Torbjörn Becker

This dissertation consists of five separate essays (and a short introductory chapter) that analyze the effects of debt policy on private consumption. Essay 1: Government Debt and Private Consumption: Theory and Evidence. The Ricardian equivalence theorem has been widely debated since (at least) the seventies. The theorem states that households should not change their consumption path in response to changed timing of taxes, given the path of government consumption. In this essay, theoretical models giving rise to the equivalence result as well as models predicting deviations from debt neutrality are presented. In general, the Ricardian models are based on unrealistic assumptions, such as infinite horizons, perfect capital markets and lump-sum taxes. The issue of Ricardian equivalence is thus perhaps better viewed as a question concerning to what extent the equivalence hypothesis is a reasonable approximation of the real world. This could only be established by empirical studies. To formulate a test of Ricardian equivalence, it is however vital to extend the standard analysis in deterministic models to stochastic models. In a stochastic model we need to incorporate the fact that agents have to make predictions about future levels of government consumption, and that public debt might be a useful predictor for that purpose. It is therefore necessary that an empirical study distinguishes between debt as a potential source of net wealth, which is the concern of the equivalence proposition, and debt's role as a signal of future levels of government consumption, which is due to the stochastic nature of the world. It is argued that there are few empirical studies that make this distinction, and in case the distinction is made, the evidence is in favor of the Ricardian equivalence proposition, namely that public debt is not net wealth to households. Changing the timing of taxes will therefore not change private consumption. In other words, although the Ricardian equivalence hypothesis is burdened with unrealistic assumptions, it seems (historically) to provide a reasonable approximation of actual data. Essay 2: An Investigation of Ricardian Equivalence in a Common Trends Model. A common trends model for gross national income, private consumption, government consumption and net taxes is estimated on US data. The system has two cointegrating vectors and thus two common stochastic trends, interpreted as a technology trend and a public sector trend. The two temporary shocks are interpreted as a private demand and government financing shock, respectively. Theoretical models suggest that the two cointegrating vectors could be due to the private and public sectors' intertemporal budget constraints. We find two co-integrating vectors, as predicted by no-Ponzi game constraints on the sectors. However, a stronger version of the no-Ponzi game constraint is a solvency condition, which implies particular co-integrating vectors. These cointegration vectors are both rejected for the sample period, indicating that the public sector will not be able to repay its debt if the current policy is maintained. However, the private sector is at the same time accumulating wealth, which is consistent with predictions from a Ricardian model. Further, the equivalence theorem predicts that private consumption should be unaffected by financing shocks. Data, however, indicate that there is a significant short run effect on both income and private consumption from the financing shock, but the effect indicates that increasing taxes is accompanied by increasing private consumption, contrary to both standard Ricardian and Keynesian models. In the theoretical world, this type of pattern could be generated in models with risk averse individuals and uncertainty about future taxes. Essay 3: Risky Taxes, Budget Balance Preserving Spreads and Precautionary Savings. This essay analyzes the effects on consumption from changes in the riskiness of taxes. It starts by reinterpreting the Sandmo [1970] paper on general capital income risk to the case of risky capital taxation. In his framework the concept of a mean preserving spread (MPS) is used for the risk analysis. In connection with risky taxes it is however possible to explicitly connect the tax risk with the government's budget constraint. In this essay the concept of a budget balance preserving spread (BBPS) is developed and used for the analysis of stochastic taxes. The essay is concluded with a comparison of the effects that a MPS and a BBPS has on consumption decisions. It is shown that the comparative statics results for a BBPS could be different from the results obtained with a MPS. Essay 4: Budget Deficits, Tax Risk and Consumption. This essay analyzes the effects of budget deficits on consumption when individual taxes are stochastic. It is shown that the co-movements between budget deficits and private consumption will depend on how risk averse individuals are. In the case of lump-sum taxes, it is sufficient to assume that individuals have a precautionary savings motive to obtain the result that consumption today will decrease with increased disposable income today. Furthermore, if we use a time separable iso-elastic utility funcition, the standard analysis of capital income risk predicts (precautionary) savings to increase with increased risk if the coefficient of relative risk aversion is greater than one. This is no longer sufficient when the risk is due to uncertain capital income taxes. In general, the coefficient must be greater than one to obtain precautionary savings in response to the greater risk implied by a budget deficit. The results in the paper are consistent with Ricardian equivalence only for some specific utility function, but not in general. However, in the same way, the results are consistent with standard Keynesian models that display a positive relation between debt and private consumption only for certain utility functions, and could equally well generate the opposite result for individuals that are enough risk averse or prudent, without changing the expected value of government consumption. In other words, if future taxes are uncertain, increased disposable income in the present period will decrease present consumption, if households are prudent enough. Essay 5: Budget Deficits, Stochastic Population Size and Consumption. This paper analyzes the effects on present consumption of budget deficits under different assumptions regarding demographics. In the first part, birth and death rates are deterministic, and in the second part, birth rates are assumed to be stochastic. In the case of a deterministic population size, an increase in public debt raises present consumption, if the (deterministic) birth rate is greater than zero, while with a zero birth rate we obtain debt neutrality. This is consistent with the results in Blanchard [1985] and Buiter [1988]. However, for the case of stochastic birth rates, it is shown that we can obtain the result that present consumption will decrease when public debt is increased, both when we have a zero expected birth rate, and when the expected population size is assumed to be constant, so that the expected birth rate is positive and equal to the death rate. The explanation is that with an uncertain birth rate, the future tax base is uncertain, which makes per capita taxes uncertain in the future. Shifting taxes to the future thus implies greater uncertainty about future net income, and induces precautionary savings.