Testing Ricardian Equivalence Theory in Brazil and US 1985-2004

Roberto Nepomuceno Bento
Graduate Student
Northern Illinois University Economics Department
Master´s Dissertation
Testing the Ricardian Equivalence Theory: A Parallel
between Brazil and the US, 1985 to 2004
by

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Introduction
Since the Great Depression of the 1930’s, the public sector has taken an important
share of the determination of aggregate demand within the economy. With this newly
found government responsibility originated a macroeconomic theory and policy dispute
of whether fiscal policy affects income. This discussion heated up during the 1980’s and
1990’s, when countries such as Brazil and the United States ran budget deficits and
budget surpluses in different years and for distinct reasons.
From the mid 1980’s until today the Brazilian government attempted several
different economic policies to promote steady economic growth and tame hyperinflation.
Since the end of the Military Dictatorship in 1984, Brazil has switched currencies 5
different times. In 1986, the government decreed price freezes and wage increases that
created a massive shortage of goods and services. In 1987, Brazil cancelled the price
freezes and suspended payment of the interest rates on the external debt. The
government tried price freezes again in 1988 and 1989, those times coupled with
devaluation of the currency and decreases in government spending. In 1990, the
government adopted the system of floating exchange rates, together with more
government spending reduction, and the reduction of state intervention in the economy.
In 1992, Brazil shifted its focus to fighting off government deficit. During all this time,
Brazilian economic policies failed miserably and the economy experience hyperinflation
combined with slow economic growth. The country’s fortunes began to change in 1994
with the implementation of the Real Plan. This plan consisted of the last currency change

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to this date and came with some much needed microeconomic reforms that enabled the
maintenance of low inflation rates. In 1998 this plan suffered a major challenge during
the Asian Crisis and the government was forced to take measures to peg inflation,
devaluate the currency, increase government revenue and decrease government spending.
In 2002, the newly elected president chose to maintain the previous administration’s
policies, which included flexible exchange rates, pegging inflation, and primary surplus
of the government account. These policies are still in effect. The effects of these
uncoordinated macroeconomic policies on the real deficit can be seen in figure 1 below:
Figure 1 - Real Surplus Over Time in Brazil
-200
-150
-100
-50
0
50
100
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Year
RealSurplus(inMillionsofR$)
The United States’ economy has had a much calmer—but, nonetheless
controversial—experience than Brazil during the same period. Coming out of the 1981
recession and experiencing a huge budget deficit, the Reagan administration tried to fix
the economy’s problems by using “supply-side economics.” Both inflation and

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unemployment were contained. After George H. W. Bush took office the economy got
worse once again. Inflation accelerated, Congress passed a tax increase, oil prices went
up again due to the Persian Gulf War, and the economy went into a recession again in
1991. During Clinton’s administration, strong economic growth turned the huge federal
budget deficit into a large surplus. The economy also improved dramatically during
Clinton’s first term: business perked up, unemployment fell, and inflation was contained.
During Clinton’s second term economic growth accelerated, which helped inflation fall
below 2% and unemployment fall to its lowest level since 1970. These great results were
due to globalization, and advances in computer and information technology. In 2000 the
economy slowed down. By 2001, the George W. Bush administration experienced the
first recession in ten years (when Bush’s father was in office). The economy came out of
the recession with a well-timed tax cut and increased spending due to the war on
terrorism. A weak economy has always been an issue during George W. Bush’s
administration. The reaction of the real budget deficit to these macroeconomic policy
changes can be seen below:

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Figure 2 - Real Surplus Over Time in the U.S.
-5
-4
-3
-2
-1
0
1
2
3
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Year
RealSurplus(inBillionsofUS$)
The causes and consequences of changes in the budget deficit of Brazil and the
United States have fostered much debate. However, the most important dispute has been
over how the funding these budget deficit fluctuations affect consumers. In this front,
two views have been developed to explain such influence. The traditional view, known
as the Keynesian view of fiscal potency, suggests that an increase in government debt is
perceived by private individuals as net wealth. As this argument goes, private
consumption is reduced if government spending is financed by current taxation but is
increased if government spending is funded by debt accumulation through the economy’s
multiplier effect. This positive sensitivity of private sector consumption to government
debt accumulation can have powerful effects to the economy.
Revived by Barro (1974), the alternative to the conventional view is known as the
Ricardian Equivalence Hypothesis. The Ricardian Equivalence Theorem assumes that

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consumers are rational and foresee current debt accumulation as future tax liabilities. In
this case, government debt is not perceived as private sector wealth and, thus, an increase
in government debt accumulation does not affect consumer spending. Consequently, the
choice between funding current government expenditures through taxation or government
borrowing simply represents a transfer of tax collection from the present to the future.
In this paper I use a consumption function that includes fiscal variables to show
that Ricardian Equivalence Hypothesis does not hold in Brazil and the U.S. in the period
of 1985 to 2004. The results suggest that Brazilian consumers do not take into account
government behavior when choosing their preferred level of consumption. The same is
true for American consumers. In addition, one particular result supports the Fiscal
Potency view in the U.S.
This study is divided as follows: Section 2 describes the data used for
econometric estimations; Section 3 reviews the literature available on Ricardian
Equivalence Hypothesis; Section 4 illustrates the theoretical model used in the study; and
Section 5 presents the empirical results. In addition, I provide an appendix with a
synopsis of macroeconomic policies attempted by Brazilian policymakers during the
period in study to give the reader a better idea of Brazil’s economic experience in this
twenty-year period.

