What is the Ricardian Equivalence?

Ricardian equivalence, sometimes called Barro-Ricardo equivalence, is a hypothesis used to suggest that deficit spending cannot stimulate the economy. The proposed equivalence is between taxes in the present and taxes in the future. According to Ricardian equivalence, deficit spending is equivalent to an immediate increase in taxes because participants in the economy will recognize that the deficit requires future taxes.

The theory receives its name from David Ricardo, who suggested it in 1820. Ricardo himself, however, did not fully endorse the idea. The modern formulation was developed in 1974 by Robert Barro. Barro actively promoted the theory, and expressed it in a general form, stating that interest rates would not be affected by the distribution of deficit between debt and taxation.

The logic behind Ricardian equivalence is that households will recognize that government debt requires future taxation. The amount of taxation necessary in the future to pay off debt initiated in the present will expand as a function of time and the interest rate. Private wealth will expand in the same way. Thus, a household planning perfectly for the future should set aside precisely the amount of money it would pay in taxes now, since this money will earn interest at the same rate at which the government's debt grows.

Many assumptions go into the idea of Ricardian equivalence. Families must plan infinitely far ahead in the future. They must be completely rational. They must expect to continue earning taxable income at the same rate. The government must have no other sources of income or strategies for resolving its debt. People must also value their future wealth to exactly the same degree that they value their present wealth. In addition, they must value their children's wealth to the same degree and there must be a smooth transition of wealth to parents and children.

For the theory to work, there must also be no growth in population that would distribute present debt across more taxpayers. There must be no increase in national wealth—economic growth—that would make the debt collectively easier to pay off. Some of these assumptions were acknowledged by Barro himself; others were highlighted by critics such as Martin Feldstein and James Buchanan.

Strong empirical evidence for Ricardian equivalence is sparse, and most economists do not accept the hypothesis as correct. Many arguments for and against debt still exist, but Ricardian equivalence does not serve as a strong tool on either side of the debate.