Ricardian Equivalence

David Ricardo was a British political economist. One of his famous works is the Ricardian equivalence. According to Ricardian equivalence, consumers are forward looking and their consumption depends not only on the current income but also on the expected future income. It states that changes in the budgetary decisions don’t affect the consumption pattern of the people. It is used to analyse fiscal policies.

Suppose the government proposes a tax cut today and there is no change in the government spending. When a budget is balanced, the taxes are equal to government spending (G = T). A tax cut implies more current income for the people and therefore, consumption should increase and savings should fall as a result of increased income. But David Ricardo claimed that because the consumers are forward looking they understand that a tax cut today implies a budget deficit (G > T i.e. spending is more than tax revenue), and the deficit will be financed by higher taxes in future. A tax cut which is financed by government borrowing does not reduce the tax burden, it just reschedules it, and therefore, the rational consumers must not increase their consumption as increased current income will balance decreased expected future income. Hence he claimed that financing a government by debt is equivalent to financing it by taxes.

According to the proposition, there is no change in the aggregate consumption patterns. Also, the extra disposable income is saved to offset the increase taxes in future. But then what is the use of fiscal policies if everything is unchanged?

In order to stimulate consumption or savings, fiscal policies should be formed keeping in mind the assumption of forward looking rational consumers. If the government states that a tax cut today will be financed by a reduction in the government spending, then, people will increase their consumption as there is no future tax liability on them. This will then fulfill the objectives of fiscal policies.

But at the same time, there are some arguments which question the ricardian equivalence proposition:

• Myopia: It refers to shortsightedness. One of the assumptions made while forming the model was that consumers are forward looking. But this assumption doesn’t hold every time. People may not fully comprehend the implications of the budget deficits and behave irrationally.
• Borrowing constraints: A person who wants to increase its current consumption but is restricted by constraint which doesn’t allow it to borrow will find the tax cut beneficial. The consumer will spend all the increase in disposable income. This contradicts to what Ricardo has said.
• Future generations: Because the tax burden is going to fall in the future, the current generation may increase their consumption at the expense of future generation. This again contradicts the equivalence. But Barro, an economist, argued that generally the future generations are children and grandchildren of current generation. Because people leave some bequests for their next generations, it states that instead of consuming extra income people save and leave it for their children to face liability in future.

Because of above stated facts and some empirical results, Davis Ricardo was unconvinced of its own idea. Robert Barro then analysed it thoroughly and came up with some arguments to support the hypothesis. It is a major determinant of the fiscal policy analysis. Ricardian equivalence is crucially important in the new classical macroeconomics.

Click here for government certifications