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University of Amsterdam
Faculty of Economics and Business
Are the Finnish consumers Ricardian?
Investigation to the consumption behavior during the fiscal
expansion in the early 1990s recession
BSc thesis in International Economics and Finance
by
Roope Mikael Kolehmainen
6160093
Supervised by
Pedro Robalo
Table of Contents
1. Introduction ........................................................................................................................ 3
2. Theoretical framework ....................................................................................................... 5
2.1 The concept of the Ricardian equivalence ................................................................... 6
2.2 Empirical research methodology ................................................................................. 8
2.3 Empirical results for Finland and in fiscal expansion................................................ 11
3. Empirical evaluation ............................................................................................................ 12
3.1 Research method ............................................................................................................ 12
3.1.1 Null hypotheses ....................................................................................................... 13
3.2 Data description ............................................................................................................. 14
3.3 Limitations ..................................................................................................................... 16
4. Data analysis ........................................................................................................................ 17
4.1 Instrumental variable estimation .................................................................................... 19
4.2 Ordinary least squares estimation .................................................................................. 21
5. Conclusion ........................................................................................................................... 23
Appendix A. ............................................................................................................................. 25
A.1 Data ............................................................................................................................... 25
A.2 Construction of the household wealth data ................................................................... 25
References ................................................................................................................................ 28
2
1. Introduction
During a recession governments traditionally engage in an expansionary fiscal policy. The
government spending exceeds (tax) revenues 1 and government runs up debt. According to the
traditional view, debt driven fiscal expansion is expected to provide a stimulus for
consumption and, consequently, raise aggregate demand and bring the economy back towards
the equilibrium (Sutherland, 1997, p. 2). However, public debt has to be repaid in the future.
If a rational consumer perceives the debt issuance today as a postponement of taxes until the
future, the net effect on consumer wealth is invariant. This substitutability of taxing and
issuing debt and their impotency as a fiscal policy instrument is known in economic theory as
the Ricardian equivalence.
The Ricardian equivalence is an age-old debate among the economists, and the contemplation
over the debt and tax dynamics date back centuries. The 18th century economist, David
Ricardo, compared the financing of the war expenditures by bonds to current taxing. Barro
(1974) popularized the theorem 2 generalizing the war bond studies by Ricardo, conducted
over 150 years earlier. In his paper ’Are Government Bonds Net Wealth’ Barro argues that,
because the debt payment and taxing horizons merge with intergenerational transactions,
there will be no net wealth effect, and thus, no effect on aggregate demand or on interest rates
when government issues debt. In other words, he states that rational consumers perceive
issuing debt or raising taxes (with same present value) as equivalent, and hence aggregate
demand remains unchanged in a debt financed fiscal expansion. The purpose of this paper is
to evaluate the extent of the validity of the Ricardian equivalence theorem in the context of
expansionary fiscal policy during a recession. The paper will focus on the fiscal stimulus
during the depression in the early 1990s Finland.
Finland suffered its worst recession in history during the beginning of the 1990s. Overheated
economy, a sharp increase housing price level, and lenient monetary and fiscal policy led to a
drastic turndown after the economic prosperity of the 1980s. Gross domestic product fell by 6
% and unemployment rose from 3,2 % to 16,5 % between 1990 and 1993. Simultaneously,
due to the decelerated economic activity and foregone tax revenues and increased spending,
1
Throughout this paper a simplifying assumption that governments financing includes only tax and debt is
made.
2
Due to contributions of Barro, the Ricardian equivalence is widely known as Barro-Ricardo equivalence.
3
Figure 1. The trend of the Finnish gross government debt as absolute amounts (millions of euros) and as a percentage
of GDP (source: Eurostat)
€ 110.000,00
Gross public debt
60,00%
€ 100.000,00
€ 90.000,00
Gross public debt as a % of
GDP
50,00%
€ 80.000,00
40,00%
€ 70.000,00
€ 60.000,00
30,00%
€ 50.000,00
€ 40.000,00
€ 30.000,00
20,00%
€ 20.000,00
€ 10.000,00
10,00%
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
the Finnish government began heavily accumulating debt. Debt-to-GDP rose drastically from
13,9 % to 57,8 % in three years and the percentage change in debt was more than 600 %
between the beginning of 1990 and 1997 (Statistics Finland, 2012). The path of these two
measures is depicted in the Figure 1. The Finnish economy was able to fully recover from the
depression towards the end of the decade. The recovery is largely credited to the increased
exports and the prominent success of a technology industry. The fiscal stabilization policy,
however, left Finland with a debt burden that still has a vestige on the stock of public debt.
This paper aims at investigating the extent to which the Finnish government was able to
stimulate aggregate demand and resuscitate the economy by practicing expansionary fiscal
policy and issuing excessive debt during 1990-1996. Utilizing empirical analysis on the fiscal
policy, this paper will attempt to uncover evidence on the functionality of the economic
stabilizing policy during the 1990s depression by answering the central question:
”To which degree is the Ricardian equivalence a valid hypothesis during the early 1990s
economic downturn in Finland?”
4
In other words, given the definition of the Ricardian equivalence, the central question reads:
To what extent is the public debt perceived as net wealth by the Finnish consumers, and how
did the consumption behavior change during the debt driven fiscal expansion? The research
question is not only relevant for an ex-post retrospection but imposes a significant bearing for
the current policymakers as well. As illustrated by the Figure 1., in the aftermath of the 2008
financial crisis, the Finnish government debt has been increasing again heavily, and a steep
upward trend in debt as the percentage of GDP is evident. However, the 2011 elected
government is relying in financing through tax raises. Therefore, if the Finnish consumers are
Ricardian the construction of the government finance is insignificant. In case the
consumption behavior responds to tax raises traditionally, the effect on the economic
stabilization can be undesired.
In the subsequent sections I will evaluate the validity of the Ricardian equivalence in Finland
by investigating the previous theory surrounding the theorem and constructing a data analysis
using the aggregate data during 1985-2005. Within the analysis, I will try to discover possible
consumption changes during the expansionary policy. The first section evaluates the previous
literature by examining the concept of the Ricardian equivalence, the previous empirical
testing methods, and the RE theorem testing in Finland. Subsequently, I will describe the
methods and the empirical testing set-up employed to estimate the Finnish aggregate data.
