Abstract
This paper tests the Ricardian equivalence hypothesis in the context of the Dominican Republic (DR). The results rejected the Ricardian theorem but a weaker version is shown to have significant implications for the DR. If the government borrows to increase spending, private consumption is crowded out and the economy will suffer in the long run. The outcome is worst if the government borrows to deliver a tax cut. In particular, for every RD$ 1.00 of additional debt incurred to finance government primary spending, private consumption and gross domestic product (GDP) fall by a meaningful RD$ 2.15 and RD$ 1.15 respectively. If the debt is used to finance the tax cut, the fall is RD$ 2.15 in both consumption and output. Interestingly, if the government uses taxes to cover a budget deficit, the effect is neutral and consistent with Ricardian equivalence. The paper argues that fiscal distortions are in part responsible for these multipliers. Distortions are estimated to be 21 % coming from different sources including taxes evasion and fiscal drainage. These findings suggest that the DR could benefit from either reducing the level of fiscal distortions or the size and scope of the Dominican government. If, however, the government continues to pursue an active fiscal role under the current environment, it will generate an unnecessary burden to consumption and economic growth.
Similar content being viewed by others
Notes
See, for example, Haque and Montiel (1989) for an early study on liquidity constraints and Ricardian equivalence in a cross-section of countries.
The term fiscal drainage refers to fiscal revenues that are not reinvested through government expenditure or poorly invested with little or no positive wealth and/or productivity effects. The concept of tax evasion is standard and refers to taxes that are not paid.
The DR is a democratic country that shares the island of Hispaniola, the second largest in the Caribbean region, with Haiti. In 2010, gross domestic product (GDP) reached US$ 27.6 billion with a population of around 10.2 million out of which 2.5 million are estimated to be Haitians. The official currency is the Dominican peso (RD$) which trades freely at a market price that averaged 36.9 RD$/US$ in 2010. The US is our main trading partner, although Europe and Asia have become relatively important in the current account. The Central Bank, established in 1947, has a clear mandate to focus on price stability. However, it has been argued that because of fear of floating, a crawling peg regime has been followed. One of the country’s biggest challenges is its fiscal accounts with a budget deficit that reached 8.8 % of GDP in 2010 and an outstanding total debt that is around 28 % of GDP with a mix that is currently at 33 % local and 67 % foreign. The DR has worked closely with the IMF in designing and implementing reforms aimed at improving the government fiscal profile (Young et al. 1999).
Real per-capita disposable income is given by GDP (\(Y_{t}\)) minus taxes (\(T_{t}\)) denominated in RD$, deflated using DR’s consumer price index (CPI) and expressed in per-capita terms using DR’s population. Real per-capita consumption is given by private domestic consumption, also denominated in RD$, deflated using DR’s CPI and expressed in per-capita terms using DR’s population (see Table 1 for data source and description).
The literature argues that the correlation between consumption and disposable income faces causality and exogeneity issues. For instance, it is not clear whether the causality runs from income to consumption as in the Keynesian framework or if the relationship depends on the expected path of life time income as in Friedman’s (1957) permanent income hypothesis. It is also believed that consumption may not react to disposable income as suggested by Hall’s (1978) random walk hypothesis. Nevertheless, a high degree of income sensitivity should be expected in countries subject to income inequality and binding credit constraints such as the DR (Campbell and Mankiw 1991).
A similar representation and corresponding conclusion could be made for real per-capita government deficit and real per-capita GDP. The reason lies in the close correlation between the latter and private consumption as indicated by Fig. 1. In Fig. 2, real per-capita government deficit is given by primary government income minus taxes (\(T_{t}\)) denominated in RD$, deflated using DR’s CPI and expressed in per-capita terms using population (see Table 1 for data source and description).
Figure 3 shows the government outstanding debt, expressed in real per-capita terms, including both local and foreign balances. For the debt, the source is the Central Bank and Ministry of Finance of the Dominican Republic.
Inflation was successfully controlled after 1992 and maintained within a single digit until a banking crisis that started in 2003 caused the exchange rate to devalue and inflation to follow. It has been argued, however, that the main cause of this particular crisis was not triggered by fiscal events (Sánchez-Fung 2005).
