Ricardian Equivalence And The Value Of Firms In The Capital Market

The main idea of this article is that a rise in permanent general government consumption increases the permanent taxation imposed on firms and reduces the net present value of their profits and hence reduces their net present value. This hypothesis was examined empirically for Israel in the period 1974-2002 and a significant negative correlation between public consumption and the value of firms was found. The assumption that a rise in public consumption erodes private wealth is the motive for examining the mechanism linking private and public consumption. The hypothesis proposed here is that private consumption is a function of public consumption even if consumers have not internalized the government’s budget constraint. For a rise in public consumption to lead to a decline in the value of firms, the erosion of the public’s wealth, and the reduction of private consumption, it is sufficient that agents active in the capital market internalize the government’s budget constraint. In other words, an increase in permanent public consumption has a negative wealth effect, thus reducing private wealth even when individuals (consumers) do not internalize the government’s budget constraint. The empirical part of the article tests the hypothesis that the capital market is the main channel through which the above mechanism (Ricardian equivalence) operates in Israel. The regressions show that a shift in public consumption affects private consumption only through the change in firms’ value. For a given value of shares, public consumption does not affect private consumption