This is followed by the analysis based on the testing results. I will conclude by summarizing
the policy implications, and furthermore I will evaluate where the findings fit in the universe
of the RE examinations.
2. Theoretical framework
This section will assess the academic research on the Ricardian equivalence. First, I will
elaborate the notion of the Ricardian equivalence theorem in further detail and highlight the
key studies on the theorem. I will discuss the underlying assumptions and their validity.
Second, I will introduce the methodologies to the empirical testing on the RE hypothesis.
Finally, I will review the Ricardian equivalence studies for the Finnish economy, and discuss
the implications of fiscal expansion on the RE hypothesis.
5
2.1 The concept of the Ricardian equivalence
The traditional view 3 on fiscal policy implies that the issuance of government debt functions
as a consumption stimulating substitute for tax financing. By issuing bonds, instead of raising
taxes, the household wealth is higher and increased disposable income can have a stimulating
effect on aggregate demand. By popularizing the century-old ideas of Ricardo, Barro (1974)
refutes the prevailing notion that an increase in government debt is perceived as net wealth by
the consumers. He argues that a rational consumer will react to debt issuance by increasing
savings because the public debt will require repayment through future tax raises. Hence, the
alteration in public debt does not have an effect on net household wealth. A Ricardian
consumer is therefore indifferent between paying taxes now and repaying public debt in the
future and is therefore called debt-tax neutral. As an alternative to debt financed expansion,
governments can finance spending through tax increases. However, according to the
Ricardian equivalence, the net effect on consumption is again zero. For example, a
consolidation through a tax raise lowers the level of debt but implies constant consumption
under the Ricardian hypothesis due to debt-tax neutrality (Feldstein 1982, p. 9)
Since Barro’s study, academics have disputed the effects of debt financing and the
implications of debt neutrality. The extensive amount of previous literature corresponds with
the controversy on the RE theorem, and the validity proposal is heavily debated; many of the
studies also reach an inconclusive stance. For example, an extensive meta-study on the
Ricardian theorem compiled by Bernheim (1987) concludes against the RE by stating that
there is a significant likelihood that running a deficit results in an increase in consumption.
On the contrary, another broad study on the RE literature by Seater (1993) concludes that,
despite the ambiguous evidence, the theorem is strongly supported by the data and is at least
a close approximation of the reality. Again, Stanley (1998) refutes the proposition surveying
28 previous empirical papers. His meta-regression on the previous estimation results suggests
evidence against the Ricardian hypothesis. 4Of the more recent meta-studies, on contrary to
3
The traditional view corresponds to the standard textbook model where the tax and the public spending
impacts can be illustrated by the IS-LM model (Barro, 1989, p. 3).
4
To summarize, some of the most notable articles patronizing the theory are Kochin (1974), Barro (1978),
Tanner (1979), Seater (1982), Kormendi (1983) Aschauer (1985), Seater and Marino (1985), Kormendi and
Meguire (1986; 1990), Leiderman and Razin (1988), and Evans (1988). Opposing studies on the proposition
include Deaton (1985), Feldstein (1978; 1982), Boskin and Kotlikoff (1985), Modigliani and Sterling (1986;
1990), and Feldstein and Elmendorf (1990) (Evans, 1993, p. 1). Moreover, see also Stanley (1998, p. 9).
6
Stanley, Elmendorf and Mankiw (1999) and Ricciuti (2003) find inconclusive evidence on
the RE theorem. Röhn (2010) studies the private saving offset in OECD countries. He finds
that on average the private saving offsets the effect of fiscal stimulus for approximately by 40
% on a cross-country basis.
2.1.1 The assumptions
Despite the empirical approach of this thesis and of the majority of the previous RE studies, it
is noteworthy to pinpoint the theoretical set-up underlying the Ricardian equivalence
theorem. The strong-form validity of the consumer debt-neutrality requires rigid assumptions,
and for the complete RE validity each of the following must occur (Bernheim, 1987, pp. 3-4):
1. Successive generations are connected by altruistic transfers: gifts (from child to
parent) and bequests (parent to child).
2. Capital markets are perfect (or the failures are specific).
3. The tax-postponement does not redistribute resources within generations.
4. Taxes are non-distortionary.
5. Use of deficits does not create value.
6. Consumers are rational and farsighted.
7. Deficit financing does not influence political process.
The RE literature is mainly focused on validity of the assumptions 1, 2, and 6, and the extent
of the RE theorem validity depends on the plausibility of these three assumptions. Because
the focus of this thesis is the degree of the validity of the theorem I will limit my discussion
only on these main assumptions in this paper.
There is a widespread consensus among the academics that the theoretical set-up does not last
under closer scrutiny and the above assumptions do not hold in the reality. Assumptions one
and six are challenged because the debt interest payment and taxing horizons may diverge
extensively. Thus, due to consumer myopia, the (lump-sum) tax and interest payments of the
bonds with equal present value can be perceived unequal. Also, due to finite nature of human
life, a long debt interest payment horizon (beyond the death of a consumer) may significantly
change the economic decision of consumers. Barro (1974) argues that finite lives are not
relevant for the validity of the theorem because generations are interconnected “by a chain of
operative intergenerational transfers”. Finland makes an interesting environment for an
experiment due to population aging. The debt repayment and taxing horizons could diverge
drastically for a lot of consumers thus challenging the infinite life assumption. Bernheim
(1987) devotes a lengthy evaluation on the assumptions. He argues that the generational
7
family linkage is weak and the altruistic transfers do not occur. However, he states that,
depending on the focus and the timeframe of the research, the bequest motive is negligible
(1987, p. 56).
In order for the RE to hold, the households must be able to borrow without constraints. This
allows the consumers to respond to fiscal stimulus accordingly by altering their saving and
consumption behavior. Röhn (2010, p. 7) concludes that the more liquidity constrained the
consumers are the less Ricardian the economy is, thus corroborating the second assumption.
