In this chapter, the concept of Ricardian equivalence is introduced and discussed in a theoretical framework. In Section 3.1, the concept of Ricardian equivalence is introduced followed by a brief discussion in Section 3.2. The Ricardian equivalence holds under special assumptions which are delineated in Section 3.3. In Section 3.4, the assumption of finite lives and intergenerational transfer is discussed in detail. This is followed by a discussion on imperfect capital markets in Section 3.5 and on uncertainty and taxes in Section 3.6. In Section 3.7, other assumptions for Ricardian equivalence are discussed.

The concept of Ricardian equivalence

The Ricardian Equivalence Theorem is the proposition that a public loan and a lump-sum tax exert equivalent effects upon the economy. More precisely, the choice between levying lump-sum taxes and issuing government bonds to finance government spending does not affect the consumption pattern of any household nor does it affect capital formation. The fundamental logic underlying this argument was presented by Ricardo (1951, 244–45) as follows:

Ricardo assumes that the creation of public debt implies a stream of future interest payments and possible repayments of principal. These future payments have to be financed by future taxes. It is argued, that a rational individual living during the time when the expenditure decision is made will fully capitalise all future tax payments arising due to debt and will consequently write down the value of the income-earning assets which he owns by the amount of the present value of these future payments. The present values of assets will be reduced by the present value of the tax obligations created by the future service charges. Present values will be identical in the two cases.