Ricardian Equivalence

Ricardian Equivalence

Ricardian Equivalence

Introduction

When the government decides to make expenditure, the financial logistics may take an effect in one of the two ways: Raise taxes (in this case, the public finances remain balanced) or invite a deficit, implying some form of public debt. Today economic science has been concerned with the issue of the macroeconomic effects of deficit public sector spending (debt-financed spending) compared to macroeconomic effects of public spending financed by taxes. The terms of this long debate significantly altered when Robert Barro (1974) recovered and corrected an old theoretical proposal raised by David Ricardo (Barro, 2008). The purpose of this essay is to present an insight to the working of this principle.

The theoretical debate has focused on the microeconomic foundations of consumer reactions. This theory is based on an intuition that the propensity to consume would be a cyclical and a normal component. The first part is based on present income, the second on the current perception of future earnings and, more generally, on the life cycle of earnings. This is clearly a case of rational expectations.

Discussion

The Ricardian equivalence principle states to finance a given expenditure path, the choice between a flat tax or the issuance of debt has no effect either on the consumption behaviour of agents or on the accumulation of capital (Barro, 2008). The explanation is simple. Lower taxes and a budget deficit today require higher taxes in the future. The issuance of debt to finance a tax cut is only a postponement of taxes and, in any case, a reduction of the tax burden. Consumers are assumed rational; they anticipate the future tax increases implied by the debt issue. Realizing that their tax burden remains unchanged, they do not respond to tax cuts by increasing their consumption, but saving the gain of this decline to deal with the future increase of samples. It follows from this behaviour that the decline in public savings (or increase the deficit) is exactly offset by an increase in private savings.

In most OECD countries over the past 25 to 30 years, governments have generally pursued tax policies, favouring the accumulation of budget deficits that have led to a huge growth in public debt. The Ricardian equivalence theory postulates that the effect of public spending on the economy is completely independent of how expenses are funded and, in particular, the choice between tax as immediate payment, the borrowing as future payments or money creation (Figuieres & Hindriks, 2001). It is an interesting theoretical position, claiming that, under certain conditions a change in the tax system over time, such as lower taxes now and higher taxes in the future, does not affect the cost of private sector financing and subsequently has no effect on national savings, investments and the current accounts (Weber, 1989).

Macro-economic literature is marked by contemporary heated debates and anti-view points on the assumption of Ricardian equivalence between borrowing and taxes. According to the models Keynesians, a reduction in the tax rate on individuals causes an increase in their ...