Ricardian Equivalence

Ricardian Equivalence is an economic and political theory. It elucidates a scenario where short-term tax cuts imply long-term tax hikes. The theory discusses these outcomes, especially in governmental expenditure and debt financing.

The Ricardian Equivalence theorem suggests taxpayers' income will remain the same—the deficits will be repaid, and taxpayers will save their excess income anticipating future tax increases. However, the Ricardian Proposition entails multiple assumptions; hence, it is criticized by many analysts and economists. Moreover, it is in contradiction with the Keynesian theory.

• Ricardian Equivalence theory defines that government spending through debt financing does not affect the economy. The theory claims income and spending of a consumer remain constant.
• It envisions a futuristic nature of the economy—consumers end up paying higher taxes in the future—to cover the government's current spending.
• The Ricardian Equivalence theory assumes that consumers can foresee increased taxation well into the future. It assumes that consumers save excess income to cover future liabilities (increased tax).
• If the Ricardian strategy fails, it can bring recession, financial crisis, and excessive debts.

The Ricardian Equivalence theorem elucidates a scenario where short-term tax cuts lead to long-term tax hikes—for consumers. Whenever a government spends on infrastructure or public utilities, it introduces bonds. But bonds are loans; they need to be paid eventually. And this eventually comes out of the consumer’s pocket—in the form of increased taxation—at a future date.

The Ricardian Equivalence proposition was developed in the 19th century by David Ricardo—an English economist. Later, Robert Barro elaborated the theory further. Barro was an American economist and Harvard professor. Thus the theory is often referred to as the Barro-Ricardo equivalence proposition.

The concept highlights that such short-term benefits come with long-term losses. It also suggests that consumers are rational and can foresee the situation. The theory claims that consumers will save more from their excess income to cover future liabilities—tax hikes. If so, tax cuts should not benefit investors or consumers.

But the entire Ricardian Equivalence proposition hinges on an assumption. The theory assumes consumers will see tax hikes coming. Most do not agree with this assumption—the proposition attracts considerable criticism from economists and market analysts.

Critics declare the Ricardian concept irrelevant because the proposition assumes perfect capital markets. Moreover, it does not account for economic stagnation; it assumes perpetual growth.

The Ricardian Equivalence economics constructs a relationship between short-term tax cuts, their impact on consumer consumption, and long-term hikes.

Let us look at some of the assumptions of the concept.

• Among the assumptions, the Ricardian theory receives maximum flak for assuming consumer savings. The Ricardian Equivalence theorem assumes that consumers can foresee increased taxation well into the future. Therefore, it assumes that consumers save excess income to cover future liabilities (increased tax).
• The Ricardian Equivalence economics is mere conjecture—it assumes that all consumers share the same ideology and that every citizen prepares for future taxes. 
•  The theory fails to consider crucial economic elements—the disruption of capital markets, emerging patterns, and buying trends. Instead, it simply presumes that consumers will borrow to cover expenses.
• The Ricardian theory believes that parents who predict a higher tax will pass more wealth to their heirs to prepare them for future expenses (tax hikes).

Let us look at a hypothetical to understand the concept better.

There is a small country—the government possesses minimum reserves—it lacks infrastructure, resources, government schemes, and healthcare programs. Initially, citizens were paying taxes from their income. But with time, the economy required more attention—the government borrowed funds from neighboring countries and utilized them to build infrastructure.

The government builds roads, schools, hospitals, parks, and business centers—to provide resources and facilities. Everyone knew that the government would eventually have to repay the loan—citizens started saving more. 

After a period, the government imposed heavy taxes on its citizens to ensure debt repayment. This hypothetical elucidates a futuristic mindset among consumers.

This concept can also be compared with reaganomics. Ronald Reagan curtailed taxes, anticipating increased investment. But the tax savings offered to the rich did not lead to job creation.

Parallels can be drawn between affluent investors of 1980s America and the Ricardian Equivalence hypothesis. American investors knew that curtailed taxes could not last. So they increased savings; they did not increase investments (despite the increase in income). Ultimately, the rich became richer, and the poor became poorer.

Thus, the above example clearly explains the above theory with relation to a hypothetical scenario.

Many economists shared their concerns regarding the issues with the theory.

• Consumers are not always rational; therefore, it is highly unlikely for the majority of consumers to save (for future taxes). Most common folks who receive a tax cut would enjoy increased consumption immediately—future taxation would be the least of their concerns.
• The theory assumes a perfect market scenario and an undisturbed economy and therefore gets criticized vehemently. In a period of recession or abrupt stock market crash, consumption declines, and there is no cash flow in the market. Governments cannot rely on consumers’ careful savings to repay their lavish spending.
• Economists who support the Keynesian theory strongly reject the Ricardian Equivalence hypothesis—it goes against macroeconomics.
• Economists believe there are other ways of raising funds—government expenditure should not always require borrowing. Moreover, future tax hikes will burden consumers unreasonably.
• The theory does not account for economic recession and slowdown. The lack of confidence, consumption, and consumer spending could seriously derail a nation’s economy.
• Government borrowings do not always end up benefitting the citizens. Sometimes, the spending benefits the government more and people less.

It is always important to study a theory or a concept with proper understanding of its various aspects including its criticisms, so that the concept can be used under suitable circumstances for better results.

This article has been a guide to what is Ricardian Equivalence. We explain it with example and assumptions along with its criticism. You can learn more about it from the following articles -

• Government Spending
• Financial Economics
• Monetarism vs Keynesianism