What it means
The idea is named after the early nineteenth-century economist David Ricardo, who discussed it, and it was revived in the 1970s by Robert Barro. It starts from the point that government debt must eventually be repaid, and that repayment will be funded by taxes.
This means a deficit today is a tax bill postponed rather than a gift. If people look ahead, they will realise that a tax cut today means higher taxes tomorrow.
Rather than spending the extra money, they will save it to pay the future bill, so total spending in the economy stays unchanged. The government's extra borrowing is matched by extra private saving.
The theory matters for the debate on whether governments can boost an economy by cutting taxes and borrowing. If Ricardian equivalence were true, such a policy would not work, because households would offset the government's borrowing by saving.
It relies on strong assumptions. People must look ahead, understand government finances, be able to borrow and lend freely, and care about the tax bills that fall on their children.
When these conditions fail, as they often do, some of the tax cut will be spent. Evidence is mixed.
Some studies suggest households save part of a debt-financed tax cut, but few find that they save all of it, so most economists regard the theory as a useful benchmark rather than an accurate description. It sets out what would happen if people were perfectly forward-looking.
For business and finance professionals, the idea helps in reading the likely effect of fiscal policy. It reminds you that government borrowing is not free money and that expectations of future taxes can change how people behave today.
Companies planning for a tax-driven boom in demand should keep this in mind.
In practice
Real-world examples.
Example
A government announces a $500 tax rebate per household financed by new borrowing. A survey finds that households spend $150 of it and save $350. The result suggests that Ricardian equivalence holds partly but not fully. Economists call such findings partial evidence.
Example
A family hears that its government is running a large deficit. The parents decide to keep the extra money from a tax cut in a savings account so that their children can pay future taxes. This is the behaviour that the theory assumes.
Example
A retailer plans stock for a year in which a government tax cut is expected. A finance manager studies past tax cuts and finds that sales rose only a little. She forecasts a modest increase and avoids buying too much stock. The forecast turns out to be close to actual sales.
Formula
Calculation
Change in consumption = Tax cut - Increase in saving
Under full Ricardian equivalence, saving rises by the present value of the future taxes. Suppose the government cuts taxes by $1,000 per household and borrows at 10% a year, repaying in one year. The future tax bill is 1,000 x 1.10 = $1,100, which has a present value of 1,100 / 1.10 = $1,000. Households save the whole $1,000, so the change in consumption is 1,000 - 1,000 = $0.Case study
Seen in the real world.
Marlow is an illustrative, fictional country that cut income taxes by $20,000,000,000 and financed the cut by issuing bonds. Economists at its treasury predicted that spending would rise by about two-thirds of the tax cut.
After the cut, household saving rose sharply and retail sales grew by less than expected. Researchers estimated that about half of the tax cut had been saved, as households anticipated higher taxes in future.
The treasury concluded that debt-financed tax cuts delivered only part of the boost it had hoped for. In this illustrative story, the lesson was that policy forecasts should allow for the possibility that people look ahead. The treasury now publishes a range of outcomes instead of one number.
Watch out
Common mistakes.
- Believing the theory proves that government borrowing never matters, when it applies only if strict assumptions hold.
- Assuming economists agree it is true, when most treat it as a benchmark and not as a rule.
- Confusing it with the idea that deficits do not matter, when the theory says deficits matter because people expect to pay later.
Questions
People also ask.
Who first proposed Ricardian equivalence?
David Ricardo discussed the underlying logic, and Robert Barro developed and popularised the modern version.
Why might Ricardian equivalence fail?
People may not plan ahead, may face limits on borrowing or may expect that future generations will pay the tax. Short-sighted households or those with little savings are likely to spend most of any tax cut.
How does it affect business planning?
If households save much of a tax cut, businesses should not expect a large rise in sales, so forecasts should be cautious. A cautious range for sales is safer than a single optimistic figure.
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