Ricardian Equivalence

Ricardian equivalence is the theory that, for a given path of government spending, it makes no difference to total demand whether the government pays by raising taxes now or by borrowing through government bonds and raising taxes later. The reasoning is that forward-looking households recognize that today's borrowing means tomorrow's taxes, so they save any tax cut to meet that future bill. If it holds, a debt-financed tax cut leaves consumption, interest rates and output unchanged.

The idea is named after the British economist David Ricardo, who discussed it in the early nineteenth century, and was revived by the American economist Robert Barro in a 1974 paper in the Journal of Political Economy, "Are Government Bonds Net Wealth?". It is a benchmark in the theory of fiscal policy and a direct challenge to the Keynesian view that tax cuts stimulate demand through the multiplier effect.

Suppose your employer gives you a bonus this year but tells you, in writing, that next year's salary will be cut by the same amount plus interest. A careful person would put the bonus in a savings account to cover the cut, rather than spend it. Their spending this year would not change at all.

Ricardian equivalence says a tax cut paid for by government borrowing is like that bonus. If people see the future tax rise coming, they save the money and the economy behaves exactly as before. The theory's force depends on whether people really look ahead that carefully, and whether they can.

Ricardo considered how Britain might pay for a war costing £20 million a year: by a one-off tax or by issuing debt and paying interest forever. In his "Essay on the Funding System" (1820) he reasoned that, in principle, the two were equivalent in their burden, but he doubted that people actually behaved that way, warning that borrowing made citizens less aware of the true cost of war. The modern label "Ricardian equivalence" was coined by James Buchanan in a 1976 comment on Barro's paper. Barro showed that if parents care about their children's welfare and leave bequests, even taxes falling on future generations are taken into account, so households effectively behave as if they live forever.

In a simple two-period model the government's spending must be paid for by taxes in present-value terms:

• $T_1$ and $T_2$ are taxes in the first and second periods.
• $G_1$ and $G_2$ are government spending in each period.
• $r$ is the interest rate on government debt.

If spending is fixed, a tax cut today must be matched by a tax rise tomorrow with the same present value. Example: the government cuts taxes by 100 this year and borrows 100 at 5%. Next year it must raise taxes by 105 to repay. The present value of that rise is $\frac{105}{1.05} = 100$, exactly the size of the cut, so a household's lifetime wealth is unchanged. A Ricardian household saves the 100, which earns 5% and pays the 105 bill. Private saving rises by exactly as much as government saving falls, so national saving, interest rates and investment are unaffected and there is no crowding out.

The result depends on strong conditions, and each has been challenged.

• Liquidity constraints. Households that cannot borrow, or that live from paycheck to paycheck, will spend a tax cut even if they know taxes will rise, because they have a high marginal propensity to consume.
• Finite horizons. People without children or without a bequest motive may expect future taxes to fall partly on others.
• Distortionary taxes. Real taxes, such as income tax, change incentives to work and save, so their timing matters, as stressed by supply-side economists.
• Imperfect information. Households may not know how and when debt will be repaid, and the theory leans on a strong form of rational expectations.
• Uncertainty and growth. If the economy grows faster than the interest rate, debt can be rolled over without a full future tax increase.

Most empirical studies reject full Ricardian equivalence while finding partial offsets. Research on the US tax rebates of 2001 and 2008 found that households spent a meaningful share of the payments within months; a study by Jonathan Parker and co-authors published in the American Economic Review in 2013 estimated that households spent about 12% to 30% of the 2008 payments on nondurable goods in the three months after receipt, and more including cars. Such findings fit the permanent income and life-cycle models with borrowing constraints better than strict equivalence. Other work finds that private saving does rise somewhat when deficits grow.

Despite this, the theory remains influential. It disciplines claims about the size of fiscal multipliers, features in debates over austerity and the burden of the national debt, and underlies the "non-Keynesian" argument that credible deficit cuts can boost private spending by lowering expected future taxes.

• NBER: Consumer Spending and the Economic Stimulus Payments of 2008