Budgetary deficits and Ricardian equivalence: The case of India, 1950–1986

Abstract

In this paper we analyze the validity of the Ricardian equivalence (RE) theorem for a less developed country (LDC), i.e. India, for the period 1950–1986. The RE theorem states that it is inconsequential whether a government deficit is financed by debt issue or by tax increases, since under certain conditions, the effect of government consumption on aggregate demand is orthogonal to the mode of financing fiscal deficits because rational economic agents consider today's deficit financing as tomorrow's tax liabilities. The use of multicointegration analysis and estimation of the rational expectations model both invalidate the RE hypothesis in India. There are significant crowding out effects on private consumption, but such effects on private investment are insignificant because they are expected to be already included in the effect of interest rates.