Ricardian Equivalence

Ricardian Equivalence is an economic theory that states that when government tries to increase demand by increasing debt financed government spending , the demand remains unchanged. This happens because rational consumers recognize that present tax cuts  or higher spending by the government will lead to tax increases in future in order to pay off the debt. David Ricardo proposed this theory in the 19th century. However, Robert Barro extended this theory in the 20th century. Therefore, it is also known as “Barro-Ricardo equivalence proposition”.

The government can increase spending either through debt financing or tax financing. Debt financing happens when a firm or government raises money for working capital or capital expenditures by issuing bonds,notes,etc. to investors (institutional and/or individual). In debt financing, the investors becomes creditors and the firm or government becomes debtors. Tax financing is a public financing method that is used by government for redevelopment and improvement projects on existing structures. If the government follows the tax financing route, then the taxpayers fund the government activities and developmental projects. And, if the government follows the debt financing approach, and if the government does not defaults on the bonds it issues, then the interest on the government debt must be paid by the future taxpayers . Therefore, the rational consumers saves the extra income so that they can pay future tax rises. This theory suggests that if the consumers anticipate that there might be an increase in taxes in the future, they will save their current tax cuts in order to pay future tax rises.

Ricardian equivalence has been severely criticized by economists. There are various problems with it. It assumes that consumers are rational. Though consumers are not rational and many would not be able to anticipate that tax cuts will lead to tax rises in the future. Economists have also argued that Ricardian equivalence ignored economic and population growth.

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