Nicoletti (1988) also shows that debt volatility and fiscal recklessness could induce neutrality making fiscal policy ineffective.
Transfers are excluded from the specification provided that they do not impact a debt-for-tax swap nor have any implications on Ricardian equivalence (Searter 1993).
In the national income identity, private investment \((\bar{{I}}_t )\) and net exports \(\overline{ {NX} _t}\) are assumed exogenous.
Note that the derivatives with respect to government primary spending and taxes are carried out in period t, meaning that outstanding debt does not matter in the calculation of the multipliers. However, if the analysis is carryout at the steady state, such that time is irrelevant, the interest on the debt will appear in the multiplier. For example, the steady state multiplier of a debt financed tax cut over consumption will be given by: \(\left. {\partial C^{*}/\partial T^{*}} \right|_{\Delta T=\Delta B} =\left[ {\gamma _1 +\left( {1+r} \right)\gamma _2 } \right]/1-\gamma _1\), where the asterisk represent steady state values.
All variables where deflated by the CPI and expressed in per-capita terms using population statistics.
Equation (4) is a reduced version of Eq. (1) following a general-to-specific approach. The instruments used in the TSLS estimation includes lagged levels of private consumption, GDP, taxes, government primary spending, interest on debt, a constant, and a time trend. Three lags where used for each instrument providing a rank of 13 variables. A more general covariance estimator (HAC) was used, providing consistency in the presence of both heteroskedasticity and autocorrelation of unknown form (Newey and West 1987).
The \(J\)-statistic is small relative to the degrees of freedom suggesting that the overidentifying restrictions imposed by the model are not rejected by the data. The parameters estimated do well in satisfying the orthogonality condition of the instrument set.
The test includes a constant, no trend and one lag selected using the Schwarz Information Criterion (SIC). The 1, 5 and 10 % critical values are \(-3.58, -2.92\) and \(-2.60\), respectively. The test includes 47 observations after adjustment. Manual lag selection was also carried out to test robustness. The results are significant at up to eight overidentifying and redundant lags.
According to Bårdsen (1989), the standard errors of the normalized coefficients in Eq. (5) are given by:
$$\begin{aligned} {}\text{ Var}(\gamma _i ) \cong \left( {\frac{1}{-\theta }} \right)^{2} \text{ Var}(\omega _{ij})+\left( {\frac{\omega _{ij} }{\theta }} \right)^{2} \text{ Var} (\theta )+2\left( {\frac{1}{-\theta }} \right) \left( {\frac{\omega _{ij} }{\theta }} \right) \text{ cov}(\theta ,\omega _{ij}) \end{aligned}$$where the parameters and covariance matrix are obtained from the estimation of Eq. (4).
The Wald test examines an equality restriction on the long run coefficients obtained from Eq. (4).
See footnote 3 for a description of weak Ricardian equivalence.
The government primary spending multipliers over GDP and consumption, under the weak version of Ricardian equivalence, are given by \(\partial Y_t /\partial G_t =\left( {1-\gamma _2 } \right)/\left( {1-\gamma _1 } \right)\) and \(\partial C_t/\partial G_t =({\gamma _1 -\gamma _2} )/( {1-\gamma _1 })\) respectively. In addition, the tax multipliers are given by \(\partial Y_t /\partial T_t =\left( {1-\gamma _2 } \right)/\left( {1-\gamma _1 } \right)\) and \(\partial C_t /\partial T_t =\left( {1-\gamma _2 } \right)/\left( {1-\gamma _1} \right)\) respectively.
These results are consistent with those found by Aristy-Escuder (1999) using a CGE model for simulating several trade and fiscal policies in the DR during the 1990s.
Siddiki (2011) also explores the sources and causes of the violation of the Ricardian theorem in less developed countries. He concludes, for the case of Bangladesh, that a finite time horizon and the presence of liquidity-constrains are the main sources of deviation. The findings have important implications for fiscal and stabilization policies in line with the results of this paper.
See, for example, Ostry and Reinhart (1992) for measures of marginal propensities to consume found in empirical studies.
It is important to remember that other sources of distortions may lead to a departure from Ricardian equivalence. These include, among others, capital markets imperfections, like different discount rates, uncertainty, and a high proportion of rule-of-thumb/ non- optimizing consumers that may cause a failure of the permanent income hypothesis (Flavin 1981).