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Section 2: Description of Data
2.1 Brazil
The Brazilian data for this study was found at http://www.ipeadata.com.br, which
is the website for the Institute of Applied Economic Research. This research body is
funded by the Brazilian Government to foster economic research. For this study I used
annual data from 1985 to 2004. This time period represents a new era in the democratic
history of Brazil, called “The New Republic.” During the 20 years prior to The New
Republic, Brazil found itself under a military dictatorship. Since the data under a
dictatorship is not completely reliable I chose to start the study the year after the military
dictatorship ended, 1985.
The data used for each variable is described as follows: Ct – final household
consumption; Yt – gross national income; Gt – final government consumption; Tt –
government revenue; DEFt – government budget deficit; and Debtt – government total
debt. I also calculated, based on this data, the variable DIt – disposable income.
Following previous research on Ricardian Equivalence Hypothesis, I transformed the
data to real and per capita terms. Thus, all variables were divided by the price level and
by the population level. Finally, the Brazilian data is represented in millions of Reais
(current Brazilian currency).

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2.2 United States
For this study, I am using the United States economy as a basis of comparison.
Thus, I also study the period from 1985 to 2004 and all the data is in real and per capita
terms. The variables and their descriptions are: Ct – personal consumption expenditures;
Yt – national income; Gt – total government outlays; Tt – total government receipts; DEFt
– government budget deficit; and Debtt – total government debt. I also calculated DIt –
disposable income for the U.S. data.
The data for personal consumption expenditures, national income, price level, and
population level were found in the website http://www.economagic.com, and are all
originated from the U.S. Department of Commerce. The data for total government
outlays, total government receipts, government budget deficit, and total government debt
originated from the U.S. Congressional Budget Office website http://www.cbo.gov.
Finally, the United States data is represented in billions of Dollars.

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Section 3: Review of Literature
The macroeconomic impact of government debt has been an issue of great
concern to economists. Barro (1974) shows that intergenerational links can cause a series
of individuals with finite lifetimes to behave as if they are a household with infinite
horizon and, hence, there is no marginal net-wealth effect of government bonds. Thus, an
increase in government debt does not lead to an increase in private sector wealth because
individuals see this increase in government debt as an increase in future tax liabilities.
Therefore, provided a few assumptions (perfect capital markets, consumers not being
liquidity constrained, same planning horizons for private and public sectors, and taxes not
being distortionary), an increase in government debt does not affect private spending.
This result, known as Ricardian Equivalence Hypothesis (REH) has been widely
discussed in Barro (1989) and Seater (1993).
The most prominent tests of Ricardian Equivalence Hypothesis investigate the
effects of fiscal policy on private consumption and aggregate demand using consumption
functions, in which measures of government deficit or debt are included as regressors.
Based on the interpretation of the coefficients and significance of such variables the
Ricardian view can be supported or denied. Yawitz and Meyer (1976), for example,
using a consumption function that includes a variable representing private sector holdings
of government securities, find evidence against Barro’s theory. Feldstein (1982) also
finds that Ricardian Equivalence is contradicted by the data, using a consumption
function that includes variables representing government spending, debt, tax revenues,
and government transfers to individuals.

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Several studies support Ricardian Equivalence. Kochin (1974), for example,
using a consumption function that includes a variable representing the current deficit,
finds evidence that supports Barro’s theory. Tanner (1979) also supports REH, as he
estimates a consumption function that includes an approximation of future disposable
income, other forms of accrued income, and federal government debt outstanding.
Kormendi (1983) uses a standard and a consolidated approach to a consumption function
with fiscal variables to concur with the Ricardian view. Seater and Mariano (1985) find
support for the RE Hypothesis estimating a consumption function that distinguishes
between permanent and transitory movements in income and governmental expenditures
and includes marginal tax rates and interest rates as explanatory variables. Aschauer
(1985) estimates a consumption function using the method of FIML and his results
maintain Barro’s theory.
The literary war on the Ricardian Equivalence Hypothesis extended itself for
much of the 80’s and early 90’s. Barth et al (1986), Modigliani and Sternling (1986),
Darby et al (1987), Bernheim (1987), Feldstein (1988), Feldstein and Elmendorf (1990),
Kormendi and Meguire (1990), Modigliani and Sterling (1990), Haug (1990), Bomberger
(1990), and Bailey (1993) were all main players in this academic disagreement.
Interestingly, these articles have one aspect in common, which is the use of U.S. data for
econometric estimations.
Still, the Ricardian Equivalence Hypothesis has been studied continuously using
data from other countries. Leiderman and Razin (1986), for example, find evidence
opposing the REH using data from Israel, and Reid (1989) finds evidence against REH
using Canadian data. Dalamagas (1992) finds that consumers living in countries with

