Ricardian equivalence

The Ricardian equivalence proposition (also known as the Barro–Ricardo equivalence theorem[1]) is an economic theory holding that consumers internalize the government's budget constraint: as a result, the timing of any tax change does not affect their change in spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, because the effect on the total level of demand in the economy is the same.

In its simplest terms: governments can raise money 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."


In its simplest terms: governments can raise money 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. This action might suggest to taxpayers that they will have to pay higher tax in future. Taxpayers would put aside savings to pay the future tax rise; i.e. they would willingly buy the bonds issued by the government, and would 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.