Monday, August 24, 2009

Ricardian Equivalence

The alternate theory of public debt which was presented by Professor Ricardo is known as Ricardian Equivalence. According to this theory the public debt does not affect national savings and capital accumulation.

In Ricardian theory when we study the effects of fiscal policy we keep in view the behaviour of consumer who is having enough foresightedness. We see the behaviour of forward looking consumer when tax is cut, when he is aware of with this that government is not going to decrease it expenditure. In this situation so many questions rise in the mind of consumer. Whether the tax cut will increase opportunities for him, whether he will get rich, whether he will be able consume more.

Apparently nothing of this sort will rise as government has financed tax cuts with budget deficit. And in future government will have to increase tax to pay the public debt and the interest upon it. It means that tax cuts of today will be equal to imposition of taxes in future. In other words, the tax cuts yield a temporary rise in income to the consumer which will be taken back from him afterwards. As a result the consumer will not be better-off in any way. Therefore he will not bring change in his consumption.

When the consumers are having foresightedness they will easily understand it that future taxes will be equal to present tax-cuts. If government borrows by decreasing taxes it will have to repay it by imposing the taxes. This point of view is called Ricardian Equivalence. Thus Ricardian Equivalence shows that because of tax cut the debt which is raised does not influence the consumption. The savings which are made by household due to tax cuts have to be utilized by them in the payment of tax in future. The increases in private savings are offset due to fall in public savings. Thus national savings which are sum of private and public savings remain the same. As a result, the effects of tax-cut are not present here.

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