Ricardian equivalence
Encyclopedia
The Ricardian equivalence proposition (also known as the Barro–Ricardo equivalence theorem) is an economic theory holding that consumers internalize the government's budget constraint
: as a result, the timing of any tax change does not affect their change in spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, because the effect on the total level of demand in the economy is the same.
Suppose that the government finances some extra spending through deficits; i.e. it chooses to tax later. This action might suggest to taxpayers that they will have to pay higher tax in future. Taxpayers would put aside savings to pay the future tax rise; i.e. they would willingly buy the bonds issued by the government, and would reduce their current consumption to do so. The effect on aggregate demand would be the same as if the government had chosen to tax now.
David Ricardo
was the first to propose this possibility in the early nineteenth century; however, he was unconvinced of it. Antonio De Viti De Marco
elaborated on Ricardian equivalence starting in the 1890s. Robert J. Barro took the question up independently in the 1970s, in an attempt to give the proposition a firm theoretical foundation. The proposition remains controversial.
However, Ricardo himself doubted that this proposition had practical consequences. He continued:
In other words, if people had rational expectations they would be indifferent between the two systems, but since they do not have them, they are subjected to a "Fiscal Illusion
", which distorts their decisions.
(apparently in ignorance of Ricardo's earlier notion and De Viti's subsequent extensions). Barro's model assumed the following:
Under these conditions, if governments finance deficits by issuing bonds, the bequests that families grant to their children will be just large enough to offset the higher taxes that will be needed to pay off those bonds. Among his conclusions, Barro wrote:
The model was an important contribution to the New Classical Macroeconomics
, built around the assumption of rational expectations
.
In 1979, Barro defined the Ricardian Equivalence Theorem as follows:
noting that "[t]he Ricardian equivalence proposition is presented in Ricardo". However, Ricardo himself was skeptical of this equivalence.
s invalidate the assumed lifetime income hypothesis. International capital markets also complicate the picture.
In 1976, Martin Feldstein
argued that Barro ignored economic and population growth. He demonstrated that the creation of public debt depresses savings in a growing economy.
In that same year, James M. Buchanan
also faulted Barro's model, noting that "[t]his is an age-old question in public finance theory", one already mooted by Ricardo and elaborated upon by De Viti.
In particular, he criticized Barro for:
In 1977, Gerald P. O'Driscoll opined that Ricardo, in expanding his treatment of this subject for an Encyclopædia Britannica article, changed so many features of it as to result in a Ricardian Nonequivalence Theorem.
In 2009, Paul Krugman
ignited a debate among notable blogging economists and financial journalists when he grouped Barro with "first-rate economists [who] keep making truly boneheaded arguments against [organizing Keynesian stimulus]".
In 1989, Barro offered a number of defenses against various other critiques.
Budget constraint
A budget constraint represents the combinations of goods and services that a consumer can purchase given current prices with his or her income. Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices...
: as a result, the timing of any tax change does not affect their change in spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, because the effect on the total level of demand in the economy is the same.
Introduction
In its simplest terms: governments can raise money either through taxes or by issuing bonds. Since bonds are loans, they must eventually be repaid—presumably by raising taxes in the future. The choice is therefore "tax now or tax later."Suppose that the government finances some extra spending through deficits; i.e. it chooses to tax later. This action might suggest to taxpayers that they will have to pay higher tax in future. Taxpayers would put aside savings to pay the future tax rise; i.e. they would willingly buy the bonds issued by the government, and would reduce their current consumption to do so. The effect on aggregate demand would be the same as if the government had chosen to tax now.
David Ricardo
David Ricardo
David Ricardo was an English political economist, often credited with systematising economics, and was one of the most influential of the classical economists, along with Thomas Malthus, Adam Smith, and John Stuart Mill. He was also a member of Parliament, businessman, financier and speculator,...
was the first to propose this possibility in the early nineteenth century; however, he was unconvinced of it. Antonio De Viti De Marco
Antonio De Viti De Marco
Antonio De Viti De Marco was an Italian economist. He was professor of public finance in Rome from 1887 until 1931, when he resigned rather than take an oath of loyalty to the Fascist regime. He was a long time editor of the Giornale degli Economisti.He has been described as "an unyielding...
elaborated on Ricardian equivalence starting in the 1890s. Robert J. Barro took the question up independently in the 1970s, in an attempt to give the proposition a firm theoretical foundation. The proposition remains controversial.
Ricardo and War Bonds
In "Essay on the Funding System" (1820) Ricardo studied whether it makes a difference to finance a war with the £20 million in current taxes or to issue government bonds with infinite maturity and annual interest payment of £1 million in all following years financed by future taxes. At the assumed interest rate of 5%, Ricardo concluded that- In point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever, or £1,200,000 for forty-five years are precisely of the same value.
However, Ricardo himself doubted that this proposition had practical consequences. He continued:
- But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly. We are too apt to think that the war is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes. It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1000.
In other words, if people had rational expectations they would be indifferent between the two systems, but since they do not have them, they are subjected to a "Fiscal Illusion
Fiscal Illusion
Fiscal illusion is a public choice theory of government expenditure first developed by the Italian economist Amilcare Puviani.Fiscal illusion suggests that when government revenues are unobserved or not fully observed by taxpayers then the cost of government is perceived to be less expensive than...
", which distorts their decisions.
