What is the Ricardo-Barro Effect?

The Ricardo-Barro Effect is a microeconomic concept that suggests when there is a reduction in government spending and an increase in taxation, in response, households and businesses increase their level of savings to pay for the higher taxes that are expected in future. 

It says, when a government tries to stimulate the economy by increasing the tax rate and reducing its spending, the public will respond by increasing their savings. Thus, the demand remains unchanged.

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How does the Ricardo-Barro Effect Work? 

The concept of Ricardo-Barro Effect was first introduced by David Ricardo in the 19th century. The concept was further developed by Harvard professor Robert Barro who provided a more elaborate version of the theory. 

According to the theory, the lifetime present value of ones after-tax income (intertemporal budget constraint) determines his or her consumption and spending. So, if the tax rate is increased by the government the spending of the public will reduce. They will rather increase their savings in order to afford to pay the higher taxes in the future. It argues a government cannot stimulate a demand by increasing debt-financed government spending. 

Ricardo-Barro effect, also known as Ricardian equivalence, has been criticized by the economists as it failed to explain certain spending and savings pattern of the public. Economists argue that the theory is based on some unrealistic assumptions. The theory of Ricardo-Barro effect assumes that a perfect capital market exists, and the individual has the ability to decide when to borrow and save money. In reality, an individuals decision of borrowing and saving money depends on a lot of factors and they do not have an absolute freedom to choose. 

The theory also assumes that individuals will save money for future tax increases which they may not even experience in their lifetime. In todays economic scenario it doesnt hold true. In the U.S, government borrowing is climbing high and yet the savings rate has hit a multi-decade low. The theory fails to explain this scenario. 

However, the 2007 data of European Union countries showed a strong correlation between government debt finance and the individuals financial assets. It was noticed in 12 of the 15 nations and it supports the argument of the theory of Ricardo-Barro effect.

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