Ricardian Approach to Fiscal Sustainability in India

Abstract

There are several approaches to assessing the sustainability of a country’s public finances. Ricardian equivalence is one such approach, in which fiscal sustainability is defined in terms of the neutrality of generational welfare through government fiscal policy. The present work is an attempt to discuss and analyse fiscal sustainability in India in the context of Ricardian equivalence. Different forms of empirically testable equations for testing Ricardian equivalence are derived based on studies by Buiter and Tobin (1978), Kormendi (1983) and Kormendi and Meguire (1990). A key aspect of fiscal sustainability is to ensure generational equity as reflected in India’s Fiscal Responsibility and Budget Management (FRBM) Act, 2003. Based on availability of data, empirical evidence is against the presence of Ricardian equivalence, indicating that the fiscal policy India pursued during the study period (1974–2011) has been detrimental to generational welfare neutrality.

JEL Classification: H30, H20, H50, H62, H63

Keywords

Fiscal Policy Taxes Government Expenditures Budget Deficits Ricardian Equivalence India’s Fiscal Policy

1. Introduction

The causes of and consequences of rising deficits and public debt on the macroeconomy, in general, and the private sector, in particular, have been the focus of long-standing debate in economics. In general, growing deficits are a major cause of fiscal imbalance and a threat to fiscal sustainability and macro-stability. Ricardian equivalence, based on the assumptions of perfectly foresighted and altruistic economic agents with perfect capital markets and non-distortionary taxes, states that a deficit financed by debt instead of taxes to fund government spending is inconsequential in its effect on consumption, savings, investment and economic growth. A deficit is postponement of current taxes and involves higher future tax liabilities. A rational household that perfectly predicts the path of government expenditure computes the present value of such future tax liabilities. As long as the present value of government spending remains unchanged, the present value of tax liabilities would not change, because whatever the government spends must be matched by tax revenues. Ricardian equivalence, based on the above assumptions, states that the present discounted value of future tax liabilities is equal to the cut in the present tax burden. In other words, future tax liabilities due to tax-cut deficit financing at present are fully perceived and discounted by the private sector, no burden of deficit financing is shifted to the future and hence tax-cut deficit financing is neutral to generational welfare. The substitution of a deficit for current taxes (or any rearrangement of the timing of taxes) has an equivalent impact on the economy. Thus, Ricardian equivalence argues that a deficit or public debt does not affect current or future consumption, savings, investment or economic growth and hence is welfare-neutral.

There are different approaches to defining and assessing fiscal sustainability in an economy. According to Domar’s stability condition, fiscal policy is sustainable if the growth of GDP exceeds the interest rate on government borrowings or the growth of debt. Under dynamic efficiency, fiscal policy is sustainable if the present discounted value of the future primary surplus is at least equal to the stock of debt (Buiter, 1995, 2010). In a generational accounting framework, a fiscal policy is sustainable if the estimated ‘generational imbalance’ is negative (Auerbach, Kotlikoff & Leibfritz, 1999). In budget forecasting models, a sustainable fiscal policy implies that the debt/GDP ratio does not explode in the context of projected revenues and expenditures or programme-specific expenditures or reforms (Auerbach, 1994; HM Treasury, 2008).

The concept of Ricardian equivalence is one such measure of fiscal sustainability. Fiscal policy is, thus, sustainable in the Ricardian sense if the tax-cut deficit financing for a given path of government spending does not affect the generational allocation or distribution of resources, and hence is welfare-neutral to generations. Tax-cut deficit financing affects generational welfare if the private sector considers the public debt as net wealth in its optimisation behaviour. The private sector, under the rational expectation hypothesis, believes that the present stock of debt must be repaid in future with higher taxes; and that the present discounted value of future taxes would exactly offset the value of the debt, so would fail to influence optimisation behaviour and would, therefore, ensure generational welfare-neutrality (Barro, 1974, 1979, 1989). As generational equity is an important objective of fiscal policy, a sustainable fiscal policy under the Ricardian framework does not affect it adversely.

An important objective of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 is to ensure fiscal sustainability and inter-generational equity in the management of fiscal policy in India. The Act institutionalises fiscal management, targets the reduction and elimination of budgetary deficits, and improves overall macroeconomic management. It emphasises rule-based management of fiscal policy to promote fiscal sustainability and macroeconomic stability. The Act imposes restrictions on the revenue and fiscal deficits and on incremental liabilities of the central government. It also asks for a cessation of direct borrowings from the central bank, the Reserve Bank of India (RBI), in financing deficit. It sets a time limit on eliminating the revenue deficit and capping the fiscal deficit as a percentage of the GDP at 3 per cent, to provide a return in the future. The thinking behind eliminating the revenue deficit is based on restricting the government from borrowing for consumption, as this does not ensure a future return for servicing the public debt. In this context, the main objective of this paper is to examine the empirical relevance and applicability of the Ricardian Equivalence Theorem (RET) in the context of sustainability of India’s fiscal policy.

Evidently, in practice, fiscal policy becomes unsustainable when an explicit debt crisis emerges. The obvious indicator of such an explicit crisis is the explosive growth of the debt/GDP or debt servicing burden out of revenue receipts or the government’s inability to honour commitments to its creditors. The Ricardian approach does not focus on such explicit debt crises to assess fiscal sustainability. It only assesses how future taxes implicit in current period debt or deficits are discounted by the private sector, and whether the neutrality of taxes versus deficit financing is held. Its focus is on how the private sector responds to tax-financed versus deficit-financed government expenditure. Therefore, even without an explicit debt crisis, fiscal policy under the Ricardian approach might be unsustainable if the neutrality between taxes and deficits is not maintained.

In the light of the above discussion, the following research questions are relevant:

How can one conceptually and analytically link Ricardian equivalence and fiscal sustainability?

How can one empirically estimate and apply Ricardian equivalence in examining fiscal sustainability in the Indian context? In other words, what are the empirically testable equations that test Ricardian equivalence for fiscal sustainability?

The organisation of the paper is as follows: The following section offers a review of the literature. In the next sections, the analytical and empirical frameworks for the Ricardian approach to fiscal sustainability are discussed. The subsequent section is devoted to an analysis and discussion of the empirical findings, and the final section provides a summary and policy implication of this study based on empirical results.

2. Review of Literature

2.1 Theoretical Review

Domar (1944) initiated the theoretical debate about the burden of debt and fiscal sustainability. According to him the ‘burden of debt’ refers to taxes imposed to service a debt and it must be studied in relation to the national income of a country. If government deficits enable income to grow faster than debt, the burden of debt and the fear of fiscal unsustainability would disappear. Though there was no explicit mention of the Ricardian equivalence concept in Domar’s analysis, the issue received implicit attention in the context of defining the burden of debt in a growing economy. After Domar, the issue of debt burden received renewed interest with Buchanan’s seminal work Public Principles of Public Debt (1958). Buchanan argued that the ‘primary real burden’ of public debt is indeed placed on future generations because debt purchases are voluntary, tax payments are not. Moreover, a long-run effect of the substitution of borrowing for tax-financing diminishes private capital formation. He opined that fundamentally internal and external debts have equivalent effects. The issue got subsequent elaboration by Meade (1958), Bowen, Davis and Kopf (1960), Learner (1961), Modigliani (1961), Mishan (1963) and Diamond (1965). Meade (1958) challenged the orthodox or traditional view that internal debt has no real effect or burden on an economy, except for the redistribution of income and wealth between bondholders and taxpayers. He argued that internal debt has a far-reaching distortionary impact on incentives to work, save and take risks as a result of high taxes needed to finance interest payments on borrowing and repayments of debt. According to Buchanan (1958), Bowen et al. (1960), and Modigliani (1961), internal public debt imposes a real burden on the future in the form of reduced capital stock, consumption and growth, higher tax burdens and lower welfare, compared to current generations. However, Bowen et al. (1960), accepted that their conclusion of a ‘gross burden’ depends on whether the benefits of debt-financed government expenditures or projects are ignored. Thus, they argued that debt-financed government spending does not provide any prima facie evidence against deficit financing or the immediate retirement of the national debt. However, interest payments on debt financed by fresh taxation reduces the resources of the generation not owning the bond, helps the generation owning the debt to augment their lifetime consumption and hence impose a burden of debt.

