How Rival Are the Ricardian Equivalence Proposition and the Fiscal Policy Potency View?

Substitution of debt for taxes as a means of financing a given path of government expenditure would, according to the Ricardian equivalence proposition, have no important real consequences; yet it could, according to the traditional Keynesian view, have desirable countercyclical and growth effects. A reconciliation of these opposing views is not impossible if the author illuminates a source of deviation from the equivalence theorem, which has not been explored so far: the possibility that consumption decisions in each country are affected by the level of its indebtedness, when private agents operate under a debt illusion. The paper finds, within an explicit intertemporal optimization framework, strong empirical support for the debt-illusion hypothesis in a large sample of 52 countries.