Theoretical Assumptions

Let us discuss some theoretical conditions and the plausibility for debt neutrality. The debt neutrality proposition requires a number of key assumptions about the economic environment and the behavior of economic agents. These assumptions include (1) perfect capital markets with no borrowing constraints on consumers; (2) non-distortionary taxes; (3) full certainty about the path of future taxes, government budget policies, and earnings; and (4) an equal planning horizon for private and public sectors. Ricardian neutrality needs (1)-(3), while Barro’s neutrality needs (1)-(4). We now discuss each of these assumptions.

Perfect Capital Market

The debt neutrality theorem presupposes that a household optimizes consumption/ saving decisions based on present value budget constraint. This formulation is valid in a perfect capital market because the rational consumer may save and/or borrow at the same rate of interest. In reality, it may be difficult to borrow based on future income, or borrowing may require a high rate of interest. If so, the agent cannot optimize based on present value budget constraint. In such conditions of liquidity constraint, the debt neutrality theorem is not maintained.

There is substantial evidence that at least a modest fraction of the population is liquidity constrained at a given point in time. Liquidity constraints raise the marginal propensity to consume out of temporary tax changes to a large multiple of the small amount predicted under perfect capital markets. Altig and Davis (1989) showed that borrowing constraints imply the non-neutrality of government debt irrespective of whether the transfer motive is in use. However, Hayashi (1987) provided examples from the literature on imperfect capital markets in which debt neutrality holds despite the existence of borrowing constraints. His examples suggest that it is important to identify how the exact nature of imperfections in loan markets is identified.

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