Financial markets in Finland are well-developed, and therefore the validity of the second
assumption could be proposed. Bernheim (1987, p. 19) also assesses the consumer rationality
and long-term planning ability. He states that in case consumers behave irrationally, e.g.
consume according to their current disposable income, the debt-neutrality effect vanishes and
the RE theorem does not hold. However, if the focus is on short-run effects, the assumptions
have “aura of plausibility” (Bernheim, 1987, p.2). As discussed above, in the short-run the
intergenerational linkages and farsightness do not need to hold because the link between
successive generations and the consumer planning horizons are not affected by myopia
(1987, pp. 9 & 19). Despite the rigidity of the assumptions, the Ricardian equivalence can be
seen as an approximation to the response by consumers to the fiscal stimulus and empirical
testing for validity becomes significant (Röhn 2010, p. 5).
2.2 Empirical research methodology
As discussed above, the previous Ricardian equivalence research approaches the hypothesis
mainly as an empirical issue. The empirical methods used to evaluate the validity of the
theorem vary significantly. As the split between opposing and proposing RE studies suggests,
the results drawn from empirical research are also distributed between strict opposition and
very close approximation, and skewed towards non-Ricardian evidence (Stanley, 1998, p.
14). Bernheim (1987), Evans (1993), and Stanley (1998) argue that, due to the heterogeneity
of the empirical testing, the results drawn are difficult to interpret, and that the problems of
empirical estimation may be insuperable and the original source of dispersed results.
There are two main approaches to testing the validity of Ricardian equivalence: the
consumption function model and the finite life model. The consumption function model and
its variants are the most utilized estimation methods. The finite life model is based on work
of Blanchard (1985). The consumption function allows direct estimation of the impact of
fiscal variables on the consumption. Thus, it can be also used to evaluate the efficiency of
8
these variables as fiscal policy instruments. Furthermore, the popularity of the consumption
function testing permits comparison of the results with a variety of previous studies.
Therefore, this thesis will focus solely on the consumption function method, and the
theoretical and empirical utilization of the Blanchard model is beyond the scope of the paper.
The macroeconomic consumption model estimation is influenced by Feldstein (1982). In his
study, Feldstein tested six implications of aggregate macroeconomic data on household
consumption. Feldstein (1982) originally refuted the Ricardian proposition but, for example,
Aschauer (1985) and Kormendi (1983), using a similar macroeconomic approach, obtained
consistency with the Ricardian view.
The general insight of the consumption function estimation method is to relate per capita
consumer expenditure with various fiscal variables. Feldstein (1982, p. 8) and the later
literature utilizes a consumption functions similar to:
Ct = β0 + β1 Yt + β2 Wt + β3 SSWt + β4 Gt+ β5 Tt+ β6 Trt + β7 Dt
(1)
The determinants of consumption are aggregate income, household wealth, social security
contributions, government expenditure, tax revenues, government transfers to households,
and public debt.
Using regression analysis the interdependence of consumption and the fiscal variables can be
examined. By imposing restrictions on the regression coefficients, a null hypothesis
consistent with the RE theorem can be formed. Consumption function testing also allows for
a simple evaluation of the validity between the Ricardian hypothesis and the traditional view
because the implications of the estimation coefficients can be contrasted with the
expectations of the two alternative views. Table 1. illustrates the dependencies of the fiscal
variables with consumption in the Ricardian and in the traditional view.
Table 1. Summary of the fiscal variables and their expected effect on consumption under the both views.
Fiscal variable
Abbreviation
Effect on consumption
Ricardian
Traditional
+
+
Aggregate income
Y
Household wealth
W
+
+
Social security contributions
SSW
0
-
Government expenditure
G
-
-+
Tax revenues
T
0
-
Government transfers
Tr
0
+
Government debt
D
0
+
9
Thus, as noted, the coefficients reveal how effectively each fiscal variable functions as a
policy tool. The Ricardian equivalence hypothesis, as defined, suggest the impotency of fiscal
policy. In the traditional view, the significance of each variable in fiscal policy can be
interpreted from the magnitude of the regression parameter.
The major problem of the consumption function method lies in the endogeneity of the
coefficient of the tax variable β5. An exogenous change in consumer spending changes the
construction of the aggregate demand and thus increases government tax revenues. This
causes a positive correlation between consumption and tax coefficient. The increase in
consumption increase tax revenues and creates a bias in the direction of the Ricardian
theorem conformity, and the tax parameter tilts towards zero. Thus, in order to achieve nonbiased estimates, instrumental variables are required. Feldstein (1982) uses a lagged value of
the tax variable as an instrument. Despite the anticipated high correlation with the
instrumented variable, the lagged tax variable is still a problematic instrument due to possible
correlation with the consumption disturbance. However, by employing this instrument it is
possible to at least reduce the natural Ricardian bias in the regression (1982, p.13).
Unfortunately, Feldstein does not disclose information on the instrument validity or strength.
However, tax-parameter is substantially affected when IV-regression is applied. Previous
studies have also utilized a variety of other instruments ranging from lagged income and
public spending (Feldstein, 1982) to money growth, statutory tax, and wartime casualty rates
(Seater & Mariano, 1985). However, the contributions of these variables are either excludable
or, according to Bernheim (1987, p. 46), highly questionable.
The utilization of time series data imposes problems of spurious correlation and nonstationarity (Stanley 1998, p. 8). For example, the seminal consumption function model of
Feldstein (1982) measures the fiscal variables in levels whereas Kormendi (1983) uses
differenced data. The time sensitive modeling set-up decisions, however, have a significant
impact on the estimation results. For example, studies using lagged dependent variable and
differenced variables demonstrate a notable trend towards Ricardian compliance. Again, the
inconsistency afflicts the previous modeling: 14 out of 22 studies that studied the
consumption behavior, investigated by Stanley (1998, pp. 8-10), used levels instead of
10
differenced values 5, and 8 out of 22 used a lagged dependent variable. Moreover, the other
problems occurring in the empirical research include omitted variable bias (especially
corporate tax rate), inconsistency in variable definitions, data measurement and adjustment
differences, and large confidence ranges and disordered null hypothesis set-ups causing
dispersed result interpretations (Bernheim 1987, pp. 41-47).
2.3 Empirical results for Finland and in fiscal expansion
The Finnish economy has been a subject of the RE research only in a few occasions.
Moreover, there are no recent results on the RE in Finland. According to Stanley (1998), the
country specific results on the validity of the RE theorem are extremely heterogeneous.
