Ricardian equivalence

Ricardian equivalence

The Barro- Ricardo Hypothesis claims that changes in taxes would be precisely offset by an opposite change in private saving .The debate centres around an argument originally noted and rejected by David Ricardo and which was revived by Robert Barrio in 1974.
Suppose the budget is balanced initially ,and the government cut taxes ,then there is budget deficiet, financed by borrowing .The debt that is issued today must be retired next year or in some future year ,along with the interest that it carries. To repay the debt government will have to raise taxes in the future .Thus a tax cut toady means a tax increase in future.
Hence changes in taxes should have no effect on consumption because permanent income is unaffected by this jiggling of taxes.
Thus consumption is unaffected because of the assumption that consumers have far sighted. Thus consumer save today from the tax cut and decrease in government saving by tax cut will be offset by this private saving and income remain unaffected.
But it was rejected by Ricardo himself because of the problem that consumers are short sighted they don’t predict future exactly so tax cut today leads to increase their consumption The second reason was liquidity constraints where borrowing is not allowed thus consumer cannot buy if his income is less than consumption thus tax cut today will help him to increase his consumption with the given income.Third reason was that people thought that taxes will rise in future thus burden will be on future generation to pay taxes thus today generation need not to worry. This concept is explained by Ricardo and improvised by Barrio where he said that present generation is more concerned for the future generation that’s why they left bequests so that after their death there will b no burden on future generation thus it is called “Ricardo-Barrio ” hypothesis.

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