See the World Democracy Audit (2010).
The theorem is discussed and applied extensively in Davison and MacKinnon (1993). However, the use of the theorem is new to the literature on the Ricardian equivalence hypothesis.
The value of \(\delta \) was obtained by estimating Eq. (5) as follows:
$$\begin{aligned} \Delta C_t \!=\! \omega _0 + \displaystyle \sum \limits _{i=0}^s{\left(\! {\phi _{0i} \Delta C_{t-i-1} + \phi _{1i} \Delta \textit{YD}_{t-i} + \phi _{2i} \frac{D_{t-i}^{\prime } }{1-\delta } } \!\right) +} \theta \left[\! {C_{t-s-1} + \omega _1 \textit{YD}_{t-s-1} - \omega _2^{\prime } \frac{D_{t-s-1}^{\prime } }{1-\delta }} \!\right]+\varepsilon _t \end{aligned}$$with the restriction that \(\omega _2^{\prime } =\omega _1 \) . Provided that \(\delta \) only has a scaling effect, finding the value that satisfies the restriction of the parameters can be achieved by using an iterative searching algorithm.
References
Abel AB (1985) Precautionary saving and accidental bequest. Am Econ Rev 75(4):777–791
Aristy-Escuder J (1999) Dominican Republic: a CGE analysis. N Am J Econ Finance 10:207–233
Bårdsen G (1989) The estimation of long-run coefficients from error correction models. Oxf B Econ Stat 54:345–350
Barro R (1987) Government spending, interest rates, prices, and budget deficits in the United Kingdom, 1701–1918. J Monetary Econ 20(2):221–247
Barro R (1989) The Ricardian approach to budget deficits. J Econ Perspect 3(2):37–74
Bean CR (1986) The estimation of “surprise” models and the “surprise” consumption function. Rev Econ Stud 53:497–516
Bernheim BD (1987) Ricardian equivalence: an evaluation of theory and evidence. NBER Macroecon Annu 2:263–303
Bernheim BD (1989) A neoclassical perspective on budget deficits. J Econ Perspect 3(2):55–72
Bernheim BD, Shleifer A, Summers LH (1985) The strategic bequest motive. J Polit Econ 93:1045–1076
Bertola G, Drazen A (1993) Trigger points and budget cuts: explaining the effects of fiscal austerity. Am Econ Rev 83(1):11–26
Buiter W, Tobin J (1979) Debt neutrality: a brief review of doctrine and evidence. In: von Furstenburg GM (ed) Social security versus private saving. Ballinger, Cambridge
Campbell JY, Mankiw NG (1991) The response of consumption to income: a cross-country investigation. Eur Econ Rev 35:723–767
Davidson R, MacKinnon JG (1993) Estimation and inference in econometrics. Oxford University Press, New York
Dickey DA, Fuller WA (1979) Distribution of the estimators for autoregressive time series with a unit root. J Am Stat Assoc 74:427–431
Engle RF, Granger CWJ (1987) Co-integration and error correction: representation, estimation, and testing. Econometrica 55:251–276
Feldstein MS (1982) Government deficits and aggregate demand. J Monetary Econ 9(1):1–20
Feldstein MS (1988) The effects of fiscal policy when incomes are uncertain. Am Econ Rev 78(1):14–23
Finkel SE, Sabatini CA, Bevis GG (2000) Civic education, civil society, and political mistrust in a developing democracy: the case of the Dominican Republic. World Dev 28(11):1851–1874
Flavin M (1981) The adjustment of consumption to changing expectations about future income. J Polit Econ 89:974–1009
Friedman M (1957) A theory of consumption functions. Princeton University Press, London
Frisch R, Waugh FV (1933) Partial time regressions as compared with individual trends. Econometrica 1:397–401
Gërxhani K, Schram A (2006) Tax evasion and income source: a comparative experimental study. J Econ Psychol 27(3):402–422
Haggerty RA (1999) Dominican Republic: a country study. GPO for the Library of Congress, Washington
Hall RE (1978) Stochastic implications of the life-cycle permanent income hypothesis: theory and evidence. J Polit Econ 89:971–987
Haque NH, Montiel P (1989) Consumption in developing countries: tests for liquidity constraints and finite horizons. Rev Econ Stat 71(3):408–415
Heller WP, Starr RM (1979) Capital market imperfections, the consumption function, and the effectiveness of fiscal policy. Q J Econ 93(3):455–463
