F ir s t - C la s s U n iv e r s it y T u t o r s

Ricardian  Equivalence  
 

Key  Premise:  A  change  in  the  

timing  of  taxes  has  no  effect  on  
consumption  

 
The   above   statement   is   often   blurted   out   about   Ricardian  
Equivalence  without  really  being  understood.  How  it  should  read  is:  
 
Key   Premise:   A   change   in   the   timing   of   taxes,   without  
changing   the   present   value   of   the   total   amount   taxed  
over  the  two  periods  has  no  effect  on  consumption  
Yeah.  The  underlined  bit  is  really  important.  
 
To   really   nail   this   point   in:   Ricardian   Equivalence   just   says   that   if   the  
government   decreases   current   tax,   t1,   but   increases   future   tax,   t2,   by   the   exact  
same  amount  in  present  value  terms,  overall  wealth  is  not  affected,  and  therefore  
neither  is  the  consumption  choice.  
 
 
Well  Prove  it!    
   
 
 
The  Consumers  Lifetime  Budget  Constraint:  
 
𝑐! (𝑦! −   𝑡! )
𝑐! +   = (𝑦! − 𝑡! ) +    
1+𝑟 1+𝑟
 
To  save  trees,  we’ll  call  the  right  hand  side  wealth,  we.  To  show  that  a  change  in  
the   timing   of   taxes   has   no   affect   on   consumption,   I   need   to   show   that   I   can  
rewrite   the   above   equation   without   any   taxes   in   it,   to   show   that   the   budget  
constraint  is  independent  of  taxes.  
 
Here’s  the  maths:  
 
𝑇! =  𝑁𝑡!  and  𝑇!   =  𝑁𝑡!  

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   F ir s t - C la s s U n iv e r s it y T u t o r s

 
Total  Tax  Revenue  equals  the  Number  of  People  times  Tax  per  Person  (in  each  
time  period)  
 
The  Government’s  Budget  Constraint  is:  
 
𝐺! 𝑇!
𝐺! +   =   𝑇! +    
1+𝑟 1+𝑟
Substituting  in  the  above  equations  we  get  
 
𝐺! 𝑁𝑡!
𝐺! +   =   𝑁𝑡! +    
1+𝑟 1+𝑟
And  Factorising  out  N  from  each  term:  
 
𝐺! 𝑡!
𝐺! +   =  𝑁 𝑡! +    
1+𝑟 1+𝑟
Rearranging:  
1 𝐺! 𝑡!
𝐺! +   =   𝑡! +    
𝑁 1+𝑟 1+𝑟
So  we  have  an  expression  for  tax  per  person.  We  want  to  sub  this  into  our  
wealth:  
 
(𝑦! −   𝑡! )
𝑤𝑒 = (𝑦! − 𝑡! ) +    
1+𝑟
𝑦! 𝑡!
𝑤𝑒 = 𝑦! +   − 𝑡! +    
1+𝑟 1+𝑟
Finally,  substituting  in  from  our  previous  equation:  
 
𝑦! 1 𝐺2
𝑤𝑒 = 𝑦! +   − 𝐺1 +    
1+𝑟 𝑁 1+𝑟
So  we  have  shown  that  taxes  have  no  effect  on  the  consumer’s  wealth.  Rather,  it  
is  the  present  value  of  government  spending  that  determines  the  amount  of  tax,  
and   any   changes   in   timings   the   tax,   without   a   change   in   the   total   government  
spending,   do   not   change   the   consumer’s   wealth,   and   so   don’t   affect   their  
consumption  decision.  
 
Glossary  
N  The  number  of  people  in  our  economy,  the  population  
T  Total  Tax  Revenue  (note  this  is  not  time)  
t  Tax  per  person  (note  this  is  not  time  either)  
y  income  
G  Government  Spending  
we  The  consumer’s  overall  wealth,  which  we  are  showing  is  unaffected  by  the  
timing  of  taxes  
 
 
Wow  that’s  a  lot  of  symbols.  Let’s  make  this  easier:  

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   F ir s t - C la s s U n iv e r s it y T u t o r s

Quick  Maths  
For  simplicity,  assume  there  is  only  one  consumer  (N=1  =>  T  =  Nt).  
Initially,  Current  income  is  £1000  and  current  tax  per  person  is  £100.  
Future  income  is  £1100  and  future  tax  person  is  £110.  
The  interest  rate  is  10%  (0.1)  
Therefore,  the  consumers  initial  wealth  is    
£1100 − £110
𝑤𝑒 = £1000 − £100 +   = £1,800  
1.1
and  the  Present  Value  of  Government  Spending  is:  
𝐺! 110
𝐺! +   =  100 +   = £200  
1+𝑟 1.1
Ricardian  Equivalence  just  tells  us  that  if  the  government  changes  the  taxes  in  
each  period,  without  increasing  or  decreasing  the  total  tax  paid  overall,  then  
wealth  is  unaffected.  Let  us  see  this:  
 
If  the  government  taxes  the  full  amount  in  the  first  period  (t1=£200,  t2  =  £0)  
 
£1100
𝑤𝑒 = £1000 − £200 +   = £1,800  
1.1
Equally,  if  the  government  taxes  the  full  amount  in  the  second  period.  This  
£""#
amount  is  £220  because  the  present  value  of  £220  ( !.! )  is  £200.  (t1=£0,  t2  =  
£220)  
£1100 − 220
𝑤𝑒 = £1000 +   = £1,800  
1.1
Mathematically,  any  combinations  of  t1  and  t2  that  have  a  combined  present  
value  of  £200,  our  initial  Government  Spending,  will  not  change  the  consumer’s  
wealth.  

