Ricardian Equivalence - Ricardo and War Bonds

Ricardo and War Bonds

In "Essay on the Funding System" (1820) Ricardo studied whether it makes a difference to finance a war with £20 million in current taxes or to issue government bonds with infinite maturity and annual interest payment of £1 million in all following years financed by future taxes. At the assumed interest rate of 5%, Ricardo concluded that

In point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever, or £1,200,000 for forty-five years are precisely of the same value.

However, Ricardo himself doubted that this proposition had practical consequences. He continued:

But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly. We are too apt to think that the war is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes. It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1000.

In other words, if people had rational expectations they would be indifferent between the two systems, but since they do not have them, they are subjected to a "Fiscal Illusion", which distorts their decisions.