Government Debt and Private Consumption: Theory and Evidence

The Ricardian equivalence theorem has been widely debated since (at least) the seventies. The theorem states that househoolds should not change their consumption path in response to changed timing of taxes, given the path of government consumption. In the paper, theoretical models giving rise to the equivalence result as well as models predicting deviations from debt neutrality are presented. In general, the Ricardian models are based on unrealistic assumptions, such as infinite horizons, perfect capital markets and lump-sum taxes. The issue of Ricardian equivalence is thus perhaps better viewed as a question concerning to what extent the equivalence hypothesis is a reasonable approximation of the real world. This could only be established by empirical studies. To formulate a test of Ricardian equivalence, it is however vital to extend the standard analysis in deterministic models to stochastic models. In stochastic model we need to incorporate the fact that agents have to make predictions about future levels of government consumption, and that empirical study distinguishes between debt as a potential source of net wealth, which is the concern of the equivalence proposition, and debt's role as a signal of future levels of government consumption, which is due to the stochastic nature of the world. It is argued that there are few empirical studies that make this distinction, and in case the distinction is made, the evidence is in favor of the Ricardian equivalence proposition, namely that public debt is not net wealth to households. Changing the timing of taxes will therefore not change private consumption. In other words, although the Rivardian equivalence hypothesis is burdened with unrealistic assumptions, it seems (historically) to provide a reasonable approximation of actual data.