The Ricardian equivalence proposition (also known as the Ricardo-De Viti-Barro equivalence theorem) 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 agent's consumption decisions, and thus, it does not change aggregate demand. Thus, this theorem is used as an argument against tax cuts aimed to boost aggregate demand.
Governments can finance its expenditure 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" (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 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 (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 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.
- 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.
- 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.
- 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.
- O'Driscoll, G (February 1977). "The Ricardian Nonequivalence theorem". Journal of Political Economy 85 (2): 207–210.
- 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