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low debt-GDP ratios suffer from debt illusion, while individuals in countries with high
debt-GDP ratios are fully aware of the future tax implications of debt financing. Evans
(1993), on the other hand, rejects Ricardian Equivalence using data from nineteen
countries. Moreover, Bagliano (1994) uses UK data to reject REH, Ghatak and Ghatak
(1996) invalidate the RE Hypothesis in India and Khalid (1996) raises doubts on the
validity of REH for developing countries.
Additionally, Issler and Lima (1997, 2000) find evidence supporting REH using
data from Brazil, at the same time as Lopez et al (2000) reject the REH using a large set
of data including both industrial and developing countries. Moreover, Drakos (2001)
finds partial Ricardian Equivalence in Greece, Metin Ozcan et al (2003) show that REH
does not hold strictly in Turkey, and Hsing (2004) finds that REH is applicable to
Slovenia.

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Section 4: Theoretical Approach
4.1 Theoretical Model
Following the example of several prominent economists that produced over 30
years worth of literature on the Ricardian Equivalence Hypothesis, this study will also
use a consumption function for my econometric estimations. Hence, to be able to analyze
the effects of public decisions on the behavior of the private sector I must build a private
expenditures model with consumption as the dependent variable that includes fiscal
variables as explanation variables.
According to the Permanent Income Hypothesis1
(PIH), consumption is a constant
fraction of permanent income. Hence, we start with the following equation:
(a)
As Kormendi (1983) suggests, permanent income can be broken down into a
permanent component and stock of wealth. Therefore, equation (a) becomes:
(b)
1
Hall, Robert E., “Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and
Evidence,” Journal of Political Economy, December 1978, 86, 971-87.
C = δ0 + δ1Y
where: C = current consumption
Y = permanent income
C = δ0 + δ1Y + δ2W
W = stock of wealth

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To test the REH we must include in equation (b) fiscal variables that can describe
the effect of fiscal policy on private consumption. First, I will test an extreme case of
Ricardian Equivalence, which suggests that an increase in government expenditures does
not promote a rise in consumption and that the public debt does not represent net wealth.
Thus consumption becomes a function of income, wealth, and negative government
spending, suggesting that changes in government expenditures should be offset by other
variables, such that consumption remains unchanged. A variable for public debt is also
added as an additional test. Hence, equation (b) becomes:
(c)
To derive two more tests of Ricardian Equivalence I will include government
receipts to equation (c) and perform some algebraic manipulations2
.
First, add and subtract tax revenues from the right side:
C = Y + W – G + Debt + T – T
Then, rewrite the equation as:
C = Y + W – G + T + Debt – T
Factoring out the negative sign from the government spending and tax revenue, yields:
2
For the sake of simplicity I removed the coefficients from the variables throughout the algebra
manipulations. Once these manipulations are done I will add coefficients to the three models I will derive,
using different Greek letters for each models to help the reader distinguish between the three.
C = δ0 + δ1Y + δ2W – δ3G + δ4Debt
W = stock of wealth
G = government expenditures
Debt = public debt

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C = Y + W – (G – T) + Debt – T
Since the budget deficit is, by definition, (G – T):
C = Y + W – Deficit + Debt – T (d)
Equation (d) will be the second model used. To arrive at the third model equation (d)
must be taken a couple of steps further.
Now, I will rewrite equation (d) as:
C = Y – T + W – Deficit + Debt
Since disposable income is, by definition, (Y – T):
C = DI + W – Deficit + Debt (e)
Equation (e) will be the third model used.
4.2 Econometric Implications
The first model I estimate is equation (c), which looks like the following:
Ct = α0 + α1Yt + α2Wt + α3Gt + α4Debtt (f)
To find support for REH in equation (f) the results must show that α3 = - α1, which
means that a one dollar increase in government expenditures creates a one dollar
reduction in private consumption. In addition, we must find that α4 < 0, meaning that
individuals decrease consumption when the government increases its debt.
The second model I estimate is equation (d), which looks like the following:

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Ct = β0 + β1Yt + β2Wt + β3Deficitt + β4Debtt + β5Tt (g)
To find support for REH in equation (g) the results must show that β3 = - β5. This
restriction addresses the important idea of REH that a reduction in taxes that is financed
by an increase in government deficit does not affect private consumption because
individuals do not perceive such reduction as net wealth. Once again we still need the
coefficient in the debt variable to be negative, or β4 < 0.
The third and last model I estimate is equation (e), which looks like the
following3
:
Ct = γ0 + γ1DIt + γ2Wt + γ3Deficitt + γ4Debtt (h)
To find support for REH in equation (h) the results must show that γ3 = - γ1, which
indicates that the government does not affect income by running a deficit and a one dollar
increase in deficit will be offset by a one dollar reduction in private consumption. This is
the case because consumers are indifferent whether a government budget deficit is
financed by tax increases or issue of public debt since individuals perceive today’s deficit
finance as future tax liabilities. In addition, we still look for the debt variable to be
negative, or γ4 < 0.
Finally, in order for these estimations to be correct and the Permanent Income
Hypothesis to hold we must find the coefficient of the constant term to be positive and
3
Feldstein (1982) uses national income to be able to compare his results with earlier studies. In addition,
he estimates disposable income as well, which he believes to be the correct specification for the
consumption expenditures model.