Therefore, extrapolating results from one economy to the other is virtually impossible and a
cultural bias results. For example, Evans (1993) evaluates the RE theorem in Norway,
Denmark, Sweden, and Finland, countries which have a very similar political, demographic,
and economic structures. Norway and Denmark depart from the Ricardian hypothesis
significantly while Swedish and Finnish 6 evidence support the Ricardian theorem.
Furthermore, the consumption function testing has not been conducted for the Finnish
economy. In the study of Evans (1993), the validity of RE is tested using the Blanchard
model. The regression on the aggregate national data from 19 OECD countries does not
produce sufficiently significant results to judge deviation or convergence to the theorem for
the Finnish economy (see footnote 5.). Moreover, the data range employed in the time series
estimation is 1959-1987.
Bernheim (1987, pp. 69-70) evaluates the co-movement of deficit and consumption in a
variety of economies, Finland included. The only evidence disclosed in the study for single
economies is the correlation between changes in consumption and in deficit derived from raw
data. In Finland the correlation between the two variables is negative suggesting a possible
conformity to the Ricardian theorem. Naturally, correlation does not imply causality, but
when the raw data from all the countries are pooled, there is significant evidence that a
5
It should be noted, that the authors that failed to use differenced data could have experienced stationary
variables. However, because the fiscal variables are likely to be non-stationary in levels, it can be assumed that
the literature is inconsistent on the use of levels and differenced values.
6
The standalone evidence for Finland is skewed towards the RE theorem conformity but is insignificant at 5 %
level. Moreover, when the data from all the economies are pooled, the study finds significant evidence against
the RE.
11
negative correlation between consumption and deficit suggests Ricardian consumption
behaviour. Again, the data used in this study dates back to two sample sub-periods of 19721977 and 1978-1983.
The Ricardian studies typically focus on very long time periods, and the short run
implications are largely neglected in the previous studies or rely only on hypothetical
contemplation. Nevertheless, the Ricardian equivalence authors are more conservative in
refuting the RE theorem in a short-run or in a fiscal stimulus. Feldstein (1982, pp. 17-18),
who finds contradicting evidence to the theorem, hypothesize that the consumer response to
short term fiscal expansion may correspond to the Ricardian behaviour. As mentioned above,
Bernheim (1987) also hints for the possibility of a short run validity for the hypothesis.
However, he argues that the short run effect might be difficult to observe (Bernheim 1987, p.
40).
3. Empirical evaluation
In this section I will evaluate the extent of the validity of the Ricardian equivalence by
assessing the macroeconomic data from Finland during 1985-2005. To assess the validity of
theorem during the early 1990s recession I will distinguish the period of the fiscal stimulus
and contrast it with the findings for the whole period. I will commence with the methodology
of the empirical evaluation by observing the consumption function method. Subsequently, I
will form null hypotheses based on the implications of the coefficients consistent with the
Ricardian hypothesis and contrast them with the Keynesian alternative. Furthermore, the data
and the limitations to the empirical evaluation will be elaborated.
3.1 Research method
The empirical analysis will be conducted by constructing an econometric model of the
household consumption and by estimating the model by regressing consumption on the RE
influential fiscal variables. The regression will rely on time-series estimation and use the
aggregate data in Finland between 1985 and 2005. The regression function formulation for
the household consumption will be similar to the equation (1) introduced by Feldstein (1982,
p. 8) and illustrated in section 2.2, and the analysis of the regression coefficients will be
based on his insights. Thus, the basic function to be estimated is:
Ct = β0 + β1 Yt + β2 Wt + β3 SSWt + β4 Gt+ β5 Tt+ β6 Trt + β7 Dt + β8 FEt + ε (2)
12
Here C is per capita consumption, Y is aggregate income, W is household net wealth, D is
government net debt, SSW is a measure for social security contributions, G is government
expenditure, T is the tax revenue, and Tr is measure for transfers from governments to
households. I will depart from the original model of Feldstein in order to evaluate the policy
effectiveness during a fiscal expansion. I will add a binary variable FE to capture the periods
when the fiscal expansion policy can be considered to be in effect. The FE will take value of
1 when the annual increase in debt exceeds one billion. In order to reduce the bias originating
from the correlation of the tax variable and the error term in equation 2., I will use IVregression with a one-year lagged tax variable instrument, Tt-1. The further elaboration of the
IV-regression and the lagged tax instrumental variable will be discussed in section 3.3
I estimate the model measuring the fiscal variables in levels and in first differences. After the
study by Kormendi (1983), the empirical research on Ricardian equivalence has treated nonstationarity and the potential spurious correlation as a threat for obtaining reliable estimates.
In essence, if variables are non-stationary and do not exhibit cointegration, then difference
estimation should be preferred. On the other hand, if the variables are stationary and
cointegrated, the level estimation is preferred (Khalid, 1996, p. 10). In the seminal paper by
Kormendi (1983, p. 6), the regression coefficients remain rather invariant between level and
difference estimations. However, the R² of the difference regression is significantly lower
than in the OLS and hints on a potential misspefication in level data. Therefore, I will follow
the methodology of Kormendi in this regard and apply both level and difference estimations.
3.1.1 Null hypotheses
The null hypotheses will be formed according to the expected consumption dynamics of the
strong-form Ricardian equivalence. In order to evaluate the degree of the RE validity, I will
contrast the expectations of the complete Ricardian theorem with the expected outcomes of
the traditional view. Therefore, I will discuss the implications of each of the fiscal variables
on consumption or on aggregate demand through the change in consumption under the both
alternatives.
The key insight of the strong-form RE theorem implies that a one euro change in government
expenditure does not have an effect on aggregate demand. The created future tax-liability will
be completely offset by a change in consumption. Therefore, for every one euro increase in
Gt, households reduce their consumption by one euro. Thus, the strong form equivalence
implies β4 = - 1. The less strict RE validity also allows -1 < β4 < 0. However, only β4 = - 1 is
13
distinguishable from the traditional alternative that also permits β4 < 0 (Feldstein 1982, p. 9).
Thus, only β4 = -1 allows drawing conclusions on the RE validity.
