Date of Award

1-5-2007

Degree Type

Dissertation

Degree Name

Doctor of Philosophy (PhD)

Department

Economics

First Advisor

Dr. James R. Alm - Chair

Second Advisor

Dr. Martin F. Grace

Third Advisor

Dr. Felix K. Rioja

Fourth Advisor

Dr. Neven T. Valev

Fifth Advisor

Dr. Sally Wallace

Sixth Advisor

Dr. Paul J. Ferraro

Abstract

The theme of this dissertation is Ricardian equivalence, and its objective is to examine the effects of government debt on private consumption expenditures (Essay One), on interest rates (Essay Two), on the current account balance (Essay Three), and on individual intertemporal decision-making (Essay Four). The effects of government debt are important if debt is neutral (e.g., if “Ricardian equivalence” holds), then a stabilization program that is based on demand management policy to curtail fiscal deficits will not be operative. On the other hand, if debt is not neutral (or if Ricardian equivalence does not hold), then deficit finance may induce private consumption, boost interest rates, crowd out investment, and retard economic growth. Essay One contributes to the existing literature by taking into account the nature of liquidity constraints in a developing economy in an aggregate consumption function. Previous empirical tests on Ricardian equivalence have not considered the role of a dominant resource aspect of a country. Essay Two and Essay Three incorporate a dominant resource aspect in Indonesia by estimating the oil-macroeconomic relationship. Furthermore, Essay Three takes into account the role of capital inflows by including debt securities. Essay Four uses experimental economics methods to examine the role of distortionary taxes on Ricardian equivalence. There have been only a few studies that use an experimental approach to examine the effect of deficit spending on consumption expenditures, but these existing experimental studies ignore the role of distortionary taxes in affecting subjects’ consumption-saving decisions and focus on the presence of liquidity constraints, myopia, and uncertainty on future income. Essay Four contributes to the Ricardian equivalence literature by taking into account distortionary taxes in a Ricardian institution by levying taxes on savings in an intertemporal individual consumption-savings decision in laboratory experiments. By utilizing the aggregate consumption function and the Euler equation consumption function, Essay One shows that Indonesian consumers tend to behave in a non-Ricardian way. Public debt most likely will lead to crowding out of investment, and will retard capital accumulation and economic growth. The extent to which individuals perceive government expenditures as complements for their consumption is substantial. An increase in government expenditures will increase the marginal utility of private consumption and has an expansionary effect on aggregate demand. The complementarity between private consumption and government expenditures may be partly due to the allocation of government subsidies to basic goods and services such as electricity, fuel, fertilizer, health centers, and education. Liquidity constraints may cause consumption to have an excess sensitivity to income. The short-run and long-run aggregate consumption function estimates show that income affects consumption, indicating that consumers follow a “rule of thumb” of consuming their current income. A high ratio of public debt to gross domestic product (GDP) in Indonesia may also be the culprit of the excess sensitivity of private consumption to income. Due to low salaries in the formal sector, employees have been engaged in moonlighting activities, mostly in the form of self-employment (e.g., opening retail stores or services). This phenomenon may help to explain why private credit−which amounts to 29 percent of GDP−fails to explain consumption behavior. Most loans are made for investment rather than for consumption. Consumers’ behavior is insensitive to taxation, which perhaps is due to the fact that tax enactment is not explicitly revealed in Indonesia (e.g., price tags in the supermarket include the sales tax, and employees are only informed about their after-tax net wage instead of their gross wage). The share of tax collections to GDP averages only about 15 percent. There is still a large portion of the population who do not pay taxes or who pay far below what they should pay. The fiscal authority needs to focus more attention on alternative financing, i.e. taxation, whose system is essential to be enhanced. Essay Two shows that by excluding oil prices, deficits and debt significantly increase the real interest rate, thereby invalidating Ricardian equivalence. The evidence shows some preference for debt and deficit over government expenditures as determinants of interest rates. Inclusion of the oil price weakens the Neoclassical results, providing more support for the Ricardian paradigm. Deficits no longer increase interest rates, yet debt still significantly increases interest rates. This result reflects a loss of momentum for the Indonesian government two decades ago to decrease its dependency on debt. The government could have used the windfall oil revenue to pay off foreign debt; instead, the windfall was spent on import-intensive infrastructure development projects, in order to build domestic industry and to subsidize rice and petroleum products. The importance of oil prices in the interest rate estimation suggests that in modeling the Indonesian macroeconomy, the oil sector should be incorporated. The non-stationary nature of the stock of debt implies the failure of intertemporal budget balance to hold, indicating that the debt-financed deficit is unsustainable. Essay Three shows that around 80 percent of the estimation results provide support for the Neoclassical view, a result that is consistent with the twin deficits hypothesis. The long-run estimates indicate an almost one-to-one relationship between the government budget and the trade balance, while the short-run estimates show a smaller magnitude. When capital inflows are included, the twin deficits phenomenon is less pronounced in the short-run and disappears in the long-run. An increase in the oil price statistically and significantly improves the trade balance in the short-run and in the long-run. Essay Four shows that subjects fully anticipate an increase in future taxation by increasing the amount bequeathed in one-to-one correspondence to the increase in debt. Even under a Ricardian institution, the distorting nature of taxes on savings alters subjects’ consumption-savings decisions. The equality of the change in bequests and the change in deficit spending is not attained under the savings taxes treatment, invalidating Ricardian equivalence. In line with the results of Essays One, Two, and Three, which suggest the vital need to enhance the taxation system, the results of Essay Four entail the importance of taxes on interest income in Indonesia.

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