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the coefficient of the income variable to be between 0 and 1. This implies that we must
find: α0 > 0, β0 > 0, γ0 > 0, and 0 < α1 < 0, 0 < β1 < 0, 0 < γ1 < 0. Given the restrictions
just illustrated, we are ready to estimate equations (f), (g), and (h). This estimation will
be done using ordinary least squares estimation4
, which implicitly assumes that the fiscal
variables are exogenous.
4
I have chosen to use OLS estimation in this paper because of the short number of observations in the
period of study. Thus, I did not ignore the existence of specific econometric tools for Time Series analysis,
such as unit root tests and cointegration analysis. Instead, I simply acknowledge that those tools would not
be much help in a data set of only 20 observations.

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Section 5: Empirical Results
5.1 Empirical Results for Brazil
Due to the economic experiences that Brazil went through during the period in
study, and especially during the 1980’s, I had to carefully analyze the data. Since Brazil
went through a series of macroeconomic policy changes5
, I was particularly interested in
examining if any of these policy changes affected the relationship between real
consumption and real income, which is the base of the model for this study. Thus, I
plotted real consumption against real income, shown below:
Figure 3 - Real Consumption vs. Real Income in Brazil
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2000.00
4000.00
6000.00
8000.00
10000.00
12000.00
14000.00
16000.00
18000.00
20000.00
0.00 5000.00 10000.00 15000.00 20000.00 25000.00 30000.00 35000.00 40000.00 45000.00 50000.00
Real Income (in Millions of R$)
RealConsumption(inMillionsofR$)
5
Refer to the Appendix A for a full description of these policy changes.

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The graph yields an expected upward sloping straight line. However, two points appear
troublesome. The first point, which represents the year 1986, lies completely away from
the otherwise straight line. This point lies in such a way that real income seems to be
extremely high. The second point, which represents the year 1987, lies within the
straight line, but much further apart from the other points, suggesting that consumption is
exceedingly high. Given these findings, I decided to plot real income and real
consumption over time to see how the series behave, shown below:
Figure 4 - Real Consumption Over Time in Brazil
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4000.00
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8000.00
10000.00
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1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Year
RealConsumption(inMillionsofR$)

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Figure 5 - Real Income Over Time in Brazil
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5000.00
10000.00
15000.00
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25000.00
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35000.00
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45000.00
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1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Year
RealIncome(inMillionsofR$)
By analyzing the two graphs above we see that real consumption shot up in 1987
and real income shot up in 1986. Furthermore, we can suggest that between the years of
1986, 1987, and possibly 1988, there is a lag between consumption and income. After
1988 this lag disappears and real consumption follows real income consistently. The
behavior in these series is expected because in 1986 the Brazilian government
implemented the Cruzado Plan that, among other things, decreed a complete freeze of all
prices, fares, and services for a year and wage increases for workers in general and for the
minimum wage. The price-freeze and wage increase created an exaggerated wave of
consumption in that year and created a shortage of goods and services in the economy. In
this case, despite the fact individuals had income in their hands, goods and services were
not available to be consumed in 1986. Towards the end of the year the government

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cancelled the price freeze, which eliminated the shortage and enable private consumption
to resume.
These conditions will alter the econometric model that I estimate. In order to
account for these discrepancies in the relationship between real consumption and real
income, I will add dummy variables for both years, which I will call D1986 and D1987.
Given the nature of the issue, I expect the circumstances of year 1986 to shift
consumption down and those of year 1987 to shift consumption up. Another change
made to the models estimated is the omission of the variable that represents stock of
wealth (Wt). Besides the lack of a good measure of wealth for Brazil and, thus, the
statistical insignificance of this variable in preliminary calculations, I will also argue that
this variable has a much diminished value in Brazil. This argument is based on two facts:
first, Brazil has an estimated 53 million people living below the poverty line (2002)6
and,
second, the country has averaged a Gini Coefficient7
of close to 0.60 throughout the
period of this study. These facts suggest that not only is wealth a negligible component
of individuals’ permanent incomes, it is also highly concentrated in the hands of a
minority of the population.
Given these changes to our models, results follow in the table below:
6
These figures originated from the Brazilian Institute of Economic Research website
www.ipeadata.com.br.
7
The Gini Coefficient measures the degree of inequality that exists in the distribution of income of
individuals in an economy. Its value varies from 0, when there is no inequality, to 1, when inequality
reaches its maximum. Brazil ranks in the top ten countries with highest income inequality in the world.

