THE RICARDIAN

EQUIVALENCE
THEOREM
Introduction
 INTRODUCTION
• Richardian equivalence theorem (also know as the Ricardo – de viti – Barro equivalence
theorem), is an economic hypothesis propose by David Ricardo which was advanced by
Robert Barro, according to the theorem a cut on tax has no effect on consumption,
National savings or real GDP as consumers are forward – looking knowing that the tax
cut today means an increase in future taxes, so the tax cuts doesn’t make the consumers
better off causing private savings to rise in the same amount as the falling public savings,
leaving the national savings unchange.  Loading… 
• The theory maintains that a deficit in the government spending is equivalence to spending
out of current taxes, as consumers needs to save to payoff the expected taxes in the future
in other to balance the  effects of macroeconomic increased in Government spending in
the long run. The theorem underlines the important of fiscal reforms since such reforms
are needed in other to change part of government expenditure when implementing
comprehensive fisc
 ARGUMENTS SUPPORTING THE
THEOREM
• Governments can finance their spending either by taxing or by borrowing (and presumably taxing later to
service the debt). In either case, real resources are withdrawn from the private economy when the government
purchases them, but the method of financing is different. Ricardo argued that under certain circumstances,
even the financial effects of these can be considered equivalent, because taxpayers understand that even if
their current taxes are not raised in the case of deficit spending, their future taxes will go up to pay the
government debt. As a result, they will be forced to set aside some current income to save up to pay the future
taxes. 
• Because these savings necessarily involve forgone current consumption, in a real sense they effectively shift
the future tax burden into the present. In either case, the increase in current government spending and
consumption of real resources is accompanied by a corresponding decrease in private spending and
consumption of real resources.
• Barro’s version of Ricardian equivalence has been widely interpreted as undermining Keynesian fiscal policy
as a tool to boost economic performance. Because investors and consumers adjust their current spending and
saving behaviors based on rational expectations of future taxation and their expected lifetime after-tax
income, reduced private consumption and investment spending will offset any government sending in excess
of current tax revenues.
 ARGUMENTS OPPOSING THE
THEOREM
• Critics of the ricardian equivalence proposition argue that the
proposition is premised on unrealistic assumptions.Some of the
unrealistic assumptions of the ricardian equivalence include the
existence of a perfect capital market where individuals and households
can save excess money as they wish and also borrow whenever they
want to. Another argument apposing the proposition is often times ,
individuals do not save excess amount in anticipation of tax increase
or heftier tax responsibilities, according to the critics of the
proposition. Ricardos theory is opposing the keynesian economics
theories.
 Supporting the implications wITH regards to the
interest rates,investment etc of the Ricardian
equivalence theorem arguments
• Government cannot stimulate consumer spending since people
assume that whatever is gained now will be offset by higher taxes due
in the future. It also implies that no matter how a government
chooses to increase spending by borrowing or raising taxes, demand
will remain unchanged, because debt-financed public spending will
"crowd out" private spending.
• In addition, a number of studies of spending patterns in the U.S. have
found that private sector savings increase by about 30 cents for every
additional $1 of government borrowing. This suggests that the Ricardian
theory is at least partially correct.
 BASIS OF THE THEOREM
• Ricardian equivalence in it's pure and strong form requires several strong assumptions
• 1. Perfect capital markets:
• 2. Knowledge of the issue:
• 3. Forward looking individuals:
• 4. Taxes and distribution of income:
• NOTE: Ricardian equivalence does not mean that effect of fiscal policy (increase in government
expenditure) is zero. It only means that effect will be small and fiscal policy will be less effective.
GRAPHICAL REPRESENTATION OF THE
THEOREM