Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Debating who’s right

Although Ricardian equivalence is elegant, it requires a very high level of sophistication on the part of individuals and firms. If people are given a tax cut, do they really save all the extra disposable income to pay for the future tax increase?

Economists suggest a number of reasons why the answer is ‘probably not’:


Myopia: The idea that people don’t look far into the future when making decisions today. They’re short-sighted and so aren’t really interested in future taxes – they only care about taxes now and in the immediate future.


Finite lives: Ricardian equivalence requires people to believe that they’ll be around to pay the future taxes. But if individuals think that the burden will be left for future generations, increasing consumption today is a rational response to a tax cut.

Some economists think that you can get around this objection by saying that people care about their children and so an increased tax liability placed on their children is equivalent to increased taxes today. Furthermore, if you care about your children, and your children care about their children, and their children care about their children and so on, you may behave as though you’ll live forever.

This kind of dynastic argument is used quite a lot in macroeconomics research to justify why people behave as though they will live forever, even though their lives are finite. (Yes, we know, economists are a crazy bunch.)

Credit constraints: Quite likely, many people who’d like to consume more today can’t because they don’t have access to credit. They’re unable to borrow money and thereby increase their consumption today at the cost of reducing future consumption.

The problem isn’t that they can’t afford to (the present value of their income is sufficient to cover the present value of their consumption), it’s that no one is willing to lend to them. In this case, reducing taxes today leads to an increase in consumption today, as if the government is lending them money – ‘here’s some extra money today, but you’ll have to pay it

back in the form of higher taxes tomorrow.’ But that’s exactly what they want!

For these reasons, few economists believe that Ricardian equivalence literally holds true in the real world (including David Ricardo himself!). At the same time, it probably contains some truth, and it’s a useful warning to those policy makers who’d try to stimulate the economy by making unfunded tax cuts or increases in government expenditure!

Chapter 12