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Results for testing Ricardian Equivalence in Brazil, 1985-20048
Variables/Models (1) (2) (3)
Constant 5.674638E-7 (0.65) 7.599161E-7 (0.89) 0.00000492 (5.94)
D1986 - 0.00016951 (- 50.20) - 0.00016704 (- 44.95) - 0.00015943 (- 25.19)
D1987 0.00000973 (4.94) 0.00001162 (5.00) 0.00001456 (3.53)
Income 0.57853 (53.18) 0.56500 (39.47)
Disposable Income 0.53663 (21.91)
Government 0.10870 (0.95)
Debt - 0.00123 (- 0.17) - 0.00067283 (- 0.09) - 0.02189 (- 1.96)
Deficit - 1.86095 (- 1.47) - 2.34082 (- 1.02)
Taxes 0.09801 (0.89)
Adj. R-Squared 0.9986 0.9987 0.9957
F-Value 2761.95 2456.51 886.95
DWS 1.132 1.556 1.215
The results confirm my predictions about the dummy variables: there, indeed, was
a downward shift in real consumption in Brazil in 1986 and an upward shift in real
consumption in 1987. The negative coefficient of the dummy variable D1986 and its
high statistical significance in all of the models suggests that the macroeconomic policies
implemented in that year, indeed, affected the relationship between real consumption and
real income negatively. We can also conclude that an upward shift in real consumption
in 1987 has been sustained, given that the dummy variable D1987 has a positive
8
The values in parenthesis represent the t-values associated with each variable.

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coefficient and is highly significant in all of the models. This implies that the relaxation
of the price freezes in Brazil at the end of 1986 produced a boost in real consumption in
1987.
It is also important to note that in all three models the assumptions made about
the Permanent Income Hypothesis hold. That is, the coefficient of the constant term is
positive and the coefficients of the income variables fall between 0 and 1. As expected
the income variable is highly significant, since it is the variable that best explains
individual consumption. Conversely, the constant term is not statistically significant in
two out of the three models estimated. This is not a problem, however, because in a
multiple regression model the constant represents the value that would be predicted for
the dependent variable if all the independent variables were simultaneously equal to zero.
Since we are not particularly interested in such case, we can normally leave the constant
in the model regardless of its statistical insignificance. These outcomes suggest that I
have correctly modeled the relationship between real consumption and real income and
that I am ready to discuss the main issue of this study, which is how the public sector
affects private sector consumption9
.
In the previous section we suggested that an extreme case of the REH would be
supported by equation (f) if the coefficient of income is equal to the negative of the
coefficient of government expenditures, implying that an increase in government
spending is offset by a decrease in private consumption. In the results for equation (f),
9
The Durbin-Watson Statistics in the three models for Brazil lie in the undetermined area, meaning that the
presence of autocorrelation is a possibility. In the case of Brazil I chose to ignore this shortcoming because
the presence of the dummy variables for 1986 and 1987 are very important to the real consumption/real
income relationship. Trying to deal with this problem (such as by first differencing the models) would
seriously decrease the degrees of freedom of the models and decrease the accuracy of the results. Feldstein
(1982) reports results in which DWS’s are also in the undetermined region.

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we can see that this restriction does not hold because the government expenditure
variable is statistically insignificant. This means that consumers did not take government
spending in consideration when deciding their optimal level of consumption, which poses
a contradiction to REH. Furthermore, we proposed that REH could also be supported in
equation (f) if the coefficient of the debt variable is less than zero, implying that
consumers curtail consumption when public debt goes up. This outcome of REH is also
contradicted by the results, since the public debt variable is not statistically significant.
For equation (g) we proposed that REH would be confirmed if the coefficient of
deficit is equal to the negative of the coefficient of tax revenues, which means that
individuals do not perceive a deficit-financed tax cut as net wealth. Our results, however,
contradict this restriction because the coefficients for both tax revenues and government
deficit are statistically insignificant. This suggests that, unlike REH maintains,
government budgetary decisions did not affect individuals’ consumption decisions during
the period in study. Additionally, the results on equation (g) once again oppose the
restriction that the coefficient of debt is less than zero. Thus, consumption is negatively
affected by public debt, given that the coefficient of the public debt variable is not
significant.
For equation (h) we put forward that REH would be validated if the coefficient of
deficit is equal to the negative of the coefficient of disposable income, implying that
consumers perceive today’s deficit finance as future tax liabilities and, therefore, are
indifferent between a deficit being financed by an increase in taxes or an increase in the
public debt. The statistical insignificance of the deficit variable results in a disagreement
with this behavior. Once more we invalidate the assumption that private consumption is