Mishan (1963) and Learner (1961) refuted this doctrine of a debt burden and argued that the conclusion of a debt burden depends on how one defines the ‘burden of debt’, ‘generations’, and ‘community welfare’ and whether the economy is in ‘full-employment’ equilibrium or not. According to Learner, the objective of taxation is to control private spending to achieve the right amount of aggregate demand and avoid inflation or overheating of the economy at full employment. Diamond distinguished internal debt from external debt and established that under dynamic efficiency, both types of debt impose a burden on future generations due to higher taxes to finance ever-growing interest payments, which lowers utility to future generations. According to him, internal debt is more burdensome than external debt because, in addition to the above negative consequences, it reduces capital stock due to the substitution of public debt financing for private capital formation. His analysis fundamentally supported Modigliani’s view. The theoretical literature discussed here did not mention explicitly the concept of a debt burden in the context of the RET and fiscal sustainability. Only Mishan (1963), in a passing reference, mentioned the Ricardian concept of equivalence between taxes versus debt-financing of government expenditures. However, the Ricardian concept of neutrality of taxes versus deficit financing to affect the generational burden through aggregate economic activities and the welfare effects of public debt is implicit in most of the theoretical arguments in the literature.

Thus, the theoretical debates on the debt burden ignored the Ricardian approach to budget deficits or debts. Domar’s analysis focused on fiscal sustainability in relation to economic growth without explicit consideration of the Ricardian approach or the generational burden. Barro¹ (1974) for the first time explicitly established in the literature that budget deficits or debt has no real impact on the private sector’s optimisation behaviour under the assumptions of a perfect capital market, altruistically interconnected generational transfers and certainty about future expectations by economic agents. The future tax liabilities implicit in the current debt financing are completely perceived by the private sector and any positive wealth gain from holding a government bond is exactly outweighed by future taxes. Therefore, debt financing seldom induces any net wealth effects; government bonds are absorbed without any real impact on the economy and hence ensure neutrality of generational welfare.² However, Barro (1976, 1979, 1989) latter made refinements to his earlier arguments in the face of criticism from Feldstein (1974) and Buchanan (1976) and viewed Ricardian equivalence is valid, as deficits have no first-order effects but introduce some second-order effects³ involving excess burden due to the distorting effects of taxes, imperfect credit markets, finiteness of life and future uncertainties. Barro’s (1976) reply to Feldstein (1974) explicitly recognised that unless the government inter-temporal budget constraint under dynamic efficiency is operative, Ricardian equivalence would not hold true. Thus, the role of the government inter-temporal budget constraint (for fiscal sustainability) is crucial for Ricardian equivalence to hold. Studies by Woodford (1996), Rakshit (2005) and Ruiz-de-Gamboa and Summerhill (2009), while stating the relationship between Ricardian equivalence and fiscal sustainability, asserted that fiscal policy is Ricardian, if a set of rules that adjusts the size of the primary surplus or augments the primary surplus such that the real value of government debt stock does not explode, and government remains solvent. To be precise, fiscal policy is Ricardian if the present discounted value of debt is strictly non-positive at the end of the terminal year, regardless of the path followed by the non-fiscal variables in the government budget constraint. According to Woodford, in the presence of non-fiscal variables in the government’s budget constraint, fiscal sustainability can be ensured without holding Ricardian equivalence, and the one-to-one correspondence breaks down.

From the above theoretical review it is clear that (i) while discussing the generational burden of debt, the concept of Ricardian equivalence has not been explicitly recognised by most of the literatures; (ii) Ricardian equivalence is conditioned upon the government honouring the government inter-temporal budget constraint; and (iii) fiscal sustainability does not necessarily ensure Ricardian equivalence. Therefore, while examining the Ricardian approach to fiscal sustainability, one needs to establish the theoretical link between Ricardian equivalence and fiscal sustainability in respect to generational welfare, and then study the empirical relevance and applicability of Ricardian equivalence in examining sustainability of India’s fiscal policy.

2.2 Empirical Review

Since the mid-1970s, an important strand of the macro-fiscal empirical literature on Ricardian equivalence, that is, the impact of budget deficits and the public debt on important macro variables has drawn a great deal of attention. However, empirical studies have mostly focused on the impact of budget deficits or the public debt on important macro-variables like aggregate demand, private consumption, savings, investment, economic growth, interest rates, current account deficits and the so-called ‘crowding-out hypothesis’. Barro (1979, 1989), and Buiter and Tobin (1978) initiated pioneering empirical research on this. Subsequently, studies by Feldstein (1982) and Kormendi (1983) have been widely analysed and cited in the literature on Ricardian equivalence. While Fieldstein rejected Ricardian equivalence, Kormendi provided evidence in favour of it. Both studies examined the Ricardian equivalence in a general model of consumption that accounts for fiscal policy in a way consistent with the logic of the permanent income life cycle hypothesis (PILCH). However, Kormendi’s approach of a consumption model that distinguishes the ‘standard/traditional approach’ from the ‘consolidated/integrated approach’ added novelty to the empirical specification to test Ricardian equivalence. His study received several comments, replies, replications and extensions from researchers like Barth, Iden and Russek (1986), Modigliani and Sterling (1986, 1990) and Feldstein and Elmendorf (1990). However, the empirical findings did not uniformly support or reject Ricardian equivalence. Replication of Kormendi’s study (1983) by Feldstein and Elmendorf (1990) produced entirely different results, which, according to Kormendi and Meguire (1990), were entirely due to data errors. Modigliani and Sterling (1986, 1990) criticised Kormendi’s study on the grounds of specification of the consumption function, use of differenced data, differences in the study period and failure to include a measure of temporary taxes in the empirical testing of Ricardian equivalence, which produced opposite results. Koremendi and Meguire (1990) re-established their findings in favour of Ricardian equivalence and argued that the inclusion of temporary taxes has no material effect. Moreover, they criticised Feldstein and Elmendorf on the grounds that it is inappropriate to include only an explicit measure of temporary taxes, while neglecting temporary measures for other variables like government spending, income, etc.

Other important empirical studies in the area of Ricardian equivalence are by Evans (1988a, 1988b, 1989) and Seater and Mariano (1985). The study by Evans (1988a) using the Euler equation test empirically supported Ricardian equivalence. Other studies by Evans (1988b, 1989) empirically investigated the relationship between nominal and real interest rates in steady state with the public debt and government expenditures, and provided evidence in favour of Ricardian equivalence in the USA. In fact, the findings of no-positive relationship between the public debt and government purchases with real and nominal interest rates in steady-state from January 1981 to March 1986, offered very strong evidence to support Ricardian equivalence. Studies by Seater and Mariano (1985) while replicating Feldstein’s (1982) study, provided evidence for Ricardian equivalence and empirically investigated the permanent income consumption function model with a new specification of the tax-discounting hypothesis, based on Barro’s (1989) argument, which provided very strong evidence for Ricardian equivalence. The study by Motely (1987) produced mixed results: it argued that tax revenues have a stronger influence on private sector consumption than government purchases and thus rejected Ricardian equivalence. However, it also found that public debt had no stimulating impact on consumption, and hence was not considered as net wealth by households, and cited this as evidence in favour of Ricardian equivalence.

