The Ricardian equivalence suggests that deficit spending is equivalent to an immediate tax increase because participants in the economy will recognize that the deficit requires future taxes. The theory is named after David Ricardo and was developed by Robert Barro in 1974, but strong empirical evidence for it is scarce and most economists do not accept it as correct.
The Ricardian equivalence, sometimes called the Barro-Ricardo equivalence, is a hypothesis used to suggest that deficit spending cannot stimulate the economy. The proposed equivalence is between taxes in the present and taxes in the future. According to the Ricardian equivalence, deficit spending is equivalent to an immediate tax increase because participants in the economy will recognize that the deficit requires future taxes.
The theory is named after David Ricardo, who suggested it in 1820. Ricardo himself, however, did not fully endorse the idea. The modern formulation was developed in 1974 by Robert Barro. Barro actively promoted the theory and expressed it in general form, arguing that interest rates would not be influenced by the distribution of the deficit between debt and taxation.
The rationale behind the Ricardian equivalence is that households will recognize that public debt requires future taxation. The amount of tax needed in the future to pay off debt initiated in the present will expand as a function of time and the interest rate. Private wealth will expand as well. Therefore, perfect family planning for the future would have to set aside exactly the amount of money it would now pay in taxes, since this money will earn interest at the same rate as the government’s debt grows.
Many hypotheses go into the idea of Ricardian equivalence. Families have to plan infinitely far ahead in the future. They must be completely rational. They should expect to continue earning taxable income at the same rate. The government must have no other source of income or strategies for resolving its debt. People must also value their future wealth at exactly the same level as they value their current wealth. Furthermore, they must value the wealth of their children equally, and there must be a smooth transition of wealth to parents and children.
For the theory to work, there must be no population growth that distributes current debt to more taxpayers. There must be no increase in national wealth – economic growth – that would make debt collectively easier to pay off. Some of these hypotheses have been recognized by Barro himself; others have been highlighted by critics such as Martin Feldstein and James Buchanan.
Strong empirical evidence for the Ricardian equivalence is scarce, and most economists do not accept the hypothesis as correct. There are still many arguments for and against debt, but the Ricardian equivalence is not a strong tool on either side of the debate.
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