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decreased by an increase in public debt (that the coefficient of debt is less than zero) due
to the statistical insignificance of the debt variable.
The results presented above clearly reject Ricardian Equivalence Hypothesis in
the case of Brazil. From this we conclude that individuals seem to not take account of the
future tax liabilities implied by current deficit spending. We can conclude, then, that
individual consumers could not respond to the fiscal decisions of the Brazilian
government when making their consumption decisions. The macroeconomic context that
prevailed during the period in study removed individuals’ ability to form expectations.
Consumers, therefore, based their consumption on their current incomes.
5.2 Empirical Results for the United States
Unlike Brazil’s case, the United States data has behaved in a very consistent way
during the period in study. Preliminary estimations, however, revealed the presence of
autocorrelation based on Durbin-Watson Statistics that were significantly far from 2.0.
Since the presence of autocorrelation can bias the results, this problem had to be
addressed. Therefore, I chose to model the first difference of the variables in this study.
I also gave attention to the presence of multicollinearity created by the addition of
the wealth variable to the model. I had to address this issue because multicollinearity
decreases the precision of the parameter estimates. Since the presence of the stock of
wealth variable is not central to this study I chose to drop it throughout estimations and,
instead, enjoy the extra degree of freedom created by this action.
Given these changes, the results follow in the table below:

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Results for testing Ricardian Equivalence in the United States, 1985 - 200410
Variables/Models (1) (2) (3)
Constant 3.05308E-9 (5.70) 3.055019E-9 (5.61) 3.204622E-9 (6.65)
Income 0.41271 (6.72) 0.45555 (5.24)
Disposable Income 0.47200 (5.80)
Government 0.10230 (0.39)
Debt - 0.06640 (-1.56) - 0.07165 (-1.63) - 0.07323 (- 1.71)
Deficit 0.04957 (0.15) 0.26161 (3.47)
Taxes - 0.17488 (- 0.37)
Adj. R-Square 0.7568 0.7484 0.7583
F-Value 19.67 14.39 19.83
DWS 1.901 1.946 2.009
The results above confirm correct estimation of the Permanent Income
Hypothesis. The coefficient of the constant term is positive, the coefficients of the
income variables fall between 0 and 1, and they are all statistically significant. We can
also conclude from the Durbin-Watson Statistics that using first difference was, indeed,
the correct specification for the model, since the DWS’s of all models are extremely close
to 2.0. We are now ready to analyze the implications for REH, as it was done for Brazil
in the previous sub-section.
10
The values in parenthesis represent the t-values associated with each variable. In addition, the
estimations for the United States presented in this table were done in first difference in order to address the
issue of autocorrelation.

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The restrictions that support REH for equation (f), namely that the coefficient of
government must be equal to negative the coefficient of income and that the coefficient
of debt must be less than zero, do not hold true. This can be concluded from the
statistical insignificance of the coefficient for the government spending and public debt
variables. In the case of equation (g), the restrictions that the coefficient of deficit must
be equal to negative the coefficient of tax revenues and that the coefficient of debt must
be less than zero, do not hold as well due to statistical insignificance of the coefficients
for budget deficit, tax revenue, and public debt. Finally, the restrictions corresponding to
equation (h), namely that the coefficient of deficit is equal to the negative of the
coefficient of disposable income and that the coefficient of debt must be less than zero,
also fail due to statistical insignificance of the coefficients for the budget deficit and
public debt variables.
These results clearly reject Ricardian Equivalence Hypothesis for the United
States during the period in study, confirming the findings on Brazil. Thus, we can also
conclude that American consumers suffer from debt illusion and do not take into account
the future tax liabilities implied by an expansion of government deficit. In the case for
the U.S., this conclusion is even stronger if we consider that the coefficient for the budget
deficit variable in equation (h) is statistically significant on 10% level. Interpreting this
parameter we conclude that, given this level of confidence, a dollar increase in the budget
deficit encourages a $0.26 increase in private consumption. This conclusion gives
support to the Fiscal Potency view that private consumption responds positively to deficit
spending, which is a strong contradiction to Ricardian Equivalence Hypothesis.

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Conclusion
In this paper I used a consumer expenditures function that included fiscal
variables to provide evidence against Ricardian Equivalence Hypothesis in Brazil and in
the United States from 1985 to 2004. Three models that included a few distinct tests of
REH were estimated by OLS using real per capita data. The results were based on the
statistical insignificance of the fiscal variables, which suggests that Brazilian and
American consumers did not take public sector behavior in consideration when deciding
their optimal level of consumption for the period in study. Furthermore, one model for
the United States provided evidence supporting the Fiscal Potency view on a 10% level.
I believe distinct reasons lead the results to be the same in both countries. In
Brazil, the inexistence of a well-defined macroeconomic-policy plan stripped consumers
of any ability to form expectations and react to government performance. Thus, instead
of taking fiscal behavior into consideration when making consumption decisions,
Brazilian consumers relied solely in the amount of current income available to them.
Alternatively, American consumers may suffer from debt illusion because they are unable
to perceive the future tax implications of a current expansion in the public debt. This
could be the case because the United States’ debt as a share of GDP is low, making the
U.S. a highly solvent country. American consumers may take advantage of this property
of the U.S. economy to increase their current consumption at the cost of a higher, but
easily payable, public debt.

