Outline and Explain the Ricardian Equivalence Theorem and Assess the Evidence Bearing on It.

Topics: Tax, Public finance, Macroeconomics Pages: 6 (1528 words) Published: April 1, 2008
Outline and explain The Ricardian Equivalence Theorem and assess the evidence bearing on it.

The Ricardian Equivalence Theorem, developed by David Ricardo and advanced by Robert Barrow in the 19th century, suggests that taking into account the government budget constraint a budget deficit will have no effect on national saving- the sum of private and public saving, in an economy. In this essay I am going to explain the reasoning behind this, assess its likelihood and finally review evidence either supporting or opposing the theorem.

In an economy, if government spending exceeds government revenues, borrowing money (for example by issuing government bonds or increasing taxation) can finance the deficit.

Ricardian Equivalence states that if a government opts to tax ‘in the future’ and instead borrow money, even though economic agents now have more disposable income, they do not alter their real spending patterns, as they fully predict future tax increases in order to finance governments outstanding bonds and so results in having no effect on an agent's intertemporal budget constraint. As such agents choose to save now so that they have enough when taxes are increased in the future to pay back the borrowing. Due to households holding both assets (government bonds) and liabilities (future tax obligation), this does not represent net wealth for them . Consumers are saving exactly the same amount governments are overspending, and so total demand is unaffected.

As a result, Ricardian Equivalence Theorem implies that using active fiscal policy to alter aggregate demand proves ineffective. This is in stark contrast with the Keynesian economic theory (fig 1), whereby increasing government spending increases both output and the interest rate, as they base consumption on current income.

Fig. 1

Figure two shows that taking the Ricardian approach, as explained above, agents envisage extra spending will at some point in the future have to be paid by escalating taxation, and so increase current savings, resulting in unchanged level of output.

Fig. 2

Ricardian Equivalence theorem therefore disproves the Solow Model, as it opposes the fact that in the Solow model private consumption is dependent upon net wealth, which is made up of government debt.

The Ricardian Equivalence Theorem is based upon a number of highly contentious assumptions, which make a number of economists wary about its validity.

Firstly, Ricardian Equivalence states that agents need to be foresighted and rational. Due to the existence of permanent income and life-cycle hypothesis, Seater 1993, supports this, however there are critics who challenge the idea of foresightedness and rationality. They believe that agents choose consumption levels based purely upon their current disposable income and are ignorant to future tax burdens. Modigiani and Sterling supported this idea, declaring that ‘consumers are unable to distinguish taxes implied by government debt' .

Another assumption is that of perfect capital mobility market, whereby agents are able to borrow and save as much as they need and people must be able to borrow at the same interest rate at which the government borrows, or the equivalence breaks down. Households tend to be more risky than governments to lend to, and as a result may have to pay a larger risk premium than governments, placing limits upon the amount individuals can borrow and save. This thwarts agents from optimizing their behavior and may invalidate Ricardian Equivalence.

Thirdly, Ricardian equivalence can only hold when current agents know the exact timing of when taxes are to be collected. If an agent realizes that the government would collect taxes after they had died, than current consumption would in fact change as bonds would represent net wealth to those that are living (Diamond 1965) . This was challenged by Barrow who put forward the idea that Ricardian equivalence holds if the current generation has...
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