Abstract

The purpose of this paper is to test the Ricardian Equivalence Theorem (RET). This testing first requires a consumption function whose basic assumptions are consistent with those of the RET. Therefore I conducted the tests within the Permanent Income Hypothesis with rational expectations (PIH).

The basic statement of the RET is that the choice between tax and debt finance is irrelevant to resource allocation in the economy. The debt finance just postpones the current taxes, provided that government expenditures are given and that population growth is constant. Therefore government bonds are not net wealth, since they bring in higher taxation in the future.

If this statement is true, today's consumption decisions would be independent of some fiscal variables such as lump sum taxes, government debt outstanding or the budget deficit given that government expenditures are fixed. The PIH consumption function also implies that change in consumption cannot be forecast by the change in lag(s) of any variable including the change in those fiscal variables. Thus, the test of RET is a nested test of the PIH. Among twenty countries that were chosen based on data availability, the result of this paper is that the RET holds in all countries and that the PIH holds in majority of the countries. The failure of the PIH occurs in developing countries except Finland. When pooled data set for ail countries is used, the PIH again fails whereas the RET holds only if Chile is excluded from the data set.