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Appendix: A Macroeconomic Synopsis of Brazil, 1985 – 2004
After living 20 years under a Military Dictatorship, the Brazilian people had their
hopes high with the beginning of the New Republic.
Sarney Administration (1985 to 1990)
When Jose Sarney took over, the country was stuck in a vicious financial cycle.
That is, entrepreneurs preferred to invest their profits in financial markets, rather than
back in production. This created a lack of investments that only worsened the country’s
producing capability. In order to fight off inflation, promote better income distribution,
and restart to expand economically, the Sarney administration created the Cruzado Plan.
The price-freeze and the wage increase created an exaggerated wave of consumption:
savings accounts were emptied out, while sales reached a maximum. Consequently,
The Cruzado Plan (February of 1986)
Implemented on February 28, 1986, the Cruzado Plan adopted the following measures:
1. Switch of currencies from Cruzeiro (Cr$) to Cruzado (Cz$). The government mainly cut
three zeros off of the old currency, using the following proportion: 1 Cruzado is equal to
1,000 Cruzeiros [Cz$1.00 = Cr$1,000.00];
2. Complete freeze of all prices, fares, services, and wages for a year;
3. A wage increase of 8% for workers in general and 15% for the minimum-wage, in
addition to future readjustments that would be made automatically (wage trigger) every
time inflation added up to 20%, and;
4. Extinction of the monetary correction. From this point on, wages and investments were
no longer corrected by the inflation rate of the previous month.

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companies increased working hours and labor, and enlarged their production capacity.
The capital invested in financial markets was transferred to the stock market. It was the
beginning of the much-waited economic growth after a major recession.
Four months later, however, the Cruzado Plan started to fail. Many products
disappeared from the market, as the industry could not keep up with demand.
Entrepreneurs complained they were taken by surprise and that their prices were out of
line. Many products were reintroduced with different packaging to justify price
increases. In order to readjust the economy the government launched the Cruzado II
Plan, which basically cancelled the price freeze and restored monetary correction. The
government also suspended payment of the interest rates related to the external debt to
avoid sending billions of dollars abroad every year. These measures, however, did not
work: prices went up, people’s purchasing power decreased, sales plummeted and many
companies, especially small and of medium size, broke.
The government tried again, this time with the Bresser Plan. This plan decreed: a
90-day freeze on prices, wages, and rents; the extinction of the wage trigger; the creation
of a mechanism to adjust prices and salaries every 3 months based on the average
inflation of the previous 3 months; a small devaluation of the Cruzado in relation to the
dollar; and a decrease in government spending. These measures did not work either, as
the country continued to experience slow growth with high inflation.
The government tried a fourth time, launching a new plan on January 15th
, 1989.
The Summer Plan included measures such as: a new price and wage freeze; the
substitution of the Cruzado (Cz$) for the New Cruzado (NCz$), cutting three zeros off of
the old currency and using the proportion 1 New Cruzado is equal to 1,000 Cruzados

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[NCz$1.00 = Cz$1,000.00]; the extinction of monetary correction and creation of a new
mechanism for monthly wage adjustment, based on the inflation of the previous month;
and the increase in interest rates to inhibit consumption and the formation of inventory.
This plan also failed, as abusive price readjustments helped inflation skyrocket. Investors
changed all their funds into financial assets such as gold, dollars, and overnights, while
prices started being announced in dollars. The increasing fear of hyperinflation made
1989 a year of economic terror.
Collor Administration (1990 to 1992)
The expectations towards the newly elected administration were very high. By
the new president’s request, the country decreed a holiday for banks, closing them for
two days. With closed banks, President Fernando Collor de Mello announced his plan to
eliminate inflation.
The Brazil Plan or the Collor I Plan (March of 1990)
The Collor I Plan was composed of several measures, which included:
1. The return of Cruzeiro (Cr$) as national currency without change in value;
2. Blockage for 18 months of all bank accounts above NCz$50,000.00;
3. Partial freeze of prices and wages;
4. Opening of the economy to foreign investments and gradual reduction of taxes on imports;
5. Adoption of floating exchange rates;
6. Increase in taxes and tariffs and creation of a tax over financial transactions;
7. Administrative reform and reduction of government spending;
8. Creation of a program to privatize state-owned companies, and;
9. Reduction to a minimum of state intervention in the economy.