Moreover, in the Ricardian theorem the public debt Dt does not constitute net wealth, and all
the wealth is captured by Wt. Hence, debt does not influence consumption and increased
personal wealth stimulates it, and thus β7 = 0 and β2 > 0. In the traditional alternative debt is
perceived as a part of the household net wealth: therefore also β7 > 0. Due to debt-neutrality
assumption both tax and deficit financing are seen as undynamic policies under the RE. Thus,
also β5 = 0. The alternative objects this view starkly: the traditional view proposes that a tax
increase reduces consumption. Thus, the implied coefficient should be negative. However,
the endogeneity of the tax coefficient creates a bias towards Ricardian behavior even under
the traditional setting (and the endogeneity issue is further discussed in sections 2.2 and 3.3).
The government transfer payments can be perceived as a substitution for tax reduction and
thus, in the Ricardian view, should leave the consumption unaffected. Despite the immediate
rise in disposable income, a new tax liability is created and thus β6 = 0. On the contrary, the
traditional view perceives government transfers as a dynamic policy tool. The grants are
typically awarded for liquidity constrained consumers and regarded as permanent income.
Therefore, the traditional view implies a positive coefficient (Feldstein 1982, pp. 9-11). β3
offers an additional experiment for the equivalence: if β3 = 0 the consumers perceive current
social security contributions equal to the future transactions back to households while if β3 <
0 the traditional view prevails and social security benefits are considered as a reduction in
disposable income by consumers.
The binary variable will indicate the occurrence of expansionary fiscal policy. Therefore, the
coefficient parameter implies the effect of economic downturn on the consumption.
Coefficient value in conformity with the Ricardian is β8 = 0. The RE theorem in essence
argues that the expansionary fiscal policy is an impotent tool and hence the occurrence of the
fiscal stimulus should not have effect on consumption. On the contrary, the traditional view
argues that debt driven stimulus has positive impact on the consumption. Hence, expectation
consistent with traditional view is β8 > 0.
3.2 Data description
The data employed in the empirical assessment of the RE validity is retrieved using
DataStream with an access at the University of Amsterdam. The Ricardian literature is not
overly consistent with the definitions for the fiscal variables, and different data is used
14
interchangeably depending on the research set-up, on the characteristics of the underlying
economy, on availability of the data, and on the researcher in question. Therefore, I will
briefly discuss the data selection regarding the more ambiguous variables. A definition for
each of the variables including the source of the data is listed in the Table 4. in Appendix A.1.
Furthermore, the limitations concerning the data will be elaborated in the following
subsection.
The data range for all the variables is from midyear 1985 to midyear 2006, excluding the
lagged tax variable which naturally ranges from one year earlier. All the fiscal variables are
measured in current 2012 euros on per capita basis. Per capita division is conducted with total
Finnish population. As described, I will apply both data in levels and data in first differences.
Consumption, aggregate income, government expenditure, and net debt follow the general
textbook definitions. However, the measures for household wealth, social security
contributions, tax revenue, and transfers to households require a brief elaboration. The record
for the Finnish net household wealth is not available before 1995. This imposes a serious
limitation for the robustness of the regression and the implications drawn from the respective
estimation parameter. The limitations are discussed thoroughly in the subsequent section and
the construction of the missing data is illustrated in Appendix A.2. The Finnish social security
system is mainly funded with pay-as-you-go policy 7. Therefore, the data corresponding to the
social security contributions consists of the current transfers to the social security system as
oppose to total market value of the stock of social security wealth. I will define the
government tax receivables as the total government tax revenues. This data includes the
corporate tax payments and partly addresses the omitted corporate tax rate bias noted by
Bernheim (1987, p. 46). Transfers to households are regarded as the general government
social benefit transfers to households. The transfers are total transfers other than transfers in
kind i.e. includes all the cash and cash equivalent transfers that have a direct effect on
disposable income.
7
85 % of the total and 100 % of the minimum pension are funded through pay-as-you-go system (Hautala &
Tuukkanen , 2000, p. 5). Moreover, the computation of the stock of social security wealth is cumbersome and a
possible source of unreliable results (Bernheim, 1987, p. 47)
15
3.3 Limitations
A serious limitation estimating the changes in consumption is the lack of the net household
wealth data for the Finnish economy. Because in the RE bonds are not perceived net wealth,
household net wealth measure should solely include all acquest of the consumers. Therefore,
it forms the core for the evaluation of the validity of the theorem, and the implications drawn
from the estimation parameter could be highly influential for the result analysis. The wealth
variable needs to be included in order to avoid bias rising from variable omission. However,
the absence of concrete data forbids a robust extraction of implications from this coefficient. I
have addressed this issue by constructing a proxy for the household wealth data. For more
detailed description of the construction of this variable, see the Appendix A.2.
As discussed in section 2.2 the endogeneity of the tax variable imposes a serious threat on the
consistency of the regression estimate β5. Following the footsteps of Feldstein (1982) I will
utilize instrumental variable regression to reduce the natural tendency of the tax parameter
towards the RE consistency. Following the methodology of Feldstein, I will use the lagged
tax variable as the main instrumental variable.
According to econometric standards instrumental variable should the highly correlated with
the systematic part of the instrumented variable but uncorrelated with the regression
disturbance. The one-year-lagged tax value is able to achieve high correlation with the
current tax value. However, the correlation with the regression noise term cannot be
completely achieved because the cyclical conditions tend to persist longer than a year.
Therefore the natural bias created by the tax endogeneity cannot be completely eliminated by
employing lagged value as an instrument but it can be significantly reduced (Feldstein 1982,
p. 13). Thus, the results derived from coefficient β5 are still slightly biased towards the
Ricardian equivalence. Despite the apparent difficulties with the lagged tax value as an
instrument, the empirical Ricardian research has not been able to provide a better instrument.
Because the tax variable offers a key distinction between the traditional and the Ricardian
views, I will utilize the lagged tax variable as an instrument in order to achieve more tenable
conclusions.
In addition to tax value, the lagged public spending and national income values are also used
as instruments by Feldstein. However, he does not disclose specific results and merely states
that the regression estimates are not affected by the added instruments. I will, nonetheless,
run the IV-regression with these additional instruments to address the above instrument
16
variable shortcomings. The cyclical conditions apply naturally on the government
expenditure and national income as well. Therefore the bias arising from correlation with the
error remains even if additional instruments are utilized.
