Ricardian equivalence

The Ricardian equivalence proposition (also known as the Ricardo–De Viti–Barro equivalence theorem) is an economic hypothesis holding that consumers are forward looking and so internalize the government's budget constraint when making their consumption decisions. This leads to the result that, for a given pattern of government spending, the method of financing that spending does not affect agents' consumption decisions, and thus, it does not change aggregate demand. Thus, this theorem is used as an argument against tax cuts and spending increases aimed to boost aggregate demand.

Governments can finance their expenditures 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. According to the hypothesis, taxpayers will anticipate that they will have to pay higher taxes in future. As a result, they will increase their savings to pay the future tax increase; i.e. they 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 its empirical relevance.Antonio De Viti De Marco elaborated on Ricardian equivalence 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.

In "Essay on the Funding System" (1820) Ricardo studied whether it makes a difference to finance a war with £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 terms of spending the two alternatives amounted to the same value. However, Ricardo himself doubted that this proposition had practical consequences. He followed up the initial exposition with a claim that individuals do not actually evaluate taxes in such a manner and, in particular, take myopic view of the tax path.

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:

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