The methodologies used in the studies are ordinary least squares (OLS), generalised least squares (GLS) and two-stage least squares (2SLS), time-series unit root tests and the co-integration technique. The tests for Ricardian equivalence have used the standard approach, the PILCH approach and the tax-discounting hypothesis to model private sector consumption and savings behaviour. The standard approach incorporates a fiscal policy in which personal disposable income is defined as personal income minus direct taxes, plus government transfers including interest payments on the public debt, etc., and implicitly neglects the impact of government spending on the private sector. This approach considers the government debt as net wealth and thus implicitly assumes that the private sector is not rational to discount future tax liabilities to repay debt and its servicing. Under the PILCH, the consumption–savings decision depends on the total disposable income of the economy, defined as the difference between total income flows in the economy and ‘government dissipation’ due to government purchases, which are determined and financed by politics rather than the economic marketplace, where the marginal cost of resource and derived benefits differ (Kormendi, 1983). The PILCH incorporates fiscal policy through total government expenditures rather than taxes as in the standard approach, because consumption expenditure in society is jointly determined by private and public expenditures as part of their overall optimisation process, and consequently government deficits have no wealth effects. Kormendi called such an approach a ‘consolidated approach’.

The tax-discounting hypothesis under the assumption of liquidity constraints, tests whether public debt is net wealth to the private sector or not. Households facing liquidity constraints, in order to smooth their consumption, consider the negative impact of current taxes on consumption and treat a government bond as net wealth. This helps in expanding their present consumption when present taxes are reduced and government bond (i.e., budget deficit) is issued. Such rearrangement of tax burdens, where future taxes implied by issuing government bonds are not discounted by the private sector while taking decision about current consumption, defy Ricardian equivalence. The empirical test of Ricardian equivalence should be designed to uphold the spirit of Ricardian equivalence under respective theoretical approaches. Empirical verification of Ricardian equivalence needs careful attention to the specification and design of the test under the Ricardian approach, measurement and inclusion of relevant variables, and the application of appropriate techniques. Any failure in these aspects would result in erroneous conclusions (Seater, 1993).

In India, studies on Ricardian equivalence are few and notably by authors like Gopalakrishnan (1991), Mohanty (1995), Ghatak and Ghatak (1996) and Singh (1998). Gopalakrishnan (1991) was perhaps the first in India to examine the effect of domestic public debt on private consumption to empirically verify the RET for the period 1961–81. Domestic debt was decomposed into several components like monetised debt, market debt, small savings, provident funds and other liabilities. Private final consumption was specified as a function of the aforementioned debt components individually and aggregate variables like the net national product (NNP), net expenditure on goods and services and taxes net of transfer and subsidies. Based on OLS regression, the results refuted the RET in India. Mohanty (1995) first used the ‘standard consumption function approach’ following Kochin (1974), and Buiter and Tobin (1978). He applied the OLS regression of private consumption on government deficits, expenditure, tax and national income and obtained evidences against RET in India for the period 1961–90. Further, based on a ‘consolidated approach’ by Kormendi (1983) and Modigliani and Sterling (1986), Mohanty modified the consumption equation to depend on government debt, private wealth and revenue deficits instead of overall deficits, and applying 2SLS provided evidence against Ricardian equivalence. Ghatak and Ghatak (1996) using multico-integration and estimation of the rational expectation hypothesis also provided evidence against Ricardian equivalence by showing significant crowding-out of consumption and little direct crowding-out of private investment in India during 1950–86. According to them, small direct crowding-out of private investment should not indicate Ricardian equivalence, as the reduction of private investment through interest rate channel (another channel of crowding-out of private investment) is significant. Singh (1998) rejected Ricardian equivalence while developing a model to decompose the domestic debt and private sector wealth into anticipated and unanticipated components under the framework of PILCH to test the impact of domestic debt on consumption for the period 1971–95. While studies by Mohanty (1995) and Singh (1998) paid careful attention to the measurement of variables like the decomposition of private sector consumption into non-durable, semi-durable, durable and services, other studies like Gopalakrishnan (1991) and Ghatak and Ghatak (1996) used total private final consumption expenditures (PFCE) as a dependent variable and failed to address the measurement of interest. This is important because spending on durable goods is a savings rather than consumption by the households or private sector. Similarly, Ghatak and Ghatak (1996) used private sector wealth defined as a sum of money and bond holdings. Mohanty used the private sector’s capital stock while Singh used the private sector’s net capital stock without incorporating financial wealth as a measure of private sector wealth. While measuring government deficits, Ghatak and Ghatak (1996) used total deficits, however, in India, borrowing from the public does not entirely finance total deficits. A part of the total deficits is monetised and has a differential impact on private sector behaviour. Thus, while empirically testing Ricardian equivalence in the Indian context, the appropriate measurement of relevant variables is essential to arrive at an unambiguous conclusion.

3. Ricardian Approach to Fiscal Sustainability—the Analytical Framework

Following Barro (1974, 1979), a simple analytical framework of the Ricardian approach to fiscal sustainability is presented below.

Let us consider a two-period (t and t + 1 or t − 1 and t) optimisation problem of a representative private agent (consumer) under assumptions of the rational expectation hypothesis (REH) with the presence of government and its fiscal policy. Cs, Ys, Gs and Ts are respectively consumption, income, government expenditures and taxes, and r is the real interest rate or discount rate in the economy. The inter-temporal budget constraint is

C_{t} + C_{t + 1} ​ / 1 + r = Y_{t} + Y_{t + 1} / 1 + r

(1)

Equation (1) is expressed without government

C_{t} + C_{t + 1} ​ / 1 + r = (Y_{t} - T) + (Y_{t + 1} - T) / 1 + r

(2)

Equation (2) includes government with a balanced budget, T = G

C_{t} + C_{t + 1} ​ / 1 + r = (Y_{t} - T_{1}) + (Y_{t + 1} - T_{2}) / 1 + r

(3)

Equation (3) is more realistic as it incorporates government with a deficit budget in period t, that is, T₁ < T = G, with the amount of deficit (difference between T and T_1, ΔT = T − T₁) B_t = ΔT, and T₂ as the tax in period t + 1.

Thus, the gain in disposable income to an individual is B_t = ΔT. If it is assumed that the bond B_t will mature next year and that the government budget is balanced, the individual will receive interest and the principal value of B_t, that is, (1 + r)B_t = B_t_+1, where B_t₊₁ is the value of the bond in t + 1.

The modified version of Equation (3) is expressed as,

C_{t} + C_{t + 1} ​ / 1 + r = (Y_{t} - T_{1}) + (Y_{t + 1} - T_{2}) / 1 + r + (1 + r) B_{t}

(4)

The left-hand side (LHS) of Equation (4) shows the total consumption of the individual, which is the sum of current period consumption (C_t) and discounted future period consumption (C_t_+1/1 + r), where 1/1 + r is the discount factor in the economy. The three terms in the right-hand side (RHS) of Equation (4) are current disposable income, discounted future disposable income and receipts of interest and the principal of the bond value.