Hendry DF (1995) Dynamic econometrics. Oxford University Press, Oxford
Hubbard RG, Judd KL (1986) Pension wealth and individuals saving: some new evidence. J Money Credit Bank 18(2):167–178
Jaramillo L, Sancak C (2009) Why has the grass been greener on one side of Hispaniola? A comparative growth analysis of the Dominican Republic and Haiti. IMF Staff Papers 56(2):323–349
Johansen S (1991) Estimation and hypothesis testing of cointegration vectors in Gaussian vector autoregressive models. Econometrica 59:1551–1580
Kochin LA (1974) Are future taxes anticipated by consumers? J Money Credit Bank 6(3):385–394
Kormendi RC (1983) Government debt, government spending, and the private sector behavior. Am Econ Rev 73(5):994–1010
Kotlikoff LJ, Assaf R, Rosenthal RW (1990) A strategic altruism model in which Ricardian equivalence does not hold. Econ J 100(403):1261–1268
Lovell MC (1963) Seasonal adjustment of economic time series. J Am Stat Assoc 58:993–1010
MacKinnon JG (1991) Critical values for cointegration tests. In: Engle RF, Granger CWJ (eds) Long-run economic relationships: readings in cointegration. Oxford University Press, Oxford
MacKinnon JG (1991) Critical values for cointegration tests. In: Engle RF, Granger CWJ (eds) Long-run economic relationships: readings in cointegration. Oxford University Press, Oxford
MacKinnon JG, Haug AA, Michelis L (1999) Numerical distribution functions of likelihood ratio tests for cointegration. J Appl Econ 14:563–577
Newey W, West K (1987) A simple positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix. Econometrica 55:703–708
Nicoletti G (1988) A cross-country analysis of private consumption, inflation and the debt neutrality hypothesis. OECD Econ Stud 11:43–87
Ostry JD, Reinhart CM (1992) Private savings and term of trade shocks. IMF Staff Papers 39(3):495–517
Perelman S, Pestieau P (1993) The determinants of the Ricardian equivalence in the OCDE countries. In: Verbon HA, Van Winden FA (eds) The political aconomy of Government debt. North-Holland, Amsterdam
Ricardo D (1821) On the principles of political economy and taxation. John Murray Publishers, London
Ricciuti R (2003) Assessing Ricardian equivalence. J Econ Surv 17(1):55–78
Sánchez-Fung J (2005) Exchange rates, monetary policy, and interest rates in the Dominican Republic during the 1990s boom and new millennium crisis. J Lat Am Stud 37:727–738
Searter JJ (1993) Ricardian equivalence. J Econ Lit 31(1):142–190
Siddiki JU (2011) The Ricardian equivalence hypothesis: evidence from Bangladesh. Appl Econ 42(11):1419–1435
Torgler B (2005) Tax morale in Latin America. Public Choice 122(12):133–157
Young P (2002) The Dominican Republic, stabilization, structural reform, and growth. IMF Occasional Paper 206. Washington.
Young P, Dunn D, Giustiniani A, Tanner E, McHugh J (1999) Dominican Republic: selected issues. IMF Staff Country Report, Washington
Acknowledgments
I would like to thank Professor Robert M. Kunst and two anonymous referees for invaluable comments and suggestions to the paper. I am also grateful to Dr. Jose Sánchez-Fung and the University of London ISA for the invitation to participate in the “Dominican Republic: Issues and Prospects” conference. Finally, I would like to thank Ms. Jeanet Cabrera for precious research assistance and the American Chamber of Commerce of the Dominican Republic for inviting me to several forums and for participating in the 2011 Dominican Week at Washington, DC. The author takes full responsibility for any errors and omissions in the article.
Author information
Authors and Affiliations
Corresponding author
Rights and permissions
About this article
Cite this article
Prazmowski, P.A. Ricardian equivalence and fiscal distortions in the Dominican Republic. Empir Econ 46, 109–125 (2014). https://doi.org/10.1007/s00181-012-0669-y
Received:
Accepted:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s00181-012-0669-y