 
So  what  has  changed?  
Simply  our  Endowment  Point  
 
  c2   Ricardian  Equivalence:  
When   the   Government   decreases  
current   taxes,   but   increases  
future   taxes   by   the   exact   same  
(1+r)we  
amount   (in   present   value   terms),  
only   the   Endowment   point  
moves.  Wealth  is  unaffected,  as  is  
(y2  –  t2)   E1   our  optimal  consumption  bundle.  
E2  
(y2–  t2)   As   the   consumer    
knows  that  there  is  
going   to   be   no  
U*  
chance   to   their  
wealth,  they  simply  
(y1  –  t1  )   (y1  –  t1)   we   c1   save   the   extra  
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Ricardian  Equivalence  and  Saving  

 
We  have  determined  that  although  consumption  doesn’t  change,  savings  do  as  
the  consumer  reacts  to  offset  the  change  in  taxes.  

Quick  Maths  
The  same  example  as  above  looking  at  the  two  extreme  cases:  
 
If  the  government  taxes  the  full  amount  in  the  first  period  (t1=£200,  t2  =  £0)  
£1100
𝑤𝑒 = £1000 − £200 +   = £1,800  
1.1
 
Equally,  if  the  government  taxes  the  full  amount  in  the  second  period.  This  
£""#
amount  is  £220  because  the  present  value  of  £220  ( !.! )  is  £200.  (t1=£0,  t2  =  
£220)  
£1100 − 220
𝑤𝑒 = £1000 +   = £1,800  
1.1
How  can  the  consumer  react  to  this  change  if  they  don’t  want  to  change  from  
their  initial  consumption  bundle.  I.e.  they  want  to  consume  £800  in  the  current  
period  and  £1100  (present  value  at  r=10%  is  £1000)  in  the  second  period?  
 
They  simply  consume  the  desired  £800  in  the  current  period  and  save  the  
extra  £200  in  a  bank  account.  This  will  amount  to  £220  after  interest  in  the  
future  period,  which  is  exactly  what  they  need  to  pay  off  the  future  taxes,  
leaving  £1100  left  to  consume.  
 
Bottom  Line:  A  change  in  the  timing  of  taxes  only  
affects  savings,  not  consumption  or  wealth.  
 
When  the  government  cuts  current  taxes,  its  current  budget  deficit  increases.  In  
the  above  example,  all  taxes  were  moved  to  the  future  period,  so  the  government  
needed  to  issue  £200  of  Bonds  (Government  Loans)  to  fund  this.  
 
However,   the   consumers   were   happy   with   their   original   bundles   so   when   all   the  
tax  is  moved  to  the  future  period,  the  consumers  know  this,  and  so  simply  saved  
the  extra  £200  of  income  to  keep  their  optimal  bundles  from  being  changed.  
 
Therefore,  the  increase  in  the  number  of  Bonds  was  exactly  met  by  an  increase  
in  the  Private  Savings  so  that  overall,  the  interest  rate  was  unaffected.  
 
Glossary  
B,  Bonds  Government  Loans.  The  e.g.  the  government  is  loaned  £200  by  the  
consumer  and  promises  to  pay  them  back  with  interest,  £220  
SP  Private  Savings  the  sum  of  all  individual’s  savings  
 

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interest  
  rate,  r   B1   B2  
 
 
 
  SP1   SP2  
 
 
 
 
 
 
 
 
 
 
 
  B1=  SP1   B2=  SP2   Bonds,  Private  Savings  
 
 
We  see  above  that  the  increased  issue  of  bonds  is  exactly  offset  by  the  increase  
in  private  Savings  as  the  consumers  know  that  the  tax  cut  is  going  to  be  exactly  
offset  by  a  future  tax  rise,  and  so  simply  save  the  entire  tax  cut.  
 
Bottom  Line:  A  decrease  in  current  taxes  that  is  exactly  
offset  by  an  increase  in  future  taxes  has  no  effect  on  
consumption  as  consumers  will  just  save  the  difference

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Why  Invent  A  Theory  that  has  never,  and  will  never,  

hold?  
 
Ricardian   Equivalence,   like   Perfect   Competition   relies   on   such   heavy   and  
unrealistic   assumptions   that   it   is   only   useful   for   understanding   why   it   doesn’t  
hold,   and   this   helps   us   understand   why   and   how   we   react   to   changes   in   the  
timing  of  taxes.  
 
Ricardian  Equivalence  will  not  hold  when:  
1. Credit  Market  Imperfections  
Different  Borrowing  and  Lending  Rates  
Credit  Limits  
Limited  Commitment  and  the  Housing  Model  
Asymmetric  Information  
2. If  Consumers  and  Governments  face  different  life  spans  so  that  a  change  
in  the  timing  of  taxes  affects  different  generations  differently  
Social  Security  Programmes  
i. Pay-­‐As-­‐You-­‐Go  
Fully  Funded  
3. Distortionary  Taxes  (not  lump  sump)  that  also  affect  the  decision  to  work.  
4. Not  everyone  pays  the  same  taxes,  as  so  those  on  higher  incomes  may  
receive  proportionately  more  tax  cuts.  

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