Final answer:
The Ricardian equivalence theorem suggests that individuals anticipate future taxes due to government deficits and adjust their saving behavior accordingly, although empirical evidence shows that this does not always hold true.
Step-by-step explanation:
The Ricardian equivalence theorem posits that government deficits do not affect the level of output because people recognize that current deficits must be paid in the future and they increase savings today to pay future higher taxes. Essentially, the theory suggests that rational private households might shift their saving behaviors to offset government saving or borrowing. This is encapsulated in option (C) of the multiple-choice question, which states that people increase savings today in anticipation of future tax liabilities stemming from government deficits.
Many economists have debated the premise of Ricardian equivalence. While it is a compelling theory, it relies on the assumption that people are forward-looking and rational in their decision-making, taking into account the government's budgetary situation when they save or spend. However, in reality, this theory sometimes holds true and sometimes does not, as shown by empirical data such as the Bureau of Economic Analysis and Federal Reserve Economic Data.
The national saving and investment identity indicates that a change in the government budget deficit can lead to changes in private savings, private investment in physical capital, or the trade balance. Thus, according to the theory of Ricardian equivalence, additional private saving should offset any increase in government borrowing, and conversely, reduced private saving should offset a decrease in government borrowing. However, the relationship is not strict and there are many real-world factors like liquidity constraints, intergenerational considerations, and imperfect knowledge that can lead to deviations from this theory.