In a similar fashion, the two-period budget constraint of the government can be expressed as,

T_{1} + T_{2} / 1 + r = G_{t} + G_{t + 1} ​ / 1 + r + (1 + r) B_{t}

(5)

The implication of Equation (5) is that the sum of the current and future discounted value of tax revenue receipts is equal to the sum of the current and discounted value of government expenditures. This is a two-period government inter-temporal budget constraint or solvency constraint (GSC). This restriction is important to convince the private sector to buy government bonds. Therefore, the resultant optimisation problem for the private sector is,

Max U = U (C_t, C_t₊₁),

{Ct, Ct + 1}

subject to C_t + C_t₊₁/1 + r = (Y_t − T₁) + (Y_t₊₁ − T₂)/1 + r + (1 + r) B_t and T₁ + T₂/1 + r = G_t + G_t₊₁/1 + r + (1 + r) B_t

The above optimisation decision depends on the budget constraint of the private sector (Equation 4) and the GSC (Equation 5). Equation (5) involves Ts, Gs and budget deficits (Bs). Budget deficits are actually future taxes and deficit financing at present implies higher future taxes. If future taxes are not discounted at present in the optimisation process, the future generation unduly bears the burden of the deficit. Such undue burden reduces the welfare of future generations and violates the objective of inter-generational equity or generational welfare neutrality and make fiscal policy unsustainable. The objective of the Ricardian approach to fiscal sustainability would be satisfied if the optimisation decisions of the private sector discount the burden of future taxes implicit in the deficit and does not impose any undue burden on future generations.⁴ Under the RET, if the forward-looking private sector fairly predicts future government expenditures, it would substitute Equation (5) into Equation (4) to get Equation (6):

C_{t} + C_{t + 1} / 1 + r = {Y_{t} + Y_{t + 1} ​ / 1 + r} - {G t + G_{t + 1} ​ / 1 + r}

(6)

Equation (6) is the effective budget constraint of the private sector after substituting Equation (5) into Equation (4) and does not represent taxes (Ts) or the deficit (B). The private sector’s optimisation behaviour depends on the new budget constraint and its consumption behaviour depends on its income and government expenditures and not on taxes or the deficit.⁵ This is what the essence of RET conveys. However, one needs to empirically test whether fiscal policy by the use of taxes, deficits, debt or government expenditures, affect generational welfare in terms of impacting macro-variables like consumption, savings, investment, growth and so on.⁶ Fiscal policy in Ricardian sense would be sustainable if the choice of a tax versus deficit financing does not make current generation better off by augmenting C_t at the cost of lower future generation welfare, by shifting the burden of repaying debt to the future and reducing C_t₊₁. The existence of a GSC does not allow both generations to be better-off if government adopts deficit financing. However, if the current generation recognises the future tax liabilities implied by deficit financing and optimises accordingly, no generation is worse off, which ensures fiscal sustainability in terms of neutrality of generational welfare.

4. Ricardian Approach to Fiscal Sustainability—an Empirical Framework

The issue is to identify the empirically testable equations that directly assess generational welfare in the presence of a GSC.⁷ The most important variable that affects generation welfare is private consumption. The overlapping generation (OLG) model considers present and future consumption as a measure of the generational welfare impact of fiscal policy (Diamond, 1965). The Ricardian approach to fiscal sustainability argued that taxes versus debt financing of government spending would not affect current or future consumption. In the present context, the question is whether fiscal policy in terms of tax-cut debt financing affects current consumption or not, as a measure of the Ricardian approach to fiscal sustainability. In this context, this section specifies an estimable current period private consumption model for empirically testing the RET. Different formulations to test the RET based on Buiter and Tobin (1978), Kormendi (1983) and Kormendi and Meguire (1990) along with sign conditions and parameter restrictions are summarised below.

Following Buiter and Tobin (1978), one can express the consumption of non-durables and services (here after CNDS) as,

C N D S_{t} = α + β_{1} P I_{t} + β_{2} T_{t} + β_{3} D E F_{t} + γ W_{t} + δ C N D S_{t - 1} + μ_{t}

(7)

where CNDS is the sum of non-durable and service consumption, PI is the private income, T is the total taxes net of transfers including interest payments on public debt, DEF is the government deficit and is defined as DEF_t = G_t − T_t, where G is the total government expenditure of the combined central and state governments after deducting the inter-governmental flow of resources and liabilities between the central and state governments. W_t is the liquid wealth of the private sector and defined as the sum of money holdings and government debt and µ_t is the error term.

In the absence of data on net liquid wealth defined as the difference between aggregate liquid financial wealth and financial liabilities, this paper considers W_t an appropriate measure of the private sector’s wealth to determine consumption. If the effective real per capita disposable income from the private sector’s view is (PI − T − DEF), and since total government expenditures equal taxes plus the deficit (i.e., G = T + DEF), then the reduced form of Equation (7) can be expressed as,

C N D S_{t} = α + β_{1} P I_{t} + β_{2} G_{t} + γ W_{t} + δ C N D S_{t - 1} + μ_{t}

(8)

The expected sign on the parameters are 0 < β₁ < 1, β₂< 0, β₃ < 0, γ and δ > 0 and the hypotheses for testing RE are |β1| = |β2| and |β2| = |β3| or |β1| = |β2| = |β3| form Equation (7). The restriction 0 < β₁ < 1 implies that the value of the marginal propensity to consume (MPC) out of PI is positive but less than one. The restriction of β₂ < 0 and β3 < 0 indicates the negative impact of taxes and deficits on consumption, under the standard approach of modelling the consumption function by Buiter and Tobin (1978). The wealth effect on consumption is positive (γ > 0) and the lagged value of CNDS is expected to have a positive impact (δ > 0) on the CNDS in the next period. The hypotheses for testing RE are |β1| = |β2| and |β2| = |β3| or |β1| = |β2| = |β3| form Equation (7). The equality of the absolute value of the coefficients of income (PI), taxes (T) and deficit (DEF) is required for Ricardian equivalence.

Equation (8) incorporates the restriction that the estimated coefficient of G from Equation (8) is the sum of the estimated coefficient of T and DEF from Equation (7). By definition, G = T + DEF. If T and DEF have equal and negative impact on CNDS, T and DEF can be added together to get G. Therefore, G captures the total impact of T and DEF taken together. Thus, the required hypothesis to be tested is the estimated β2 from Equation (8) should be equal to estimated (β2 + β3 ) from Equation (7) for Ricardian equivalence.

If T and DEF have the same estimated negative coefficient and if the restriction of Equation (8) holds true, then following Buiter and Tobin (1978), Equation (8) can be expressed as,

C N D S_{t} = α + β_{1} (P I_{t} - G_{t}) + γ W_{t} + δ C N D S_{t - 1} + μ_{t}

(9)

Equation (9) explicitly incorporates the restriction that the estimated coefficients of PI and of G are of the same magnitude but with opposite signs. PI has a positive impact on CNDS and G (= T + DEF) a negative impact on the CNDS. If the restriction in Equation (8) holds true, the estimated coefficient of PI and G would be of the same magnitude with different signs.

The presence or absence of the RET is treated in the failure to accept or reject the hypothesis that the absolute value of the coefficients of PI, T and DEF are the same at a chosen level of significance form Equation (7) by computing the Wald test statistic at appropriate degrees of freedom (D.F). The hypothesis that the estimated coefficient of G from Equation (8) is the sum of the estimated coefficients of T and DEF from Equation (7), and the hypothesis that PI and G have the same estimated coefficients will be tested by comparing the R² of Equation (7) with Equation (8), and that of Equation (7) with Equation (9), respectively, by restricted F test statistics at the appropriate D.F. If the computed F statistic is significant, it rejects the RE.

Following Kormendi’s (1983) and Kormendi and Meguire’s (1990) modified ‘consolidated private consumption model’, another way of modelling CNDS can be expressed as,

C N D S_{t} = a_{0} + a_{1} ​ P I_{t} + a_{2} ​ T_{t} + a_{3} ​ G F C E_{t} + a_{4} ​ W_{t} + a_{5} ​ C N D S_{t - 1} + μ_{t}

(10)

GFCE is the government final consumption expenditures,⁸ which measures the purchase of goods and services by the government. The expected sign of the parameters under the ‘standard approach’ for the RET are, 0 < a₁ < 1, a₂ < 0, a₃ = 0, and under ‘consolidated approach’ for RET, 0 < a₁ < 1, a₂ = 0 and a₃ < 0. The ‘standard approach’ to modelling consumption is silent about the impact of G, what does matter is the impact of taxes on consumption. Consumers under the ‘standard approach’ are short-sighted, in the sense that they accept only the present liabilities in terms of taxes to government. However, consumers under the ‘consolidated approach’ are rational and have perfect foresight about the future, in the sense that the deficit which is used by the government to finance its expenditure bears future tax liabilities. Therefore, under the ‘consolidated approach’, the method of financing government expenditure (i.e., G) is immaterial; what does matter is the path of G, not the method of its financing. The wealth effects which includes government debt under the standard approach is positive, that is, a₄ > 0. Under the consolidated approach, as the tax-discounting hypothesis is operative, a government bond has no impact on private consumption and hence a₄ = 0.

