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Ricardian equivalence and fiscal distortions in the Dominican Republic

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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.

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Notes

  1. For research on the Ricardian proposition see Kotlikoff et al. (1990), Abel (1985), Feldstein (1988), Heller and Starr (1979), Hubbard and Judd (1986), and Bernheim (1987); Bernheim (1989).

  2. See, for example, Haque and Montiel (1989) for an early study on liquidity constraints and Ricardian equivalence in a cross-section of countries.

  3. According to the literature, weak Ricardian equivalence is an empirical situation in which the relevant variables suggested by the theory are significant and adequately signed but the equality restriction is violated (Feldstein 1982; Kormendi 1983).

  4. 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.

  5. 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).

  6. See Haggerty (1999) for a comprehensive review of the DR’s social, political, and economic history. Finkel et al. (2000) provides some highlights of the DR’s corruption environment.

  7. 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).

  8. 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).

  9. 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).

  10. 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.

  11. 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).

  12. Nicoletti (1988) also shows that debt volatility and fiscal recklessness could induce neutrality making fiscal policy ineffective.

  13. A similar specification can be found in Buiter and Tobin (1979) and Perelman and Pestieau (1993).

  14. 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).

  15. In the national income identity, private investment \((\bar{{I}}_t )\) and net exports \(\overline{ {NX} _t}\) are assumed exogenous.

  16. 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.

  17. All variables where deflated by the CPI and expressed in per-capita terms using population statistics.

  18. 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).

  19. 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.

  20. 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.

  21. 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).

  22. The Wald test examines an equality restriction on the long run coefficients obtained from Eq. (4).

  23. See footnote 3 for a description of weak Ricardian equivalence.

  24. 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.

  25. 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.

  26. 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.

  27. See, for example, Ostry and Reinhart (1992) for measures of marginal propensities to consume found in empirical studies.

  28. 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).

  29. See the World Democracy Audit (2010).

  30. 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.

  31. 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.

  32. This is one of the fundamental conclusions that arise from the application of the Frisch and Waugh (1933)–Lovell (1963) theorem, in which \(\delta \) only has a scaling effect in the estimation of the consumption equation.

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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.

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  1. American Chamber of Commerce of the Dominican Republic and Grupo León Jimenes, X-16445, P.O. Box 025389, Miami, FL, 33102-5389, USA

    Peter A. Prazmowski

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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

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