Therefore, their lifetime income remains unchanged and so consumer spending remains unchanged. Similarly, higher government spending, financed by borrowing, will imply lower spending in the future. If this theory is true, it would mean a tax cut financed by higher borrowing would have no impact on increasing aggregate demand because consumers would save the tax cut to pay the future tax increases. Thus, if consumers anticipate a rise in taxes in the future, they will save their current tax cuts to be able to pay future tax rises. Rational expectations on behalf of consumers.
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Ricardian equivalence is an economic theory that argues that attempts to stimulate an economy by increasing debt-financed government spending are doomed to failure because demand remains unchanged. The theory argues that consumers will save any money they receive in order to pay for the future tax increases they expect to be levied in order to pay off the debt.
This theory was developed by David Ricardo in the early 19th century and later was elaborated upon by Harvard professor Robert Barro. The recipients of a government windfall perceive it as such. Therefore, the government, cannot stimulate consumer spending. Key Takeaways Ricardian equivalence maintains that government spending to stimulate the economy is not effective. That is, individuals who get extra money will save it in order to pay for the future tax increases they know must follow.
This theory has been widely discounted by economists who subscribe to the theories of Keynesian economics. The underlying idea is that no matter how a government chooses to increase spending, whether through borrowing more or taxing less, the outcome is the same and demand remains unchanged.
For instance, it assumes that people will save in anticipation of a hypothetical future tax increase. It also assumes that they will not find it necessary to use the windfall. It even assumes that the capital markets, the economy in general, and even individual incomes all will remain static for the foreseeable future.
Real-World Proof of Ricardian Equivalence The theory of Ricardian equivalence has been largely dismissed by many economists. However, there is some evidence that it has validity. In a study of the effects of the financial crisis on European Union nations, a strong correlation was found between government debt burdens and net financial assets accumulated in 12 of the 15 nations studied. In this case, Ricardian equivalence holds up.
Countries with high levels of government debt have comparatively high levels of household savings. In addition, a number of studies of spending patterns in the U.
This suggests that the Ricardian theory is at least partially correct. Compare Accounts.
Are you kidding me? Impact of tax cuts under Ricardian Equivalence The principle behind Ricardian equivalence can be illustrated by this simple trade-off. The Ricardian equivalence proposition is an economic eequivalence — developed by British 19th century political economist David Ricardo — that suggests that when the government attempts to stimulate the economy by raising debt-financed government spending, demand does not increase, but remains the same. The initial increase equivslence government spending may cause a further rise in spending in the economy causing the final increase in GDP to be bigger than the initial injection into the economy. Consumers are not rational. Among his conclusions, Barro wrote:.
Reflections on Ricardian Equivalence
Introduction[ edit ] Governments can finance their expenditures by creating new money, by levying taxes, or by issuing bonds. Since bonds are loans, they must eventually be repaid—presumably by raising taxes in the future. The choice is therefore "tax now or tax later. According to the hypothesis, taxpayers will anticipate that they will have to pay higher taxes in future. As a result, they will save, rather than spend, the extra disposable income from the initial tax cut, leaving demand and output unchanged. David Ricardo was the first to propose this possibility in the early nineteenth century; however, he was unconvinced of its empirical relevance. Barro took the question up independently in the s, in an attempt to give the proposition a firm theoretical foundation.