Finally, following the ‘augmented consolidated private consumption model’ nesting both the ‘standard’ and ‘consolidated’ approaches, the augmented version of modelling CNDS can be expressed as,

\begin{matrix} C N D S_{t} = a_{0} + a_{1} ​ N P I_{t} + a_{2} ​ T_{t} + a_{3} ​ G F C E_{t} + a_{4} ​ G T R_{t} + a_{5} ​ C R E_{t} + \\ a_{6} ​ G I P_{t} + a_{7} ​ W_{t} + μ_{t} \end{matrix}

(11)

where NPI (net private income) = private income − GIP (government interest payments on public debt) − GTR (government transfers to the private sector) and CRE (corporate retained earnings).

The objective of Kormendi (1983) was to nest both the standard and consolidated approaches to modelling the generalised consumption function for testing the RET. Kormendi used the concept of disposable income under the standard approach, defined as income net of T, CRE, GTR and GIP, to augment his original consolidated approach consumption function modelling for the stated purpose. Equation (11) is the augmentation of private income into different components for nesting both the ‘standard’ and ‘consolidated’ approaches.

Under the standard approach, the expected signs of the parameters are, 0 < a₁ < 1, a₅ < 0, a₆ > 0 and a₇ > 0, and for the RET to specifically hold under the standard approach, a₂ < 0 and a₃ = 0 must hold. Thus, the restrictions on a₂ and a₃ are essentially to test the RET. Under the consolidated approach, 0 < a₁ < 1, a₄ = a₅ = a₆ = a₇ = 0 and for the RET, a₂ = 0 and a₃ < 0 must hold. The restrictions on a₂ and a₃ under the consolidated approach are opposite to those under the standard approach for the RET. If the restrictions on a₂ and a₃ do not hold under either of the approaches for the RET, other restrictions become redundant. The coefficient of the GTR, a_4, depends on the objective of government transfer payments. If the GTR shifts wealth from the rich (low propensity to consume) to the poor (high propensity to consume), then a₃ is positive under both approaches.

In Equations (7)–(11), the measure of private consumption is CNDS and that of income is PI. However, there exists a strong argument to measure the private sector’s total consumption which includes spending on durables, because government collects taxes from durable and non-durable goods and from the consumption of services. Similarly, Kormendi (1983) argued for the need to consider the total income from all sources, and accordingly defined total disposable income, instead of private income and private/personal disposable income, as an appropriate measure of income to model consumption. According to Kormendi, this should be total consumption, a part of which goes to the private sector, while the rest goes to the government, and accordingly modelled private consumption. Thus, in the present context, alternative measures of private consumption, namely PFCE along with CNDS and total income (NNP) along with PI are considered.

4.1 Variable Description and Data Sources

Table 1 summarises the description, measurement and data sources of different fiscal and macro variables used in the study.

Table 1
Measurement and Data Sources of Variables

Variables Description and Measurement Data Source(s)

Private sector’s consumption expenditures There are two measures of private consumption, CNDS and PFCE. The CNDS is defined as the sum of non-durable, services and service derived from durable goods consumption in the domestic market. PFCE includes all the components of private consumption—durable, semi-durable, non-durable and service consumption. India’s National Account Statistics (NAS), various issues (Government of India)

Private income (PI) National income + the sum of government transfer payments and interest on national debt—property income of government departments and profits of government enterprises The NAS, various issues (Government of India)

Gross current transfers from governments (GTR) General transfer payments by the combined central and state governments to the private sector The NAS, various issues (Government of India)

Net private income (NIP) PI —government transfer payments to the private sector (GTR)—interest payments on government debt stocks (GIP) by the combined central and state governments The NAS and various issues of Indian Public Finance Statistics (IPFS) from 1974 to 2013 (Government of India)

Net tax revenue (T) Tax revenues of the combined central and state governments—GTR. Various issues of IPFS from 1974 to 2013 and the NAS (Government of India)

Government’s expenditures on goods and services (GFCE) Government’s final consumption expenditures on goods and services Reserve Bank of India (RBI) (2013)

Deficit (DEF) The difference between the combined expenditures of the central and state governments on goods and services less the net tax revenue. The DEF is not exactly the same as the fiscal deficit or primary deficit of the combined central and state governments. Various issues of IPFS from 1974 to 2013 (Government of India)

Corporate retained earnings (CRE) Private corporate sector profits less dividends and net of retained earnings of foreign companies The NAS, various issues (Government of India)

Government interest payments on outstanding debt stock (GIP) Interest payments of the combined central and state governments on their outstanding debt stock Various issues of IPFS from 1974 to 2013 (Government of India)

Private liquid wealth (W) Sum of money holding by the public and outstanding government debt, net of the amount issued for the Market Stabilization Scheme (MSS) since 2004–05 RBI (2013) and various issues of IPFS from 1974 to 2013

Population Yearly population figures in crores RBI (2013)

Variables	Description and Measurement	Data Source(s)
Private sector’s consumption expenditures	There are two measures of private consumption, CNDS and PFCE. The CNDS is defined as the sum of non-durable, services and service derived from durable goods consumption in the domestic market. PFCE includes all the components of private consumption—durable, semi-durable, non-durable and service consumption.	India’s National Account Statistics (NAS), various issues (Government of India)
Private income (PI)	National income + the sum of government transfer payments and interest on national debt—property income of government departments and profits of government enterprises	The NAS, various issues (Government of India)
Gross current transfers from governments (GTR)	General transfer payments by the combined central and state governments to the private sector	The NAS, various issues (Government of India)
Net private income (NIP)	PI —government transfer payments to the private sector (GTR)—interest payments on government debt stocks (GIP) by the combined central and state governments	The NAS and various issues of Indian Public Finance Statistics (IPFS) from 1974 to 2013 (Government of India)
Net tax revenue (T)	Tax revenues of the combined central and state governments—GTR.	Various issues of IPFS from 1974 to 2013 and the NAS (Government of India)
Government’s expenditures on goods and services (GFCE)	Government’s final consumption expenditures on goods and services	Reserve Bank of India (RBI) (2013)
Deficit (DEF)	The difference between the combined expenditures of the central and state governments on goods and services less the net tax revenue. The DEF is not exactly the same as the fiscal deficit or primary deficit of the combined central and state governments.	Various issues of IPFS from 1974 to 2013 (Government of India)
Corporate retained earnings (CRE)	Private corporate sector profits less dividends and net of retained earnings of foreign companies	The NAS, various issues (Government of India)
Government interest payments on outstanding debt stock (GIP)	Interest payments of the combined central and state governments on their outstanding debt stock	Various issues of IPFS from 1974 to 2013 (Government of India)
Private liquid wealth (W)	Sum of money holding by the public and outstanding government debt, net of the amount issued for the Market Stabilization Scheme (MSS) since 2004–05	RBI (2013) and various issues of IPFS from 1974 to 2013
Population	Yearly population figures in crores	RBI (2013)

Source: Author’s compilation.

Notes: All the variables are expressed in per capita real terms. The NDP deflator base year 2004–05 has been used to deflate all the nominal series. The period of study is from 1974 to 2011.

5. Empirical Results and Discussion

Empirically, current private consumption is estimated for Ricardian equivalence. If current consumption is augmented by budgetary deficits or the public debt, it implies that the current generation is better-off at the cost of lower future generation welfare, as the burden of repaying the debt to future has been shifted by reducing future consumption. This violates the RET and fails to ensure fiscal sustainability in terms of neutrality of generational welfare.