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The blockage of all accounts shocked the economy. Technically, the country was
leveled: everyone who had money in banks could only use NCz$50,000.00. The price
and wage freezes, however, loosened as soon as May came. Employers and employees
were allowed to negotiate contracts, but the wage trigger was prohibited. Inflation
seemed under control, but recession was a threat to society again due to strikes, reduction
of working hours, and dismissals. Besides, the government could not reduce spending,
which contributed to the poor performance of the economy.
In an attempt to improve the economy, the government launched the Collor II
Plan, which ended operations “overnight”, increased the tax over financial transactions
and of public fares, instituted price and wage freezes, and reduced taxes on imports. The
new plan did not produce significant results. Despite a fall in inflation, unemployment
increased, companies went bankrupt, and industrial production, as well as economic
activity and profits, decreased. Besides his failure with the economy, President Collor
was found in the midst of a big corruption system involving his close advisor, his
secretary, and a few other politicians. In a process that took more than a year, Collor was
impeached and Itamar Franco, the vice-president, took over the Presidency.
Franco Administration (1992 to 1995)
Fighting off government deficit was the objective of the Franco administration.
Several measures were adopted to meet this objective, including policies to combat tax
evasions and contract defaults, the expansion of privatization of state-owned companies,
cut in costs throughout government, and salary cutbacks. In December of 1993 Fernando
Henrique Cardoso, Minister of the Treasure Department, sent to Congress a group of

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economic, financial, and fiscal measures to prepare the economy for the implementation
of the Real Plan in the following year.
The effects of the Real Plan were immediately felt: the inflation rate plummeted,
the commerce attracted buyers by accepting pre-dated checks and credit cards, and the
freeze of public fares (electricity, telephone, and mail), fuel, and important food items
decreased the cost of living of those with lower income. There was an explosion in
consumption and the ease of importing brought into the country many foreign products
such as cars, appliances, food items, and some luxuries. The evaluation of the Real Plan
after its first year was positive and the population supported the plan. This public
The Real Plan (July of 1994)
Contrary to the previous economic plans, the Real Plan was not a package of measures to
shock the economy in a day. The plan was preceded by stages of preparation, which gave the economy
the possibility to accommodate and the government the chance to balance its accounts. In this sense,
the Real Plan introduced the following measures:
1. Creation of a Social Fund of Emergency (FSE), which keeps 15% of the revenue from all
taxes and federal contributions. With this mechanism, the government was able to
guarantee resources without the need to emit currency;
2. Creation of the Unit of Real Value (URV), a daily index tied to the dollar that began
measuring the present inflation (and no longer the past inflation). The URV was used to
correct federal taxes and public fares;
3. Conversion of all wages to URV using an average of the 4 previous months. In addition,
they could only be readjusted after 12 months.
4. Voluntary conversion of all prices to URV, and;
5. Transformation of URV into national currency, Real (R$), starting July 1st
, 1994.

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sentiment was reflected in the Presidential elections of 1994, in which Fernando
Henrique Cardoso, father of the Real Plan, was elected President of Brazil.
Cardoso Administration (1995 to 2002)
The new administration brought in reforms they considered essential to modernize
the country, stabilize the economy, and resume economic growth. The most important
changes included the breakdown of monopoly over petroleum and telecommunications,
and alteration in the definition of national company, in order to welcome foreign capital.
During this administration Mercosul—a free-trade area between Brazil, Argentina,
Paraguay, and Uruguay—was implemented. The president also gave continuity to the
Real Plan by promoting a few adjustments to the economy, such as increasing interest
rates to cool off internal demand, and the devaluation of the Real to stimulate exports and
adjust the Trade Balance. With the Real Plan and the control over the currency
exchange, the government controlled inflation at very low levels. However, there were
signs of recession, such as a decrease in consumption and massive layoffs, which resulted
in high unemployment in the industrial and agricultural sectors. Also, international
dependency helped increase the external debt.
During the 1998 Asian Crisis, the government tried to save the Real and the
escape of investments by increasing interest rates and by getting help from the IMF. The
country contracted a US$ 40 billion loan and was forced to take measures, such as
pegging inflation, the devaluation of the Real, an increase in government revenue, and a
decrease in government spending, which decreased economic activity. From that point
on, the administration tried different measures to keep inflation low, but that came with

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the price of low economic growth. By 2002 inflation was once again becoming a
problem, mainly due to the result of the Presidential elections in which the government’s
candidate lost to a leftist union leader, member of the Worker’s Party.
Luís Inácio Lula da Silva (2003 to 2006)
The Lula administration is the first to give continuity to policies originated in the
previous administration since the installment of the New Republic. Instead of coming up
with a new economic plan of their own, the Lula administration has kept the main
policies of the Cardoso Administration, including: flexible exchange rates, pegging
inflation, and primary surplus of the government account. This administration’s
objective has been to control inflation, decrease the country’s foreign dependency, and
promote some much-needed microeconomic reforms.
So far, the tight monetary policy has been successful at controlling inflation, but
that has come at the cost of slow economic growth. The central bank has also increased
its holdings of foreign currency to diminish Brazil’s sensitivity to international
fluctuations. Economic growth, however, has occurred mainly due to the excellent
performance of the trade balance, since the soaring taxes and the high rates of interest
have inhibited consumption and investment.

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