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Ricardian equivalence

Overview

Ricardian equivalence, (also known as the Barro-Ricardo equivalence proposition) is an economic theory that suggests consumers internalise the government's budget constraint

Budget constraint

A Budget constraint represents the combinations of goods and services that a consumer can purchase given current prices with his or her income. Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices...

and thus the timing of any tax change does not affect their change in spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, the effect on total level of demand in an economy will be the same.

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Encyclopedia

Ricardian equivalence, (also known as the Barro-Ricardo equivalence proposition) is an economic theory that suggests consumers internalise the government's budget constraint

Budget constraint

A Budget constraint represents the combinations of goods and services that a consumer can purchase given current prices with his or her income. Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices...

and thus the timing of any tax change does not affect their change in spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, the effect on total level of demand in an economy will be the same. It was proposed, and then rejected, by the 19th-century economist David Ricardo

David Ricardo

David Ricardo was an English political economist, often credited systematizing economics, and was one of the most influential of the classical economists, along with Thomas Malthus and Adam Smith. He was also a member of Parliament, businessman, financier and speculator, who amassed a considerable...

.

Introduction

In simple terms, the theory can be described as follows. Governments may either finance their spending by taxing current taxpayers, or they may borrow money by issuing bonds. In the latter case, they must eventually repay this borrowing by raising taxes above what they would otherwise have been in future. The choice is therefore between "tax now" and "tax later".

Suppose that the government finances some extra spending through deficits - i.e. tax later. Ricardo argued that although taxpayers would have more money now, they would realize that they would have to pay higher tax in future and therefore save the tax cut in order to pay the future tax rise. The effect on demand would be exactly the same as if the government financed its saving through taxes.

In "Essay on the Funding System" (1820) Ricardo studied whether it makes a difference to finance a war with the £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 point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever ... are precisely of the same value". However, Ricardo himself was skeptical about the empirical validity of this equivalence. He continued: "but the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly. We are too apt to think that the war is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes. It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1000". In other words, if people had rational expectations they would be indifferent between the two systems, but since they do not have them, they are subjected to a "fiscal illusion", which distorts their decisions.

In 1974 Robert J. Barro published an article entitled "Are Government Bonds Net Wealth?" in the Journal of Political Economy
Journal of Political Economy
The Journal of Political Economy is an academic journal run by economists at the University of Chicago and published every two months by the University of Chicago Press. The journal publishes articles in both theoretical economics and empirical economics...

(Vol. 82, No. 6. (Nov. - Dec., 1974), pp. 1095-1117). This model assumes that families act as infinitely lived dynasties because of intergenerational altruism, capital markets are perfect (meaning that all can borrow and lend at a single rate), and the path of government expenditures is fixed. Under these conditions, if governments finance deficits by issuing bonds, families will grant bequests to children just large enough to offset the higher taxes that will be needed to pay off those bonds. In the Conclusions of the paper (page 1116) he stated that "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". This sentence sounded as the negation of the Keynesian theory and unleashed a strong reaction by the Keynesian school.
This paper was an important contribution to the New Classical Macroeconomics

New classical macroeconomics

New classical macroeconomics emerged as a school in macroeconomics during the 1970s. As opposed to Keynesian macroeconomics, it builds its analysis on an entirely neoclassical framework...

, built around the assumption of rational expectations

Rational expectations

Rational expectations is an assumption used in many contemporary macroeconomic models, and also in other areas of contemporary economics and game theory and in other applications of rational choice theory....

.

Empirical research rejects Ricardian equivalence in its pure form, although some studies have found Ricardian effects in saving behavior. For a technical review of the literature, see M. Gabriella Briotti, "Economic Reactions to Public Finance Consolidation: a Survey of the Literature", European Central Bank

European Central Bank

The European Central Bank is one of the world's most important central banks, responsible for monetary policy covering the 16 member States of the Eurozone. It was established by the European Union in 1998 with its headquarters in Frankfurt, Germany.-History:Technically the predecessor to the ECB...

Occasional Paper No. 38, Oct. 2005.

Assumptions

Ricardian equivalence states that under some conditions tax and bond financed increases in government spending are equivalent. This can be contrasted with standard Keynesian theory where a bond financed spending has a bigger effect than tax financed spending. If consumers are "Ricardian" they will save more now to compensate for the higher taxes they expect to face in the future, as the government has to pay back its debts.

