Ricardian Equivalence

The Ricardian Equivalence theorem (RET) was first formulated by David Ricardo in 1820 and elucidates a scenario where short-term tax cuts imply long-term tax hikes. In essence, RET suggests that fiscal stimuli which are defined in terms of deficit-financed public spending hikes or tax cuts will lead consumers to anticipate the future to hold lower spending and tax raises. This leads to a crowding out of private consumption, thereby decreasing the effectiveness of fiscal policy in boosting economic activity.

Assumptions of Ricardian Equivalence:

1. Income Life-cycle hypothesis

Consumers wish to smooth their consumption over the course of their life. Thus, if consumers anticipate a rise in taxes in the future, they will save their current tax cuts to be able to pay future tax rises.

2. Consumer rationality

Rational expectations on behalf of consumers. This infers that consumers respond to tax cuts by realising it could mean future taxes rising.

3. Perfect capital markets

Households are able to borrow in order to finance consumer spending if necessary.

4. Public debt neutrality

Ricardian debt neutrality means that so long as tax relief due to debt issuance and tax burden of debt redemption occur in the same generation, debt policy is meaningless.

5. Intergenerational altruism

Tax cuts for the present generation may imply tax rises for future generations. Therefore, it is assumed that an altruistic parent would respond to current tax cuts by attempting to provide more wealth to their children in order for them to pay future tax rises.

Relevance of RET in Turkey:

The debt scenario in Turkey consisted of generously high current account and budget deficits. These are regularly accused as the fundamental sources of macroeconomic instability leading to 2 financial crises in the post-1990 period. 

Major economic reforms in Turkey during the 1980s led to the fall in wage rates of labour. This fall was attributed to new capital-intensive techniques being introduced into the economy with the subsequent rise in foreign direct investment and trade balance. Due to the fall in wages, consumer spending also declined.

Whilst Turkey sees slight hints of the RET, there is no direct clarification regarding the presence of Ricardian equivalence in Turkey.

Criticisms of Ricardian Equivalence:

The main criticism of the RET is its highly impractical assumptions. Firstly, perfect capital markets do not exist in real life, only in theory. The assumption of myopia is not accurate for all consumers and there are many examples of consumers without intergenerational altruism. Finally, and most obviously, some consumers act irrationally and thus would not worry about tax burdens so would not alter their rate of consumption depending on tax rates. These assumptions altogether nullify the use of Ricardian Equivalence when analysing economies such as Turkey.

Conclusion:

In theory, Ricardian Equivalence is comprehensible and makes sense. However, the impractical assumptions lead this theorem to become irrelevant in the eyes of many critics. This is because it is inapplicable to real-world economies with only small hints of its existence in economies such as post 1980s Turkey.