Question

What is the theory of Ricardian equivalence?

Short answer

Current taxes (and current deficits) or future taxes (and current deficits) will have the same effect on the overall economy.

Step-by-step solution

Concept

Ricardian equivalence happens when people realize that paying lower taxes today means paying higher taxes later, so rather than using their tax reduction, they save it to pay future taxes.

Explanation

Reductions in income taxes will not enhance aggregate demand, according to Ricardian equivalence theory, because people will save the majority of the extra income. Due to a slump in the economy over the last nine months, the government has decided to lower income taxes. The overall impacts of funding government spending with current taxes or future taxes (and current deficits) are the same.