Equation (7), which is the specification of private consumption under the standard approach, is estimated for the RET. The estimates reported in Table 2 depict that all the coefficients are statistically significant with their expected signs. This holds true whether one considers the PFCE or CNDS as dependent variable to measure private consumption, and PI or NNP as an important explanatory variable to measure income. The intercept term being positive in all estimates of private consumption supports the non-proportional form of the consumption function in which the RET has been tested in literature. The positive value of the intercept is as per theoretical prediction. All the estimates of the MPC out of real income are positive but less than unity. The lagged values of private consumption in all the alternative estimates are positively significant, and around one-fourth of current consumption is explained by immediate past consumption. The estimates of T and DEF associated with PI consistently exceed those of T and DEF associated with the NNP as a measure of income for estimating private consumption. However, the coefficients of T in all the alternative estimates exceed those of DEF. This implies that, though both T and DEF have a negative impact on consumption, DEF being the future tax is not fully discounted by the private sector, and provides evidence against the RET. In other words, the partial discount of DEF entails the augmentation of current consumption at the cost of future consumption, and adversely affects generational welfare neutrality. The coefficient of W, which includes government debt, has a significant positive impact on private consumption. Thus, public debt positively affects current consumption and does not support the debt neutrality hypothesis. Further, the computed Wald statistics at their appropriate D.F reject the two null hypotheses; (i) H₀; b 1 = | b 2| = | b 3| and (ii) H₀; b 2 = b 3 for the RET and provides very strong evidence against it.

Tables 3 and 4 respectively report the estimates of Equation (8) and Equation (9), which are mainly the reduced form of Equation (7). Equation (8) uses the identity that government expenditure is the sum of tax revenue (T) and deficits (DEF), while Equation (9) is based on the fact that the if DEF is equivalent to taxes, then the total amount of taxes imposed on the private sector is T + DEF, which is again equal to G. Therefore, the effective disposable income of the private sector is PI less G.

Table 2
Estimates of Private Consumption for Ricardian Equivalence Based on Specification of the Structural Form of Equation (7) under the Standard Approach

PFCE-dependent Variable
PFCE-dependent Variable
CNDS-dependent Variable
CNDS-dependent Variable

Variables Coefficients ‘t’ value Variables Coefficients ‘t’ value Variables Coefficients ‘t’ value Variables Coefficients ‘t’ value

α 1727.7* 5.7 α 1405* 4.5 α 1733* 6 α 1345.2* 4.2

PI_t 0.43* 11.6 NNP_t 0.46* 10.3 PI_t 0.42* 11.3 NNP_t 0.42* 9.2

T_t −0.74* −4.33 T_t −0.61* −3.3 T_t −0.83* −4.9 T_t −0.66* −3.4

DEF_t −0.45* −5 DEF_t −0.21** −2.3 DEF_t −0.41* −4.8 DEF_t −0.19*** −1.9

W_t 0.41* 9.5 W_t 0.29* 7 W_t 0.37* 9.1 W_t 0.25* 5.92

PFCE_{t − 1} 0.21* 2.9 PFCE_{t − 1} 0.26* 3.4 CNDS_{t − 1} 0.23* 3.2 CNDS_{t − 1} 0.31* 3.8

Adj R² = 0.99, D-h = 0.034 Adj R² = 0.99, D-h = 0.69 Adj R² = 0.99, D-h = 0.24 Adj R² = 0.99, D-h = 0.91

(i) H0; β1 = |β2| = |β3| (i) H0; β1 = |β2| = |β3| (i) H0; β1 = |β2| = |β3| (i) H0; β1 = |β2| = |β3|

(ii) H0; β2 = β3 (ii) H0; β2 = β3 (ii) H0; β2 = β3 (ii) H0; β2 = β3

Wald statistic Wald statistic Wald statistic Wald statistic

(i) 5.94** at 2 d.f. (i) 12.13at 2 d.f. (i) 11.8 at 2 d.f. (i) 12.9* at 2 d.f.

(ii) 5.93* at 1 d.f (ii) 7.97* at 1 d.f (ii) 11.7* at 1 d.f (ii) 9.8* at 1 d.f.

PFCE-dependent Variable	PFCE-dependent Variable	CNDS-dependent Variable	CNDS-dependent Variable
α	1727.7*	5.7	α	1405*	4.5	α	1733*	6	α	1345.2*	4.2
PI_t	0.43*	11.6	NNP_t	0.46*	10.3	PI_t	0.42*	11.3	NNP_t	0.42*	9.2
T_t	−0.74*	−4.33	T_t	−0.61*	−3.3	T_t	−0.83*	−4.9	T_t	−0.66*	−3.4
DEF_t	−0.45*	−5	DEF_t	−0.21**	−2.3	DEF_t	−0.41*	−4.8	DEF_t	−0.19***	−1.9
W_t	0.41*	9.5	W_t	0.29*	7	W_t	0.37*	9.1	W_t	0.25*	5.92
PFCE_{t − 1}	0.21*	2.9	PFCE_{t − 1}	0.26*	3.4	CNDS_{t − 1}	0.23*	3.2	CNDS_{t − 1}	0.31*	3.8
Adj R² = 0.99, D-h = 0.034	Adj R² = 0.99, D-h = 0.69	Adj R² = 0.99, D-h = 0.24	Adj R² = 0.99, D-h = 0.91
(i) H0; β1 = \|β2\| = \|β3\|	(i) H0; β1 = \|β2\| = \|β3\|	(i) H0; β1 = \|β2\| = \|β3\|	(i) H0; β1 = \|β2\| = \|β3\|
(ii) H0; β2 = β3	(ii) H0; β2 = β3	(ii) H0; β2 = β3	(ii) H0; β2 = β3
Wald statistic	Wald statistic	Wald statistic	Wald statistic
(i) 5.94** at 2 d.f.	(i) 12.13*at 2 d.f.	(i) 11.8* at 2 d.f.	(i) 12.9* at 2 d.f.
(ii) 5.93* at 1 d.f	(ii) 7.97* at 1 d.f	(ii) 11.7* at 1 d.f	(ii) 9.8* at 1 d.f.

Source: Author’s estimation based on Equation (7).

Notes: ***, ** and * indicate significance at the 1 per cent, 5 per cent and 10 per cent levels, respectively.

Table 3

Estimate of Private Consumption for Ricardian Equivalence Based on Specification of the Reduced Form of Equation (8) under the Standard Approach

PFCE-dependent Variable			PFCE-dependent Variable			CNDS-dependent Variable			CNDS-dependent Variable
Variables	Coefficients	‘t’ value	Variables	Coefficients	‘t’ value	Variables	Coefficients	‘t’ value	Variables	Coefficients	‘t’ value
α	1809.7*	5.7	α	1509.1*	4.4	α	1743*	5.2	α	1338*	3.8
PI_t	0.38*	11.8	NNP_t	0.38*	10.1	PI_t	0.33*	10.5	NNP_t	0.32*	8.7
G_t	−0.38*	4.2	G_t	−0.43**	−1.91	G_t	−0.32*	−3.4	G_t	−0.45**	−2.1
W_t	0.34*	9.4	W_t	0.23*	5.8	W_t	0.28*	7.7	W_t	0.18*	4.5
PFCE_t _{− 1}	0.28*	3.8	PFCE_t _{− 1}	0.36*	4.5	CNDS_t _{− 1}	0.35*	4.6	CNDS_t _{− 1}	0.44*	5.4
Adj R² = 0.99, D-h = −0.34			Adj R² = 0.99, D-h = 0.31			Adj R² = 0.99, D-h = −0.014			Adj R² = 0.99, D-h = 0.28
H₀; β2 from Equation (8) = (β2 + β3) from Equation (7)						H₀; β2 from Equation (8) = (β2 + β3) from Equation (7)
Computed F_1,31 = 5.91*			Computed F_1,31 = 7.93*			Computed F_1,31 = 11.72*			Computed F_1,31 = 9.82*

Source: Author’s estimation based on Equations (7) and (8).

