I n the 1988 presidential campaign, virtually every serious candidate spoke of the urgent need to trim government budget deficits. Public opinion polls have identified federal deficits as a key economic issue, second only to unemployment. While many economists are relieved by what they perceive to be a long overdue political response to a critical economic problem, others regard the fuss as much ado about nothing. It is indeed remarkable that economists can disagree so severely over an issue which commands such a uniform reaction from laymen of widely different ideologies and political affiliations. Generally speaking, there are three schools of thought concerning the economic effects of budget deficits: Neoclassical, Keynesian, and Ricardian. Before proceeding further, it is useful to review the basic structure and implications of each paradigm. The Neoclassical paradigm envisions farsighted individuals planning consumption over their own life cycles. Budget deficits raise total lifetime consumption by shifting taxes to subsequent generations. If economic resources are fully employed, increased consumption necessarily implies decreased saving. Interest rates must then rise to bring capital markets into balance. Thus, persistent deficits "crowd out" private capital accumulation. In the current economic environment, most economists would agree that these consequences would be highly detrimental.

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A Neoclassical Perspective on Budget Deficits

In evaluating the existing theory and evidence on Ricardian equivalence, it is essential to distinguish between the short run effects of government borrowing (primarily the potential for stimulating aggregate demand) and the long run effects (primarily the potential for depressing capital accumulation). I argue that the theoretical case for long run neutrality is extremely weak, in that it depends upon improbable assumptions that are either directly or indirectly falsified through empirical observation. In contrast, the approximate validity of short run neutrality depends primarily upon assumptions that have at least an aura of plausibility. Nevertheless, even in this case behavioral evidence weighs heavily against the Ricardian view. Efforts to measure the economic effects of deficits directly through aggregate data confront a number of problems which, taken together, may well be insuperable. It is therefore not at all surprising that this evidence has, by itself, proven inconclusive. Overall, the existing body of theory and evidence establishes a significant likelihood that deficits have large effects on current consumption, and there is good reason to believe that this would drive up interest rates. In addition, I find a complete lack of either evidence or coherent theoretical argument to dispute the view that sustained deficits significantly depress capital accumulation in the long run.

Ricardian Equivalence: an Evaluation of Theory and Evidence

Public goods, merit goods, and the relation between private and government consumption *

An empirical analysis on the substitutability between private consumption and government purchases

Ricardian Equivalence states that, under certain circumstances and for a given path of expenditures, the substitution of debt for taxes does not affect private sector wealth and consumption. Ricardian Equivalence is based on the premise that debt financing is only a change in the timing of taxation that has no impact on private sector consumption if the present value of the stream of taxation remains unchanged. This paper provides a model that illustrates the implications of Ricardian Equivalence, surveys the relevant literature, and considers the effects of relaxing the basic assumptions. It also critically reviews recent empirical work on Ricardian Equivalence.

Modelling and Testing Ricardian Equivalence: A Survey

Many previous empirical studies of the Ricardian Equivalence Hypothesis have found a relatively high degree of future tax liability discounting such that current deficits appear to have relatively little or no influence on current consumption demand. However, the validity of these empirical estimates can be questioned as they may not have adequately distinguished between permanent and transitory income flows. This paper attempts to address this problem by using cycle-averaging as a simple method of capturing the permanent path of income over time. The empirical evidence generated in this paper rejects the strict debt neutrality proposition of the Ricardian Equivalence Hypothesis.

Bradford G. Reid

Papers

Aggregate consumption and deficit financing: an attempt to separate permanent from transitory effects