To work, this needs several conditions, most commonly:

A perfect capital market where any household can borrow or save as much as is required at a fixed rate which is the same for all persons at a given date.
The path of government spending is fixed
Intergenerational concern. The tax rise required may not occur for centuries, and will be paid off by the great-great-grandchildren of the population around at the time the debt was incurred. Ricardian equivalence only happens when the current generation has some concern for all future generations, even if not perfect concern. Barro phrased this as "any operative intergenerational transfer".

These assumptions are widely challenged. The perfect capital market hypothesis is often held up for particular criticism because of the existence of liquidity constraint

Liquidity constraint

A liquidity constraint in economic theory is a form of imperfection in the capital market. It causes difficulties for models based on intertemporal consumption.Many economic models require individuals to save or borrow money from time to time....

s which invalidate the lifetime income hypothesis which it is based on. The existence of international capital markets also complicates the picture.

However, the underlying intuition of the Barro-Ricardo model is that individual action can unravel Government policy, that the economy does not act in a mechanistic manner, and that policies can have unintended consequence

Unintended consequence

Unintended consequences are outcomes that are not the results originally intended by a particular action. The unintended results may be foreseen or unforeseen, but they should be the logical or likely results of the action...

s. This is a key point of modern macroeconomic policy.

Critiques

In 1979 Robert J. Barro published an article entitled "On the Determination of the Public Debt" in the Journal of Political Economy (Vol. 87, No. 5. , pp. 940-971) where he defined (page 940) as "Ricardian equivalence theorem on public debt" that proposition "that 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." and (note 1, page 940) he wrote that "The Ricardian equivalence proposition is presented in Ricardo". However, it should be noted that Ricardo himself was skeptical of this equivalence.
In 1976 Barro's result was criticized by Martin Feldstein
Martin Feldstein
Martin Stuart "Marty" Feldstein is a conservative American economist. He is currently the George F. Baker Professor of Economics at Harvard University, and the president emeritus of the National Bureau of Economic Research . He served as President and Chief Executive Officer of the NBER from 1978...

in "Perceived Wealth in Bonds and Social Security: A Comment" in the Journal of Political Economy (Vol. 84, No. 2. , pp. 331-336), who argued that Barro achieved his results by ignoring the growth of economy and the growth of population. He demonstrated that the creation of public debt depresses savings in a growing economy.
In 1976 the result was criticized by James M. Buchanan
James M. Buchanan
James McGill Buchanan, Jr. is an American economist known for his work on public choice theory, for which he won the 1986 Nobel Prize in Economics. Buchanan's work initiated research on how politicians' self-interest and non-economic forces affect government economic policy.-Biography:Buchanan...

in "Barro on the Ricardian Equivalence Theorem", in the Journal of Political Economy (Vol. 84, No. 2. , pp. 337-342) for:

having neglected to compare the differential impacts of taxation and debt issue;
having "superimposed" an issue of public debt without offsetting or compensating changes;
having considered the "helicopter drop" to currently old households and the sale of bonds on a competitive capital market, with the proceeds of this sale used to effect a lump-sum transfer to generation 1 households as wrongly equivalent;
having missed to provide empirical evidence about the full discount of future taxes;
not having considered that, under his hypothesis, there should be roughly indifferent public reactions to a fully funded and to an unfunded pension system;
not having considered the political consequences of the equivalence.

In 1976 "Perceived Wealth in Bonds and Social Security and the Ricardian Equivalence Theorem: Reply to Feldstein and Buchanan" (The Journal of Political Economy, Vol. 84, No. 2., pp. 343-350.) Barro recognized that uncertainty may play a role in changing individual behavior, but, 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" (page 346). Barro's position is one that denies the existence of a fiscal illusion as stated by Ricardo, who argued that the taxpayer would underestimate his future tax liabilities, and thus makes a systematic error.

External links

Essay On the Funding System by David Ricardo, (1820), contributed to the supplement of the Encyclopaedia Britannica
New School Online History of Economic Thought: Section on Ricardian Equivalence
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
Why a tax cut just isn’t fair on teenagers by Tim Harford, Financial Times
Government debt, NBER Working Paper 6470, by L. Elmendorf and N. Mankiw (1998), summarizes much of the debate on Ricardian equivalence. Published as Chap. 25 of Taylor and Woodford, eds., (1999) Handbook of Macroeconomics, vol. 1C. North-Holland, ISBN 0444825282.

Ricardian equivalence

Introduction

Assumptions

Critiques

See also

External links