Exogenous tax changes and interest rates: testing for Ricardian equivalence using an efficient markets model

Abstract

This article tests the Ricardian theory (i.e., Barro 1974) using Mishkin’s (1981, 1982) efficient markets model of interest rates. Employing Romer and Romer’s (2010) measure exogenous tax changes, I am able to test whether the U.S. bond market reacts in a Keynesian or Ricardian manner to exogenous tax policy changes. This helps avoid the endogeneity problems associated with measuring the interest rate effects of deficits and provides a cleaner test of the pure Ricardian thought experiment. I find a significant negative relationship between tax changes and interest rates which is inconsistent with the Ricardian model and support the Keynesian crowding out framework.