Testing the Ricardian equivalence theorem in the framework of the permanent income hypothesis

According to Ricardian Equivalence Theorem (RET), today's consumption decisions would be independent of some fiscal variables such as lump sum taxes, government debt outstanding or the budget deficit given that government expenditures are fixed. The Permanent Income Hypothesis (PIH) consumption function also implies that change in consumption cannot be forecast by the change in lag(s) of any variable including the change in those fiscal variables. Thus, the test of RET is a nested test of the PIH. After unit root tests and cointegration tests were conducted, the test of the RET were run by using a system in which coefficients of consumption, income, taxes and debt variables were determined in two steps. Among twenty countries that were chosen based on data availability, the result of this paper is that the RET holds in all countries and that the PIH holds in majority of the countries. The failure of the PIH occurs in developing countries.