Barro-Ricardo Equivalence
In 1974, Robert J. Barro provided some theoretical foundation for Ricardo's hesitant speculation(apparently in ignorance of Ricardo's earlier notion and De Viti's subsequent extensions). Barro's model assumed the following:
- families act as infinitely lived dynasties because of intergenerational altruism
- capital markets are perfect (i.e., all can borrow and lend at a single rate)
- the path of government expenditures is fixed
Under these conditions, if governments finance deficits by issuing bonds, the bequests that families grant to their children will be just large enough to offset the higher taxes that will be needed to pay off those bonds. Among his conclusions, Barro wrote:
- ... in the case where the marginal net-wealth effect of government bonds is close to zero ... fiscal effects involving changes in the relative amounts of tax and debt finance for a given amount of public expenditure would have no effect on aggregate demand, interest rates, and capital formation.
The model was an important contribution to the New Classical Macroeconomics
New classical macroeconomics
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics...
, built around the assumption of rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...
.
In 1979, Barro defined the Ricardian Equivalence Theorem as follows:
- ... shifts between debt and tax finance for a given amount of public expenditure would have no first-order effect on the real interest rate, volume of private investment, etc.
noting that "[t]he Ricardian equivalence proposition is presented in Ricardo". However, Ricardo himself was skeptical of this equivalence.
Criticisms
Ricardian equivalence requires assumptions that have been seriously challenged. The perfect capital market hypothesis is often held up for particular criticism because liquidity constraintLiquidity constraint
A liquidity constraint in economic theory is a form of imperfection in the capital market. It causes difficulties for models based on intertemporal consumption.Many economic models require individuals to save or borrow money from time to time....
s invalidate the assumed lifetime income hypothesis. International capital markets also complicate the picture.
In 1976, Martin Feldstein
Martin Feldstein
Martin Stuart "Marty" Feldstein is an economist. He is currently the George F. Baker Professor of Economics at Harvard University, and the president emeritus of the National Bureau of Economic Research . He served as President and Chief Executive Officer of the NBER from 1978 through 2008...
argued that Barro ignored economic and population growth. He demonstrated that the creation of public debt depresses savings in a growing economy.
In that same year, James M. Buchanan
James M. Buchanan
James McGill Buchanan, Jr. is an American economist known for his work on public choice theory, for which he received the 1986 Nobel Memorial Prize in Economic Sciences. Buchanan's work initiated research on how politicians' self-interest and non-economic forces affect government economic policy...
also faulted Barro's model, noting that "[t]his is an age-old question in public finance theory", one already mooted by Ricardo and elaborated upon by De Viti.
In particular, he criticized Barro for:
- failing to compare the differential impacts of taxation and debt issue;
- "superimposing" an issue of public debt without offsetting or compensating changes;
- erring in assuming the equivalence of the "helicopter drop" to currently old households and the sale of bonds on a competitive capital market, with the proceeds of this sale used to effect a lump-sum transfer to generation 1 household;
- not providing empirical evidence about the full discount of future taxes;
- not considering that, under his hypothesis, there should be roughly indifferent public reactions to a fully funded and to an unfunded pension system;
- not considering the political consequences of the equivalence.
In 1977, Gerald P. O'Driscoll opined that Ricardo, in expanding his treatment of this subject for an Encyclopædia Britannica article, changed so many features of it as to result in a Ricardian Nonequivalence Theorem.
In 2009, Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
ignited a debate among notable blogging economists and financial journalists when he grouped Barro with "first-rate economists [who] keep making truly boneheaded arguments against [organizing Keynesian stimulus]".
Barro's response
In 1976, Barro recognized that uncertainty may play a role in changing individual behavior. Nevertheless, he argued,- ...it is much less clear that this complication would imply systematic errors in a direction such that public debt issue raises aggregate demand.
In 1989, Barro offered a number of defenses against various other critiques.
Empirical results
Ricardian equivalence has been the subject of extensive empirical inquiry. Barro himself found some confirmation in post WW I years.See also
- Public financePublic financePublic finance is the revenue and expenditure of public authoritiesThe purview of public finance is considered to be threefold: governmental effects on efficient allocation of resources, distribution of income, and macroeconomic stabilization.-Overview:The proper role of government provides a...
- Government debtGovernment debtGovernment debt is money owed by a central government. In the US, "government debt" may also refer to the debt of a municipal or local government...
- Prisoner's DilemmaPrisoner's dilemmaThe prisoner’s dilemma is a canonical example of a game, analyzed in game theory that shows why two individuals might not cooperate, even if it appears that it is in their best interest to do so. It was originally framed by Merrill Flood and Melvin Dresher working at RAND in 1950. Albert W...
- Fiscal theory of the price levelFiscal theory of the price levelThe fiscal theory of the price level is the idea that government fiscal policy affects the price level: for the price level to be stable , government finances must be sustainable: they must run a balanced budget over the course of the business cycle, meaning they must not run a structural...
- Policy Ineffectiveness PropositionPolicy Ineffectiveness PropositionThe Policy Ineffectiveness Proposition is a new classical theory proposed in 1976 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations...
- Say's lawSay's lawSay's law, or the law of market, is an economic principle of classical economics named after the French businessman and economist Jean-Baptiste Say , who stated that "products are paid for with products" and "a glut can take place only when there are too many means of production applied to one kind...
- Treasury ViewTreasury ViewIn macroeconomics, particularly in the history of economic thought, the Treasury view is the assertion that fiscal policy has no effect on the total amount of economic activity and unemployment, even during times of economic recession. This view was most famously advanced in the 1930s by the staff...
External links
- Does It Matter How You Pay for a State Dinner? A Lesson on Ricardian Equivalence by Morgan Rose, at the Library of Economics and Liberty
- Biography of David Ricardo
- Why a tax cut just isn’t fair on teenagers by Tim Harford, Financial Times
- Romeo, Sampson, "The Effect of Budget Deficits on Long-term Interest Rates", http://www.faculty.fairfield.edu/cminers/journal/Romeo_Sampson.pdf