Ricardian equivalence, expansionary fiscal contraction and the stock market: a VECM approach

The effect of government taxation on future consumption has been explained in three ways: the Keynesian approach, the Ricardian Equivalence proposition and the German view of Expansionary Fiscal Contraction (EFC). This paper reports empirical evidence on the validity of these explanations by examining the impact of a shock in government taxation upon private consumption, once the effect of the stock market is removed. A vector error-correction model is estimated for the USA, Japan, Germany, France, the UK, Italy and Canada for 1950-1997 and the impulse response functions of a shock in taxation and in expenditure are examined. The responses to an increase in government taxation appear to lend support to the EFC, while the responses to an increase in government expenditure upon consumption suggest that the reaction of private consumption is more in line with the traditional Keynesian approach.