A Lesson on Ricardian Equivalence by Morgan Rose

Morgan Rose's A Lesson on Ricardian Equivalence

Morgan Rose's A Lesson on Ricardian Equivalence begins by imagining a scenario in which he has full ownership of all of Freedonia's finances. You are in charge of tax collection and budget spending.

Ricardian Equivalence

Then you know that the government has to make certain extra $1000 purchases to meet the needs of the people. The question is whether to raise taxes on residents or borrow more money. About 200 years ago, David Ricardo, a British political economist (1772-1823), explained this situation. This lesson focuses on the different reasons given for Ricardian equivalence.

David Ricardo's Argument

David Ricardo argued that in such a situation neither debt financing nor tax financing matters would matter at the end of the day. Raising $1000 from the tax will be equivalent to borrowing $1000. This case is a merely Ricardian equivalence. In other terms, Ricardian equivalence can be defined as an economic hypothesis that suggests that demands remain unchanged when the government increases its debt-financed spending. Borrowing, in this case, is spending future taxation. If you go through debt financing, Freedonians will have about $1100 including interest to pay within a given period. Therefore, they will have to save extra amount besides the general tax to cater for the debt. On the other hand, Freedonians have $1000 to spend today.

Permanent Increase in Government Debt

Morgan Rose goes on to include the case of the government permanently increasing the debt rather than a debt issue for one year (Buchanan et al. 95). When tax is imposed the net worth of the taxpayer directly reduces, but an equivalent amount of debt leads to an equal reduction of net value since there is a creation of future tax liabilities. Buchanan and Wanger point out that a perfect capital market is necessary for the accomplishment of the required savings and borrowing hence the equalization of people's borrowing interest with that of the government. Secondly, the period when the government debt will be repaid, some people will be deceased hence higher tax will be imposed on the rest. This scenario makes newborn children have tax to reimburse for services they never accessed. Lastly, the equivalence between tax finance and debt finance should be determined in primary schooling curriculum. Ricardian equivalence specifies the conditions that facilitate countercyclical fiscal policies.

Work Cited

Buchanan, James MacGill, and Richard E. Wagner. Democracy in deficit. Acad. Press, 1977.