Question

State and carefully explain the Ricardian equivalence proposition, and clearly state and explain all the assumptions underlying it. Discuss the implications of Ricardian equivalence on the effectiveness of fiscal policy? Why might Ricardian equivalence not hold in practice?

Answer 1

Ricardian equivalence is a theoretical study of behaviour of people towards government policy of taxation. People are assumed to have a far-sighted approach and, so they do care about their distant future. The proposed theory indicates that in such a scenario, people do not raise their current consumption, when there is tax cut Instead, they tend to save the entire tax cut. The idea is that people are forward looking. They believe in consumption smoothing with an aim to maintain a smooth consumption pattern across their life. A temporary tax increase in the present, without any corresponding increase in government spending in the current time, makes people believe that their current income will fall. Ricardian people thus expect a tax cut in future. This implies even when there are tax increases, they will maintain the same level of current consumption to smooth out their consumption level A necessary presumption is that people are forward looking. Secondly, they have perfect information about government policies. Thirdly, they always smooth out their consumption. There are of course criticisms of these assumptions. Traditional view believes that there is usually a borrowing constraint on how much an individual can borrow if the current income falls short of his consumption. A rise in current income caused by a tax cut raises the current consumption irrespective of the level of lifetime income which may fall in future. Most people are myopic too and they do not plan their entire life in advance. This impedes the effectiveness of fiscal policy as a tool to change consumption behaviour Assume that government decides to finance the increase in the government spending by raising a debt. This will not increase taxes so Ricardian people will not change their consumption directly. But now taxes are not raised so they need to pay less taxes to the government. Comparatively they are saving more and can lend more also. When the households face tight borrowing constraints, this may force private consumption to be lower than the optimum. When the government does not initiate a tax rise today it will shift, as Ricardian people assume, from today to the future. Because the households were paying less taxes today, they can afford to have a higher consumption without borrowing. Initially the consumption was reduced due to the borrowing constraint, consumption can now increase. Hence, the Ricardian equivalence breaks