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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 References Literature Aschauer, D. 1985. ”Fiscal Policy and Aggregate Demand”. American Economic Review. Vol. 75, No. 1, pp. 117-127. Barro, R. 1974. ”Are Government Bonds Net Wealth?” Journal of Political Economy, Vol. 82, No. 6 pp. 1095-1117. Barro, R. 1989. “The Ricardian Approach to Budget Deficits”. Journal of Economic Perspectives, Vol. 3, No. 2, pp. 37-54. 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