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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.
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 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.
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
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.
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:
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 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.
Ricardian equivalence requires assumptions that have been seriously challenged. The perfect capital market hypothesis is often held up for particular criticism because liquidity constraints invalidate the assumed lifetime income hypothesis. International capital markets also complicate the picture.
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 1976, Barro recognized that uncertainty may play a role in changing individual behavior. Nevertheless, he argued,
In 1989, Barro offered a number of defenses against various other critiques.
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