Public Finance: Ricardian Equivalence

Among the most well-known of the classical economists is David Ricardo. Known particularly for the concept of comparative advantage and how it—and not absolute advantage or any other measure—should be the basis for trade between individuals or nations (making trade no longer a zero-sum game), Ricardo is also well-known for laying out the theory behind what is known as Ricardian Equivalence. While he doubted the real-world existence of this proposition (and Robert Barro’s subsequent work in the 1970’s seemingly finding evidence for it is still frequently discussed), Ricardian Equivalence essentially states that taxpayers are rational and infinitely (or close to infinitely) forward-looking. Thus, they internalize the government’s budget constraint, such that they understand that a decrease in tax rates today must imply an increase in tax rates in the future. Instead of spending their tax cut and increasing Consumption (which might be the desire of government officials engaging in expansionary fiscal policy), they will save that money knowing that they will be taxed at a higher rate later. In short, this implies a relative ineffectiveness of fiscal policy (whether expansionary or contractionary) on Consumption and thus on GDP and economic growth.

This proposition assumes of course that there is no dominant wealth effect (thus, that a tax cut today would not be more than compensated for by the larger wealth of subsequent generations, making a tax cut in essence self-financing), that taxpayers are rational, and that they are very-forward looking. Those are of course strong assumptions; we know there are a myriad of biases, egocentric and temporal errors, myopia and temporal discounting, among other decision-making factors that make taxpayers (and economic agents in general) particularly “irrational” actors. On top of that, of course, much has happened between the time of Smith, Ricardo, Mill, Malthus, etc., and economic thought has evolved correspondingly. Heckscher and Ohlin, for example, have built upon the theory of comparative advantage to include factors of production and in turn help explain sources of comparative advantage. 

In a world where public finance has been a central topic of political discourse all around the world, it is essential that economics reach comprehensive and accurate responses to a large number of questions: What is the role of public debt on economic growth and taxpayer behavior? Does deficit spending (with the explicit purpose of stimulating the economy) actually work? Is Ricardian equivalence empirically observed? If so, is its effect different between expansionary or contractionary fiscal policy? How forward-looking are taxpayers? Are tax cuts self-financing? Is there a wealth effect? Do the answers to these questions vary based on demographic makeup, political leanings, or social inclinations of the population under study? And finally, based on the answers to these questions, what is the appropriate tax and fiscal policy to ensure the proper balance between economic growth, the social and political goals of each population, and the proper management of the nation’s resources and what is in essence each generation’s intertemporal responsibility: leave behind a better and more prosperous society (for all) than the one they were born into?