The Ricardian equivalence

Abstract

This study is an analysis of the debt neutrality proposition. This hypothesis, also called Ricardian Equivalence, was first introduced by Barro (1974). Under the Ricardian Equivalence, given the path of government spending, the substitution of debt for taxes does not affect the consumption and wealth of the private sector. Private agents foresee and fully discount the future tax associated with the current tax-cut financed deficit. A dollar of tax reduction causes the national debt to increase by one dollar which must be repaid later. The tax reduction, therefore, is nothing but a "tax postponement". However, many economists have challenged the debt neutrality proposition. They showed that the presence of many imperfections in the economy prevents households from fully discounting the future tax increase. The empirical results on the Ricardian Equivalence have been ambiguous. Since most empirical studies have assumed structural stability regarding the behavior of the economic agents with respect to fiscal policy, they have simply used the OLS or GLS estimation method to approximate the complex behavioral relationship overtime. This study uses a more robust estimation method, the Varying Parameter Technique, to capture not only the transitory changes in agents'' behavior but also the permanent changes that may have occurred over time. The countries used in this study are six OECD countries; namely, the United States, Canada, France, Germany, the United Kingdom and Japan. The sample period is 1961 to 1985. The results support the Ricardian Equivalence only in the case of Germany and Canada. The empirical results seem to be reasonable in the light of a number of criticisms that are voiced against the debt neutrality proposition for ignoring the notion of market imperfection and/or the change in agents'' expectations over time.