Notes: ** and * indicate significance at the 5 per cent and 10 per cent levels, respectively.

The analysis of private consumption estimates reported in Table 3 for Ricardian equivalence conveys the same results as reported above. The coefficients of G for all the alternative estimates of private consumption for Ricardian equivalence are negatively significant. The standard approach predicts no impact of G on private consumption for Ricardian equivalence. The negative of G implies crowding-out of current private consumption, which is contrary to the prediction of the standard approach for Ricardian equivalence. Further, the coefficient of W_t, which includes government debt, has a positive impact on private consumption and is in line with the prediction of the standard approach. However, the positive wealth effect of debt under the standard approach is against Ricardian equivalence. Finally, we need to test the null hypothesis for RET from Equation (8), which is expressed as H₀; b 2 from Equation (8) = ( b 2 + b 3) from Equation (7). The appropriate test statistic for testing the null hypotheses is the restricted F test. The computed F_1,31 statistics for the hypotheses are significant at their respective D.F and again provides evidence against Ricardian equivalence. Thus, the finding of crowding-out of private consumption by government expenditure, a positive wealth effect of debt and rejection of the hypothesis that tax and deficits are equivalent forms of financing government under the standard approach reject Ricardian equivalence.

Table 4 reports estimates of another reduced-form specification of private consumption for Ricardian equivalence under the standard approach of Equation (9). The findings of Table 4 convey the same conclusions about Ricardian equivalence as mentioned above. The only difference is the test of the null hypothesis for Ricardian equivalence. In this case, two restrictions under two null hypotheses for RET are tested. The hypotheses are expressed as (i) H₀; b 2 = b 3 from Equation (7) and (ii) b 2 from Equation (8) = ( b 2 + b 3) from Equation (7). The F_2,31 statistics for the hypotheses are significant at their respective D.F and again provide evidence against Ricardian equivalence. Thus, standard consumption function modelling based on the Buiter and Tobin (1978) study uniformly rejects the empirical validity of the RET in India.

Table 4

Estimates of Private Consumption for Ricardian Equivalence Based on Specification of Reduced Form of Equation (9) under the Standard Approach

PFCE-dependent Variable			PFCE-dependent Variable			CNDS-dependent Variable			CNDS-dependent Variable
Variables	Coefficients	‘t’ value	Variables	Coefficients	‘t’ value	Variables	Coefficients	‘t’ value	Variables	Coefficients	‘t’ value
α	1819.5*	8.42	α	972.8*	5.1	α	1713*	7.5	α	910.3*	4.5
(PI_t − G_t)	0.38*	12.4	(NNP_t − G_t)	0.35*	10	(PI_t − G_t)	0.33*	10.9	(NNP_t − G_t)	0.3*	8.6
W_t	0.34*	10.2	W_t	0.26*	7.03	W_t	0.28*	8.7	W_t	0.21*	5.8
PFCE_t _{− 1}	0.28*	4.5	PFCE_t _{− 1}	0.45*	7.5	CNDS_t _{− 1}	0.35*	5.6	CNDS_t _{− 1}	0.52*	8.4
Adj R² = 0.99, D-h = −0.33			Adj R² = 0.99, D-h = −0.33			Adj R² = 0.99, D-h = −0.033			Adj R² = 0.99, D-h = −0.7
H₀; β2 = β3 from Equation (7) and β2 from Equation (8) = (β2 + β3) from Equation (7)						H₀; β2 = β3 from Equation (7) and β2 from Equation (8) = (β2 + β3) from Equation (7)
Computed F_2,31 = 2.96***			Computed F_2,31 = 6.06*			Computed F_2,31 = 5.86*			Computed F_2,31 = 6.44*

Source: Author’s estimation based on Equations (7) and (9).

Notes: *** and * indicate significance at the 1 per cent and 10 per cent levels, respectively.

Tables 5 and 6, respectively, present the estimates of private consumption for Ricardian equivalence based on the ‘consolidated’ and ‘augmented consolidated’ approach of Equations (10) and (11). The intercept and coefficients of MPC are significant with their predicted sign. For Ricardian equivalence, one needs to focus on the estimated coefficients of T and GFCE. The estimated coefficients of T for all the specifications of private consumption have a significant negative impact on private consumption. The estimated coefficients of GFCE in all cases are negative, but statistically insignificant. Thus, the significant negative impact of T and insignificant impact of GFCE for all specifications of private consumption are contrary to the predictions for Ricardian equivalence under the consolidated approach and refute the empirical validity of the RET. The measure of private liquid wealth (W_t), which includes government debt stocks has a significant positive impact on private consumption and hence provides evidence against the RET. The findings based on T, GFCE and W_t are contrary to the predictions of the existence of Ricardian equivalence under the consolidated approach. In other words, the findings are in line with the prediction of the standard approach of consumption modelling to incorporate fiscal policy. The standard approach predictions are against the RET. To distinguish between the standard and consolidated approaches to private consumption, the augmented consolidated approach to private consumption is estimated following Kormendi (1983).

Table 5

Estimates of Private Consumption for Ricardian Equivalence Based on the Consolidated Approach of Equation (10)

PFCE-dependent Variable			PFCE-dependent Variable			CNDS-dependent Variable			CNDS-dependent Variable
Variables	Coefficients	‘t’ value	Variables	Coefficients	‘t’ value	Variables	Coefficients	‘t’ value	Variables	Coefficients	‘t’ value
α ₀	2033.9*	4.7	α ₀	1518*	3.9	α ₀	2050*	4.8	α ₀	1550*	3.8
PI_t	0.45*	7.2	NNP_t	0.49*	8.5	PI_t	0.41*	6.9	NNP_t	0.44*	7.4
T_t	−0.5***	−1.7	T_t	−0.6**	−2.3	T_t	−0.52***	−1.8	T_t	−0.56**	−2.1
GFCE_t	−0.48	−1.5	GFCE_t	−0.31	−1.2	GFCE_t	−0.35	−1.15	GFCE_t	−0.17	−0.6
W_t	0.33*	6	W_t	0.26*	6.2	W_t	0.29*	5.6	W_t	0.22*	5.1
PFCE_t _{− 1}	0.22**	2.3	PFCE_t _{− 1}	0.25*	2.9	CNDS_t _{− 1}	0.25*	2.5	CNDS_t _{− 1}	0.29*	3.2
Adj R² = 0.99, D-h = −0.15			Adj R² = 0.99, D-h = 1.24			Adj R² = 0.99, D-h = 0.26			Adj R² = 0.99, D-h = 1.52

Source: Author’s compilation based on estimates of equation (10).

Notes: ***, ** and * indicate significance at the 1 per cent, 5 per cent and 10 per cent levels, respectively.

Table 6, which reports the augmented version, provides empirical evidence against the presence of Ricardian equivalence, as the coefficient of T is negatively significant while that of GFCE is insignificant. Further, W_t, which includes public debt is positively significant and rules out the debt neutrality hypothesis. Transfer payments and interest payments on public debt have no significant impact on private consumption. Corporate retained earnings (CRE), which are perceived as private saving, do not have an impact on current consumption. Thus, Kormendi’s consolidated and augmented consolidated approaches to private consumption modelling uniformly provide evidence in favour of the standard approach of consumption modelling and empirically invalidate the presence of Ricardian equivalence in India.

