Ricardian equivalence suggests deficit spending is equivalent to an immediate tax increase, as households recognize that government debt requires future taxation. However, many assumptions must hold true, and empirical evidence is sparse.
Ricardian equivalence, sometimes called 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 Ricardian equivalence, deficit spending is equivalent to an immediate increase in taxes, 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 generally, stating that interest rates would not be affected by the distribution of the deficit between debt and taxation.
The rationale behind Ricardian equivalence is that households will recognize that government debt requires future taxation. The amount of taxation required in the future to pay off debts incurred in the present will expand as a function of time and the interest rate. Private wealth will expand in the same way. So a perfectly planned family plan for the future should set aside precisely the amount you would pay in taxes now, as that money will earn interest at the same rate as the government debt grows.
Many assumptions go into the idea of Ricardian equivalence. Families must plan infinitely far ahead into the future. They must be completely rational. They must expect to continue earning taxable income at the same rate. The government must have no other sources of income or strategies to resolve its debt. People should also value their future wealth to exactly the same degree that they value their current wealth. Also, they should value their children’s wealth to the same degree and there should be a smooth transition of wealth to parents and children.
For the theory to work, there must also be no population growth that would distribute the current debt among more taxpayers. There must be no increase in national wealth – economic growth – that would make the debt collectively easier to pay. Some of these assumptions were recognized by Barro himself; others have been singled out by critics such as Martin Feldstein and James Buchanan.
Strong empirical evidence for Ricardian equivalence is sparse, and most economists do not accept the hypothesis as correct. There are still many arguments for and against debt, but Ricardian equivalence does not serve as a strong tool on either side of the debate.
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