The Ricardian Equivalence Hypothesis asserts that consumers respond in exactly the same way to a change in taxes as to a change in the government deficit. Therefore, a tax cut that leads to an equivalent increase in the government debt, would finally have no effect on the consumption pattern.

In this chapter, the implications of the Ricardian Equivalence Hypothesis on consumption behaviour is examined. In Section 4.1, the need for an appropriate consumption function to test for Ricardian Equivalence Hypothesis is emphasised. In Section 4.2, a brief discussion on consumption functions and the related empirical work is presented. The extension of the permanent income hypothesis to incorporate the rational expectations model is discussed in Section 4.3. In this section, the relationship between the Ricardian Equivalence Hypothesis and the Permanent Income Hypothesis under rational expectations emerges. Once this relationship is established, a consumption equation is then derived incorporating the fiscal variables to empirically test for the Ricardian Equivalence Hypothesis. In Section 4.4, a critical review of the existing literature on Ricardian Equivalence is presented. In Section 4.5, six major studies have been replicated to test for the robustness of the specification of the respective models given a common data set. A major issue in empirical work pertains to the market and par value of government debt. This is also empirically examined in this section. The model that has been developed in Section 4.3 of this chapter is empirically estimated in Section 4.6. Finally, conclusions from the chapter are presented in Section 4.7.

Ricardian Equivalence Hypothesis and consumption

In this section, the importance of an appropriate underlying consumption function which can be used for testing the Ricardian Equivalence Hypothesis is briefly discussed.

The major empirical work on Ricardian equivalence has generally been based on an ad hoc specification of the consumption function. It is not usually established whether the underlying consumption function itself is supported by the data. It is crucial for tests of Ricardian equivalence to assure that the consumption function in itself is robust and has an appropriate theoretical basis. Otherwise, the result with respect to Ricardian equivalence may be caused by misspecification of the consumption function itself. One of the important assumptions about Ricardian equivalence is that people can rationally forecast the future implications of decisions taken today and accordingly adjust their consumption.