260266.
- Barro, Robert J. (1979). "On the Determination of the Public Debt". Journal of Political Economy 87 (5): 940–971. Retrieved 25 May 2010.
- New School Online History of Economic Thought: Section on Ricardian Equivalence
- Clive Crook, Dismal Science, Revisited", The Atlantic Monthly online, 10 Feb 2009  Accessed 25 Apr 2010.
- Elmendorf, DW; Mankiw, NG (1998). "Government Debt, NBER Working Paper 6470". NBER Working Papers. Retrieved 25 May 2010. Summarizes much of the debate on Ricardian equivalence. Published as Chap. 25 of Taylor and Woodford, eds., (1999) Handbook of Macroeconomics, vol. 1C. North-Holland, ISBN 0-444-82528-2
- A search for synthesis in economic theory (1985), Ching-Yao Hsieh, Stephen L. Mangum, ISBN 0-87332-328-9, p.58
- Barro phrased this as "any operative intergenerational transfer", however imperfect
- Feldstein, Martin (1976). "Perceived Wealth in Bonds and Social Security: A Comment". Journal of Political Economy 84 (2): 331–336.
- O'Driscoll, G (February 1977). "The Ricardian Nonequivalence theorem". Journal of Political Economy 85 (2): 207–210.
- Krugman, P: "War and non-remembrance", 22 Jan 2009, access date 25 May 2010
- "Dumping on Robert Barro", Marginal Revolution, 23 Jan 2009
- "An interview with Robert Barro", The Atlantic Monthly, 5 Feb 2009. Access date 25 May 2010
- Barro, R (April 1976). "Perceived Wealth in Bonds and Social Security and the Ricardian Equivalence Theorem: Reply to Feldstein and Buchanan". The Journal of Political Economy 84 (2): 343–350. JSTOR 1831906.
- Barro, R (Spring 1989). "The Ricardian approach to budget deficits". The Journal of Economic Perspectives 3 (2). Retrieved 25 May 2010.
- M. Gabriella Briotti, "Economic Reactions to Public Finance Consolidation: a Survey of the Literature", European Central Bank Occasional Paper No. 38, Oct. 2005.
- 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
- Why a tax cut just isn’t fair on teenagers by Tim Harford, Financial Times
- Romeo, Sampson, "The Effect of Budget Deficits on Long-term Interest Rates",