Fiscal Effectiveness and Debt Illusion in a Rational Expectations Model

The question of how substitution of debt for taxes affects private sector wealth and consumption has long been an unresolved macroeconomic theory and policy dispute. The present study attempts to address this problem within a modified fiscal-illusion setting, by utilizing an explicit rational expectations optimizing model of consumer behaviour for a sample of six developed countries. The empirical evidence presented is strongly supportive of the assertion that consumers make their consumption decisions without regard to the future tax implications of a current expansion in government debt at low levels of public sector indebtedness. At high levels of debt-GNP ratios, however, consumers tend to fully discount the future tax obligations implicit in an expansionary debt-financed fiscal policy.