what is ricardian equivalence 
ricardian equivalence is an economic theory that says that financing government spending out of current taxes or future taxes and current deficits will have equivalent effects on the overall economy 1 this means that attempts to stimulate an economy by increasing debt financed government spending will not be effective because investors and consumers understand that the debt will eventually have to be paid for in the form of future taxes understanding ricardian equivalencegovernments can finance their spending either by taxing or by borrowing and presumably taxing later to service the debt in either case real resources are withdrawn from the private economy when the government purchases them but the method of financing is different ricardo argued that under certain circumstances even the financial effects of these can be considered equivalent because taxpayers understand that even if their current taxes are not raised in the case of deficit spending their future taxes will go up to pay the government debt as a result they will be forced to set aside some current income to save up to pay the future taxes because these savings necessarily involve forgone current consumption in a real sense they effectively shift the future tax burden into the present in either case the increase in current government spending and consumption of real resources is accompanied by a corresponding decrease in private spending and consumption of real resources financing government spending with current taxes or deficits and future taxes are thus equivalent in both nominal and real terms economist robert barro formally modeled and generalized ricardian equivalence based on the modern economic theory of rational expectations and the lifetime income hypothesis 2 barro s version of ricardian equivalence has been widely interpreted as undermining keynesian fiscal policy as a tool to boost economic performance because investors and consumers adjust their current spending and saving behaviors based on rational expectations of future taxation and their expected lifetime after tax income reduced private consumption and investment spending will offset any government sending in excess of current tax revenues the underlying idea is that no matter how a government chooses to increase spending whether through borrowing more or taxing more the outcome is the same and aggregate demand remains unchanged key assumptions of the ricardian equivalencethere are several assumptions to the ricardian equivalence the top five assumptions include the following the theory states that individuals can borrow and lend freely at the same interest rate as the government in this idealized scenario there are no credit constraints and everyone has equal access to financial markets this allows consumers to smooth their consumption over time borrowing when their income is low and saving when it s high the theory suggests that individuals make economic decisions based on a comprehensive understanding of future economic conditions consumers are expected to accurately anticipate future tax changes or increases and adjust their saving behavior accordingly the theory assumes that taxes are levied as lump sum amounts that do not affect individuals economic choices this means that taxes don t influence decisions about work savings or consumption if someone gets a lump sum tax payment it won t actually influence their spending habits the theory holds that individuals either live forever or care about future generations as much as they care about themselves this obviously means that the assumption is the current generations fully account for the tax burdens that will be faced by their descendants and make the decisions for these individuals in the future even at short term deficits such as paying a gift tax the model assumes that individuals have perfect knowledge about their future income streams and tax liabilities this allows them to make precise calculations about their lifetime resources and adjust their current consumption and saving accordingly many modern economists acknowledge that ricardian equivalence depends on assumptions that may not always be realistic arguments against the ricardian equivalencesome economists including ricardo himself have argued that ricardo s theory is based upon unrealistic assumptions for instance the ricardian equivalence assumes that individuals can borrow and lend freely at the same interest rate as the government however capital markets are far from perfect many individuals face credit constraints higher interest rates or may be unable to borrow at all due to factors such as low income poor credit history or lack of collateral this imperfection means that people can t always smooth their consumption over time as the theory suggests leading to a breakdown of the equivalence the theory also assumes that people consider the tax burdens of future generations as if they were their own however individuals have finite lifespans and may not factor in tax increases that will occur after their death behavioral economics may suggest that some people exhibit myopic behavior focusing more on short term benefits and immediate gratification rather than long term financial planning last the ricardian equivalence doesn t account for potential keynesian multiplier effects of government spending in keynesian economics government spending can have a stimulative effect on the economy this means the government can aid in increasing aggregate demand and potentially leading to higher output and employment these effects could outweigh any increase in private saving especially in times of economic downturn when there s significant slack in the economy the presence of these multiplier effects challenges the ricardian notion that government borrowing is fully offset by private saving real world evidence of ricardian equivalencethe theory of ricardian equivalence has been largely dismissed by keynesian economists and ignored by public policy makers who follow their advice however there is some evidence that it has validity in a study of the effects of the 2008 financial crisis on european union nations a strong correlation was found between government debt burdens and net financial assets accumulated in 12 of the 15 nations studied in this case ricardian equivalence holds up countries with high levels of government debt have comparatively high levels of household savings 3in addition a number of studies of spending patterns in the u s have found that private sector savings increase by about 30 cents for every additional 1 of government borrowing this suggests that the ricardian theory is at least partially correct 4overall however the empirical evidence for ricardian equivalence is somewhat mixed and likely depends on how well the assumptions that consumers and investors will form rational expectations base their decisions on their lifetime income and not face liquidity constraints on their behavior will actually hold in the real world 