4.4.2. Ricardian Equivalence

It has been argued that when a government cuts taxes and runs a budget deficit, consumers respond to their after-tax income by spending more. It is possible that these people are short- sighted and do not understand the implications of budget deficits. They may not realise that at some point in the future, the government will have to raise taxes to pay off the debt and accumulated interest. Even if they comprehend this, they may expect the future taxes to fall not on them but on future generations.

A counter argument is that consumers are forward-looking and will base their spending not only on their current income but also on their expected future income. They will understand that borrowing today means higher taxes in the future. They would increase savings now, which will fully offset the increased government dissaving.

This view is called Ricardian equivalence after one of the greatest nineteenth century economists, David Ricardo, who first argued that in the face of high deficits, people save more. It is called ‘equivalence’ because it argues that taxation and borrowing are equivalent means of financing expenditure. When the government increases spending by borrowing today, which will be repaid by taxes in the future, it will have the same impact on the economy as an increase in government expenditure that is financed by a tax increase today.