Furthermore, the fiscal variables tend to co-move causing a high correlation between the
variables. Table 2. illustrates the implied correlations between the variables derived from the
raw data. For example, the government spending is correlated by more than 0.9 with four out
of six variables, and tax and income variable are correlated by at least 0.74 with five out of
six variables. The evidently high correlations is a source of multicollinearity that could
impose problems with the standard errors in the linear regression. Abnormally high standard
errors are clearly present, for example, in the study of Feldstein (1982, p. 14) and Seater
(1982, p. 6). To address the increased standard errors, I apply data from a 20-year period in
order to produce more precise estimates. To reduce potential collinearity, I will run the
regression with the least significant variables omitted.
Table 2. The correlations between the fiscal variables
Y
W
SSW
G
T
Tr
D
Y
W
SSW
1.0000
0.7407
0.8578
0.9326
0.9922
0.8622
0.4169
1.0000
0.5622
0.5902
0.7456
0.5146
0.2820
1.0000
0.9621
0.8945
0.9799
0.6382
G
T
Tr
D
1.0000
0.9529 1.0000
0.9848 0.8972 1.0000
0.5139 0.4588 0.5758 1.0000
4. Data analysis
This section will illustrate the results obtained by conducting the empirical assessment
described in section 3. I will, in compliance Feldstein (1982), begin with instrumental
variable analysis. However, the obtained outcomes from the utilization two-stage IVestimation do not seem to provide significantly more robust results than ordinary least
squares estimation. Therefore, I will subsequently analyze the same equations with OLSmethod. The regression outcomes are contrasted with the null hypotheses introduced in
section 3.1.1. The summary of the regression results is provided in Table 3.
17
18
4.1 Instrumental variable estimation
To address the described correlation between the tax variable and the regression error, I will
now turn to instrumental variable regression. In unison with Feldstein (1982), I estimate the
model described by eq. 1 using the one-year lagged value as an instrumental variable. The
correlation of the tax and its lagged counterpart, as predicted, is high, 0,9905. However, the
results obtained from 2SLS in the IV (1) are not convincing. The standard errors of the IVregression parameter are rather large and therefore do not permit drawing significant
conclusions for any of the regression parameters of interest. The relatively high standard
errors in the above estimation imply possible difficulties in the IV-regression set up. The
impotency of the lagged tax variable as a valid instrument is confirmed by running the
Durbin-test. The outcome value of 0.004478 (p = 0.9466) is in a conformity with the null
hypothesis that the lagged tax variable is exogenous. Moreover, the first-stage estimation data
offers confirming results of the instrument weakness. The F-value = 0.643439 and the Waldtest can be rejected even at 25 % significance.
In attempt to tackle the instrument validity shortcomings, I will extend my list of instrumental
variables in regression IV (2) by adding the lagged aggregate income and government
expenditure variables, Yt-1 and Gt-1, in the spirit of Feldstein (1982, p. 13). The addition of
these variables in the list of instrumental variables, however, increases means square of errors
implying lesser correlation with the systematic fraction of the tax coefficient. Unlike in
Feldstein’s (1982, p. 13) estimation, the IV-regression outcomes change quite remarkably
when instrument selection is extended. Durbin-test null hypothesis of the variable exogeneity
is now refuted. However, the strength of the instruments, when applying the first-stage F-test,
still remains questionable. Nevertheless, when instrumented, the tax coefficient decreases
substantially to -0.8466132 with a standard error that allows refutation of null on 2,5 %
significance. Thus, the Ricardian view can be opposed. Moreover, when contrasted with the
traditional view in which consumer spending is negatively correlated with tax rates, the
obtained parameter estimation seem to be in harmony with the alternative. Yet, again, the
results obtained from the other fiscal parameters do not provide significant values.
To capture the period of fiscal stimulus I run the above regression in IV (3) with a binary
variable FE measuring the peak periods of the fiscal stimulus program of the early 1990s.
The variable takes a value of one during the years 1991-1997. The binary variable FE
19
naturally increases the standard errors of each of the regression parameters. Nevertheless, the
binary variable does not significantly alter the coefficients of the other fiscal variables and
offers mixed results compared to IV (1). Tax-offset increases slightly whereas, for example,
the debt coefficient remains virtually unchanged. Moreover, the binary variable coefficient
itself is highly insignificant. Thus, it impossible to draw concluding arguments that fiscal
expansion would have an additional impact on consumption.
The abnormally high R² measures of above regression suggest potential spurious correlation
in the regression. To address the problem I will run the instrumental variable regression in IV
(4) with the data measured in first differences. Indeed, the R² of the regression is decreased
significantly when data is transformed to differenced form suggesting that the level form is a
misspecification. However, the coefficients do not change substantially. The trend of the
coefficients, despite insignificant results, seems to be in accordance with the traditional view.
Interestingly, the debt coefficient β7 = -0.0162776 demonstrates compliance with the
Ricardian theory and is the only parameter of interest that is significant on at least 10 %
level. 8 Now the variable exogeneity is refuted, but the first-stage F-test still imposes a
question on the instrument strength.
Redefining 9 the income variable as per capita disposable income alters the expected values of
the regression parameters under the RE theorem. Because disposable income is the leftover
income after taxes and transfers, under the Ricardian interpretation, β5 should be positive to
offset the change in the aggregate demand caused by increase in taxes. This is indeed the case
when consumption is regressed on the disposable income instead of national income in IV
(5). Following the similar reasoning, the coefficients for public spending and transfers, β4 and
β6, should be negative, and the coefficients for social security contributions and debt, β3 and
β7 should be zero. The estimation is consistent with Ricardian view for β6 and rather close to
zero for β7. However, β3 and β4 depart radically from the Ricardian expectations.
8
Extending the instrumental variable list with Yt-1 and Gt-1, when data is differenced, provides more dispersed
confidence intervals and none of the parameters can be estimated even at 10 % significance. I also estimate the
eq. 2. in the differenced data form with the binary term FE added to the regression. However, the coefficients
are not affected and the standard errors and R² are further increased.
