Tuesday, March 18, 2008


I concluded my last entry on tax cuts and budget deficits by stating that there could be cases theoretically where Mankiw’s assumption about the failure of Ricardian Equivalence could be true.

I did provide some empirical evidence for a case where his conclusions about the detrimental effects from deficits failed to materialize as a result of the Regan tax cuts. What about other cases? If tax cuts lead to wealth effects and the failure of Ricardian Equivalence, then empirical evidence should show the following:

A correlation between tax cuts and an increase in demand, decrease in savings, and an increase in interest rates.

An increase in current account deficit ( if we are required to borrow from foreigners to finance tax cuts)

In an effort to see if these relationships hold up empirically, I provide the following literature review:

1) Carroll & Summers (1987) “ Why Have Private Savings Rates in the United States and Canada Diverged”? Journal of Monetary Economics. Sept 1987, 20 249-279

Observed that Canada had higher budget deficits that the US from 1983-1985, but also had higher savings rates.

2) Evans, Paul. “Do Budget Deficits Affect the Current Account?” Ohio State University Aug 1988. unpublished.

Cross country data for post WWII Canada, U.S., Canada, France, Germany and U.K. showed no correlation to budget deficits and trade deficits.

3) Robert Barrow. Macroeconomics- 5th Edition MIT Press 1997

4) Barro, Robert J. ‘The Ricardian Approach to Budget Deficits.” Journal of Economic Perspectives. Vol 33, No 2 (sp 19890 p. 37-54.

1948-1983 data revealed that the ratio of total output to government budget surplus and net foreign investment had a very weak correlation, and a correlation of only .37 only in 1983.

5) Plosser, Charles (1982) p.339. “Government Financing Decisions and Asset Returns.” Journal of Monetary Economics. May 1982, 9, p. 325-352.

Found no correlation between the interest rate on government and various other securities and budget deficits.

6) Paul Evans (1987). “Do Budget Deficits Raise Nominal Interest Rates: Evidence from Six Industrialized Countries. Journal of Monetary Economics Sept 1987, 20, 281-300

Looks at interest rates from 1974-1985 and quarterly data for 6 countries, finding no relation between interest rates and budget deficits.

7) Paul Evans. “Interest Rates and Unexpected Future Budget Defecits in the United States.” Journal of Political Economy. February 1987, 95, 34-50.

Looks at U.S. data 1931-1979. Current and past defecits had no correlation with nominal interest rates on commercial paper, corporate bonds, or realized interest rates on commercial paper.

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