The term Ricardian equivalence was coined by the American economist Robert Barro in the 1970s and subsequently became a standard topic in public finance and macroeconomic theory. The Ricardian equivalence theorem ascribes to David Ricardo (1772–1823), the English economist, the view that taxation and public borrowing constitute equivalent forms of financing public expenditure. The rationale behind this view is that the government is expected at some future time to redeem its debt. If one now supposes a closed economy, the repayment of debt will take place via increased future taxation, which means that, on the basis of the rational expectations hypothesis, individuals increase their savings through buying the bonds that have been issued by the government. The amount of savings, in other words, matches the size of the public deficit and therefore the interest-rate remains the same. This means that there is no crowding-out effect of private investment from public expenditure and the overall demand remains the same together with the other real variables of the economy.
A similar mechanism operates in the case of an open economy, where the redemption of public debt takes place via the sale of assets to international institutional agents. Such a possibility raises, once again, the question of limited future government income, hence the inevitable future increase of taxation. Consequently, Robert Barro in the early 1970s and the new classical economists argued that either method of financing public expenditure, that is, through taxation or borrowing, leads to the same final results. The theorem has been used to argue against government intervention in the economy through fiscal policy because it suggests that the government cannot achieve anything quite different from the free operation of market forces. Monetary policy has similar effects; for example, if government expands the money supply, the public does not increase its expenditures but rather its savings in order to meet the future tax obligations. In short, Ricardian equivalence became a necessary weapon in the armory of the new classical economics in their defense of “free market.”
The truth, however, is that Ricardo, to whom this theorem is attributed, repudiated the notion of equivalence between the two ways of financing government expenditure. He reasoned that taxation falls on current incomes and primarily reduces current consumption and only secondarily saving. By contrast, borrowing falls entirely on savings, which for Ricardo and classical economists are identical to investment. As a consequence, public borrowing diminishes the investable product and has detrimental effects on the economy’s capacity to accumulate capital.
The empirical evidence from various countries does not lend support to the Ricardian equivalence in its pure form, although there is some evidence that saving rates follow government spending—that is, it has been observed that the personal saving rate increases in the case of deficit spending and decreases in the case of government surpluses. It is very hard, however, to show a direct one-to-one relationship here. A usual criticism of the Ricardian equivalence theorem is that real-life situations are characterized by uncertainty regarding future income and also tax liability, which prevents individuals from behaving in accordance to rational expectations. Furthermore, Ricardian equivalence does not hold in cases where the growth rate of the economy exceeds the rate of interest.
SEE ALSO Policy, Fiscal; Policy, Monetary
Buchanan, James M. 1976. Barro on the Ricardian Equivalence Theorem. Journal of Political Economy 84 (2): 337–342.
Tsoulfidis, Lefteris. 2006. Classical Economists and Public Debt: J. S. Mill’s Conjecture. http://econlab.uom.gr/~lnt/images/stories/pdf/classics_and_debt.doc.