9
The redefinition is done to account for adjustments in taxes and transfers. According to Feldstein (1982, p. 8)
disposable income is more appropriate determinant for consumption. However, inclusion of both approaches
allows for wider peer study evaluation.
20
Furthermore, the standard errors, relative to the estimation betas, of each of the fiscal
variables become larger with redefined income variable and forbid significant conclusions for
every coefficient even on a 10 % level. The standard errors become even more dispersed and
MSE of the estimation is almost doubled when measured in differenced form.
In aggregate, the instrumental variable regression fails to provide significant results, and the
contribution of the lagged variable instrument functionality is questionable. Moreover, the
measuring data in first differences lowers the R² of the regression, and thus addresses the
hypothesized nonstationary bias and spurious correlation. However, the results tended to be
completely insignificant when differenced form is used. Despite the rather insignificant
results, the strong-form Ricardian hypothesis can be disregarded, and the IV-estimation
results can be seen to tilt towards traditional view.
4.2 Ordinary least squares estimation
A simple linear regression analysis on the original consumption function specified in equation
1. offers a straightforward alternative for the above instrumental regression obstacles. The
OLS regression of all the fiscal variables in OLS (1) provides brusque evidence against the
RE theorem. Starting from the complete Ricardian consumption offset hypothesis, the
government expenditure regression parameter takes a value of 0.4814817 implying a
tendency towards non-Ricardian behavior. Despite the fact that the coefficient β4 yields
results only with less than 10 % significance, the strong-form Ricardian hypothesis, β4 = -1,
can be directly refuted. However, on the 95 % interval, the parameter could take also negative
values. Thus, the changes in the consumption behavior arising from the public spending
cannot be interpreted either (incomple-form) Ricardian or traditional with certainty.
More confirming results can be drawn from the tax coefficient which is the only regression
parameter yielding significant results on the 5 % significance level. The estimation, β5 = 0.471281 stands in a clear contradiction with the Ricardian equivalence. The coefficient
implies that the consumers cut spending by almost 50 % for every one euro increase in taxes.
Moreover, the outcome is in an apparent conformity with the traditional fiscal view stating
that tax financed expansion depresses the economy. Therefore, conversely, tax-cuts can be
perceived as a dynamic fiscal policy tool to stimulate aggregate demand.
Interestingly, the government debt coefficient implies Ricardian characteristics. The debt
coefficient is relatively close to zero implying that debt does not contribute to the total
consumer wealth. However, the regression parameter standard error, again, is of the similar
21
magnitude with the coefficient and implications cannot be drawn even at 10 % significance
level. Moreover, accounting for the consumer behavior changes during the debt financed
fiscal stimulus in regression OLS (2) does not alter the regression outcomes notably, and the
variable itself is highly insignificant.
Again, to tackle the hypothesized spurious correlation of the fiscal variables, I will turn to
differenced form data in OLS (3). The R² measure is reduced to 0.8004. Interestingly, tax,
public spending, government transfer, and public debt coefficients all approach zero. Despite
the fact that only public debt is significant (at 5 % significance level), the shift towards the
Ricardian compliance is intriguing. This is in compliance with Stanley (1998, p. 8) that
differenced data estimation has a tendency towards the Ricardian equilibrium.
When in OLS (4) I drop the variables that in OLS (1) are below the 15 % significance level
from the regression, all the remaining OLS regression parameters can be estimated with at
least 2,5 % significance. The lowered standard errors are a result of the reduction of the
collinearity between the fiscal variables as described in section 3.3. Now, the results are again
in high contradiction with the Ricardian proposition and in great consistency with the
traditional expectations. Government spending parameter is positive on the 95 % interval
implying a potency of public spending as a fiscal policy tool. Moreover, the tax coefficient
implies, again, approximately 50 % cut in spending as a reflection to tax raises. However,
when I run the same regression in OLS (5) with the differenced data, the results approach the
Ricardian null values. However, the debt coefficient is the only parameter that allows
estimation at meaningful significance (5 % level).
In OLS (6) and OLS (7) I estimate the tendency towards the Ricardian view when Yt is
redefined again as personal disposable income. The tax coefficient, β5, that demonstrated
(insignificant) Ricardian behavior with redefined income measure under IV (5), is now in a
contradiction with the Ricardian null hypothesis at a 10 % level. Moreover, the sign for each
of the variables is exactly reverse to the Ricardian expectations. For example, the government
expenditure coefficient is profoundly positive suggesting public spending again functions as a
potent fiscal policy tool. The outcome is the same when the least significant variables are left
out in OLS (5). Again, the standard errors are reduced and each of the variables can be
estimated at 2,5 % significance. The estimation results therefore suggest a strong
contradiction with the RE theorem and tendency towards the traditional fiscal dynamics
perception.
22
Interestingly, in all the regressions, including the IV estimations, coefficients for wealth and
debt were very close to zero. The former implies that only disposable income and its
determinants influence consumption rather than the overall personal wealth. Moreover, debt
does not have an effect on consumption or the impact is negligible; the regression parameter
was significantly indifferent from zero in half of the regressions. Despite the consistency with
the Ricardian view, when contrasted with tax coefficient it becomes evident that Finnish
consumers are not tax-debt-neutral. Instead, tax-variable offers the most clear cut evidence
against the Ricardian view. In addition to the sign of the tax-variable, the sign of the public
spending was in conformity with the alternative in all the regressions implying compliance
with the traditional view. Interestingly, however, the transform from measuring data in levels
to differenced form measurement, produced results closer to the Ricardian hypothesis
yielding somewhat more mixed signals for the consumer behavior.
5. Conclusion
This paper aims at finding evidence on the extent of the Ricardian equivalence in Finland.
Moreover, the sub-focus is to detect changes in the consumer behavior during the debt driven
fiscal expansion relying on assessment of the aggregate data during the 1990s depression.
Empirical estimation was constructed on the macroeconomic consumption function
modeling. The null hypotheses on the regression parameters were set up in a compliance with
Ricardian equivalence and contrasted against the traditional fiscal dynamics expectations.
Despite the wide range of confidence intervals, the tendency of the regression estimators was
tilted towards the traditional view. Moreover, there was no evidence that the debt driven
fiscal expansion would have had any short run effect on the consumer behavior.
