Question

How does the Ricardian equivalence view of the effect of tax cuts (and budget deficits) differ from the traditional view? What objections to the Ricardian equivalence view have been raised? In your answer, please make sure to clearly define what Ricardian equivalence theorem is.

Answer 1

Ricardian Equivalence refers to change in saving and consumption behavior of people when government deficit rises. Government reduces tax but it does not reduce its expenditure. so it tends to drive up deficit. High deficit means government will charge higher taxes in future to payoff debt.

People and economic agents are forward looking . they correctly anticipate potential rise in taxes, so they does not spend benefits they accrue from tax fall, thus saving rises. Government policy does not affect GDP if people react in this way.

Traditional views does not agree with such statement. They assume that deficit in government budget will increase demand and GDP level. So eventually employments can be augmented.

Ricardian equivalence has been criticized for following reasons:

• People are not so forward looking, they do not tend to save when government deficit rises.
• Partially, few people can think in line with Ricardo Equivalence but all do not fall same line. So net effects would be positive.
• In recessionary period, saving high, so government deficit will not further give rise to saving.