Table 6

Estimates of Private Consumption for Ricardian Equivalence Based on the Augmented Consolidated Approach of Equation (11)

PFCE-dependent Variable			PFCE-dependent Variable			CNDS-dependent Variable			CNDS-dependent Variable
Variables	Coefficients	‘t’ value	Variables	Coefficients	‘t’ value	Variables	Coefficients	‘t’ value	Variables	Coefficients	‘t’ value
α₀	1387.3*	3	α₀	1178**	2.4	α₀	1527*	3.2	α₀	1281**	2.5
NPI_t	0.49*	8.2	NNP_t	0.5*	8.1	NPI_t	0.44*	7.5	NNP_t	0.43*	6.9
T_t	−1.06*	−3.2	T_t	−0.85**	−2.6	T_t	−1.1*	−3.3	T_t	−0.84**	−2.5
GFCE_t	−0.31	−0.96	GFCE_t	−0.21	−0.65	GFCE_t	−0.3	−0.93	GFCE_t	−0.18	−0.54
GTR_t	0.39	0.6	GTR_t	−0.28	−0.42	GTR_t	0.32	0.5	GTR_t	−0.27	−0.38
RE_t	0.41**	2.3	RE_t	0.24	1.31	RE_t	0.44*	2.5	RE_t	0.29	1.54
GIP_t	−0.15	−0.5	GIP_t	−0.26	−0.85	GIP_t	0.07	0.22	GIP_t	–0.03	−0.11
W_t	0.25*	3.23	W_t	0.23*	2.96	W_t	0.25*	3.2	W_t	0.22*	2.8
PFCE_{t − 1}	0.29*	3.22	PFCE_{t − 1}	0.31*	3.4	CNDS_{t − 1}	0.31*	3.4	CNDS_{t − 1}	0.34*	3.5
Adj R² = 0.99, D-h = −0.73			Adj R² = 0.99, D-h = 0.66			Adj R² = 0.99, D-h = −0.4			Adj R² = 0.99, D-h = 0.64

Source: Author’s compilation based on estimates of Equation (11).

Notes: ** and * indicate significance at the 5 per cent and 10 per cent levels, respectively.

A diagnostic test to check for the presence of auto-correlation in a regression involving time-series variables is important to ensure that the minimum variance property of the estimates is ensured. In the presence of a lagged value of the dependent variable as an explanatory variable, the appropriate test statistics for an auto-correlation check is the Durbin-h (D-h) statistic, instead of the usual Durbin-Watson (DW) statistic. The statistical insignificance of the computed D-h statistic for all forms of the consumption function estimates point to no autocorrelation, and indicate the appropriateness of modelling private consumption by the explanatory variables. Moreover, the insignificance of the D-h statistic indicates that the estimated coefficients are not spurious, which could occur in a regression when variables are time-series in nature and non-stationary at level as attested by the Augmented Dickey–Fuller (ADF) and Philips-Perron (PP) tests for stationarity check of variables used in the analysis (as reported in Table A1 of the Appendix). All the variables are stationary at their first difference with the specification of the trend and intercept, respectively.

In a nutshell, the empirical analysis based on the standard and consolidated approaches of consumption modelling by Buiter and Tobin (1978), Kormendi (1983) and Kormendi and Meguire (1990) unambiguously provides evidence against the RET in India from 1974 to 2011. It has emerged from the empirical analysis that the government deficit and public debt positively affect the current consumption of the private sector and hence have a detrimental impact on future private consumption, as the onus of repaying the public debt on account of the government deficit is shifted to future generations. Thus, empirical evidence against the presence of Ricardian equivalence during the study period signifies that the fiscal policy pursued in India had been unsustainable, as it has detrimental effects on generational welfare. How the private sector perceives the public debt in their optimisation decisions is discussed by the Ricardian approach to fiscal sustainability. If the private sector is rational, the deficit and debt are treated as future taxes and discounted, and the generational welfare neutrality of taxes versus deficit financing is preserved for fiscal sustainability. Thus, the source of fiscal unsustainability through the non-neutrality of financing instruments of fiscal policy by the private sector is due to their myopic treatment of the deficit and debt.

6. Conclusions and Implications

This article discusses and analyses the Ricardian approach to fiscal sustainability in India. The theoretical link between Ricardian equivalence and fiscal sustainability is established in a simple OLG model. Different forms of empirically testable equations that test Ricardian equivalence are derived, based on the standard and consolidated approaches. Different measures of private consumption and income to model private consumption are used in the empirical analysis. The empirical evidence is against the Ricardian equivalence hypothesis and suggests that the fiscal policy pursued during the study period had been detrimental to generational welfare. One of the key aspects of a sustainable fiscal policy is to ensure generational equity as reflected in the form of the FRBM Act, 2003, in India. The empirical findings of the non-equivalence of taxes versus deficit financing along with the positive wealth effects of public debt provide evidence against generational equity and entail the unsustainability of fiscal policy pursued during the study period.

The findings have wider implications for fiscal policy pursued by the government, which does not allow borrowing for consumption purposes. Significant positive wealth effects of government debt and the absence of a negative impact of government consumption expenditures on current period private consumption adversely induce the neutrality of generational welfare. Moreover, a consistently lower negative impact of the deficit compared to net taxes on private consumption implies that deficit financing of government expenditures augments current consumption at the cost of future consumption and welfare.

Footnotes

Acknowledgements

The paper is based on the author’s PhD thesis from the University of Mysore through the Institute for Social and Economic Change (ISEC), Bangalore, under the supervision of Professor M.R. Narayana. Grateful thanks are due to Professor J.J. Seater, whose suggestions at different stages of this article have been vital and inspirational. An earlier draft of the article was presented at the 52nd Indian Econometric Society (TIES) conference in January 2016. An earlier version of the article has been published by ISEC as Working Paper No. 335. The author acknowledges comments and suggestions from the anonymous referees who were instrumental in revising the article. However, the usual disclaimer applies.

Appendix

Table A1

Test of Stationarity by Augmented Dickey–Fuller and Philips–Perron Test

Variables	ADF Test		PP Test		Variables	ADF Test		PP Test
Variables	Intercept	Intercept and Trend	Intercept	Intercept and Trend	Variables	Intercept	Intercept and Trend	Intercept	Intercept and Trend
CNDS	8.04	4.0	8.1	4.5	ΔCNDS	−0.58	−4.1**	−2.2	−4.4*
PFCE	8.2	4.1	8.3	4.6	ΔPFCE	−0.52	−3.9**	−2.1	−4.1*
NNP	8.9	3.3	10.5	4.1	ΔNNP	−0.6	−4.6*	−2.2	−4.7*
PI	7.7	2.3	10.1	3.1	ΔPI	−0.84	−3.1	−3.2**	−5.9*
DTOR	2.5	0.05	2.7	0.17	ΔDTOR	−5*	−6.3*	−5.3*	−6.3*
GFCE	4.1	2.15	3.12	0.5	ΔGFCE	−0.11	−4.2*	−3.3**	−3.7**
NPI	7.3	2.31	7.3	2.31	ΔNPI	−0.93	−5.65*	−3.42**	−5.8**
GIP	1.44	2.55	1.34	−2.56	ΔGIP	−5.99*	−6.43*	−6.02*	−6.42*
GTR	4.4	2.5	4.02	1.98	ΔGTR	−5.5*	−7.1*	−5.8*	−7.1*
RE	0.44	−1.21	0.5	−1.22	ΔRE	−6.4*	−6.9*	−6.4*	−6.9*
W2	4.4	2.8	3.4	2.05	ΔW2	−3.1**	−3.6**	−3.1**	−3.7**
DEF	−0.51	−5.72*	–0.4	−2.54	ΔDEF	−6.7*	−6.6*	−6.1*	−5.4*

Source: Author’s compilation.

Notes: ** and * denote the rejection of unit root hypothesis of the respective variables at 5 per cent and 10 per cent level of significance. ADF, Augmented Dickey–Fuller; PP, Philips–Perron.

Notes

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