The most explicit evidence against the Ricardian evidence was provided by the tax and public
spending variables. In each regression, the obtained estimators are in accordance with the
traditional consumer behavior. Combined with the consumption stimulating ineffectiveness of
the public debt, and with unchanged behavior during the debt financed deficit periods, the
traditional debt driven fiscal expansion demonstrates as appealing economic revival policy.
The observed breakdown of the debt-tax-neutrality hypothesis can be interpreted as invalidity
of the assumptions. As discussed, the rapid population aging can cause divergence the taxing
and debt repayment horizons among the consumers. Thus, public debt financing can be
perceived as a preferred alternative for tax raises. Moreover, the negative impact of taxes but
an invariant effect on debt imposes a question on the consumer rationality. The tax-debt
23
unneutrality also hints that the consumers do not act as they have infinite lives but instead
egoistic consumption maximization prevails. In summary, the results are contradicting to the
previous studies on Finland that suggested a potential conformity with the RE.
The results obtained in this study follow similar trends and encounter identical problems with
the existing consumption function testing. I am not convinced by the contributions of
instrumental variables in the hypothesis testing: The first-stage F-test implies weak
instruments in each regression and the instrument validity is questionable. Furthermore, the
elimination of the potential nonstationary bias and spurious correlation by using differenced
form, caused further dispersion of the estimators. Therefore, despite the desired effect of
decrease in abnormally high R² measures, the nonstationarity and cointegration of the timeseries data should be statistically tested. The problem of insignificant estimators is apparent,
for example, in the RE supporting study by Kormendi (1983) and opposing article by
Feldstein (1982), and the large confidence intervals allow for variety of interpretations for the
RE validity. Therefore, the studies using pooled results such as Stanley (1998), Evans (1993),
and Bernheim (1987) are likely to offer more relevant information on the validity of the RE.
However, the problem of insignificant results seems to be insuperable evaluating a single
economy with the consumption function modeling. Therefore, a qualitative study on the
validity of the assumptions could also produce meaningful results on the degree of the
validity of the hypothesis.
24
Appendix A.
A.1 Data
Table 4. summarizes each of the variables used in the consumption model regression.
Table 4. The description of the fiscal variable data and their source
Fiscal measure
Variable
Consumption
C
Aggregate income
Y
Household wealth*
W
Household sector net wealth less the non-profit
corporation wealth.
Oxford Economic /
Statistics Finland
SSW
Contributions of employees and self-employed
to the social security system
OECD, Annual
National accounts
G
Total general government expenditures
OECD, Annual
National accounts
Tax revenue
T
Total general government tax revenues. The
one-year lagged tax data used for as the
instrumental variable
OECD, Annual
National accounts
Government
transfers
Tr
General government social benefit transfers in
cash and cash equivalents to households
OECD, Annual
National accounts
Debt
D
Net general government net debt
Social security
contributions
Government
expenditure
Data description
Final household consumption on durable and
non-durable goods and services. Excludes
dwellings
Gross domestic product calculated using income
approach. Alternatively, redefined as disposable
income
Total population in the scope of census
Population
*See Appendix A.2. for more information on the data.
Source
OECD, Annual
National accounts
OECD, Annual
National accounts
IMF Economic
outlook
Eurostat
A.2 Construction of the household wealth data
As provided in section 3.3, the lack of household wealth data imposes a serious limitation to
the estimation of the Ricardian equivalence. The account for the data is kept regularly only
after 1995 in addition to annual data for 1987, 1988, and 1994 obtained from other sources.
This imposes a limitation for the accuracy of the estimation of the whole regression model
and especially for the implications drawn from the regression parameter β2.
The problem of the wealth data gaps was already faced by Feldstein (1982) in the seminal
consumption function regression estimation. The issue of lack of data has been also
confronted with other RE researchers, and the methods of addressing the problem vary
depending, for example, of the characteristics of the economy. In Finnish economy the
household wealth is largely affected by the value of dwellings. For example in 1988 the
25
dwellings counted for 94,6 % of the net household wealth, and in 1998 the corresponding
percentage was 86,4 % 10 . Therefore, the stock of wealth is mainly influenced by the
fluctuations in market value of houses. The recession years were characterized by a large
housing price bubble and its subsequent burst that implied a vast reduction in the household
acquest. For example, in 1995 an average household had a stock of wealth that was
approximately 14 000 euros smaller than in 1988. I will estimate the net household wealth by
adjusting the available household wealth data with the annual fluctuations in dwelling price
levels (Lehtinen, 2007).
First, I will be concise with the definitions. I have calculated household net wealth on the
basis of household sector wealth. Household sector includes households and non-profit
organizations, thus the wealth of the latter needs to be reduced from the former. The data
retrieved from Statistics Finland is in 2009 values and is adjusted to correspond to May 2012
level with Finnish CPI. I have assumed a constant fraction of 92 % of dwellings of the total
net wealth for the years 1985-86 and 1989 and 86 % for the years 1990-1994. Naturally, if the
housing prices fall the fraction diminishes and if the prices increase the effect is opposite.
Thus, this assumption is challenged by the price fluctuations. The weights are selected to
reflect and adjust for these fluctuations. For the price fluctuation reference I have used annual
arithmetic index average of the quarterly apartment prices between 1985 and 1994. The
Figure 1 illustrates the estimated development of the total net household wealth. The Table 5.
includes the data series for the net household wealth parameter.
10
Moreover, two thirds of the households are real-estate owners (Lehtinen, 2007, p. 13).
26
Figure 2. Total net household wealth fluctuation between 1985 and 1997 (in 1000 euros)
190
180
Net household
wealth
170
160
150
140
130
120
110
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
100
Table 5. The total net household wealth (in millions of euros) data series. The proxy constructed values indicated in
red
1985
1986
1987
1988
1989
1990
1991
1992
127752,2
130896,4
141923,42
148138,74
182392,78
172807,49
167379,27
127096,52
1993 121057,81
1994 128785,24
1995
126219
1996
145770
1997
160327
1998
236933
1999
470069
2000
2001
2002
2003
2004
2005
2006
448758
353689
275069
192994
288970
343970
378740
27
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29