Private Consumption, Government Spending, Debt Neutrality: Resolving Kormendi-Feldstein- Modigliani Controversy

The debt neutrality hypothesis, in its quintessential form,postulates that debt/tax mix for fmancing deficit is irrelevant. Moreprecisely, the debt-neutrality deals with the two fundamental questions:(i) Given the volume and composition of government expenditures, does itmatter whether they are fmanced by taxes or debt issue? (ii) Do publicdeficits absorb private savings that otherwise fmance private capitalformation? Juxtaposed to the traditional Keynesian theory which answersthese questions positively, the exponents of debt-neutrality make thecounter-claim that debt is neutral and public deficits have no "crowdingout" effects on private saving or investment. The debt-neutrality ispopularly termed as the Ricardian Equivalence Hypothesis because thefundamental logic underlying this hypothesis was originally presented byDavid Ricardo in Chapter XVII entitled "Taxes on Other Commodities thanRaw Produce" of his celebrated "The Principles of Political Economy andTaxation". Although Ricardo explained why government borrowing and taxescould be equivalent, he never sponsored the case for unlimited issue ofgovernment bonds. In fact, he warned against the consequences ofcontinuous fiscal deficits in the following words: "Form what I havesaid, it must not be inferred that I consider the system of borrowing asthe best calculated to defray the extraordinaryexpenses