Budget deficits and policy ineffectiveness: The Turkish case

Especially after 1980s, budget deficits and domestic debt issues have been one themost important topics on economic agenda. But the effects of these variables on theeconomy are not obvious from either economic theory or results of empirical studies.Because the effects of budget deficits and domestic debt on the economy, changesaccording to the perceptions of the individuals. If the individuals perceive governmentbonds as net wealth, an increase in government debt due to the tax cuts, raisesdisposable income, stimulates aggregate demand, increase interest rates and crowds outprivate sector investments. This result is a product of the Keynesian Theory. RicardianEquivalence Theorem (RET) objects to this result of the Keynesians. According to RET,government bonds are not perceived as net wealth by rational individuals. According toRET, individuals perceive present tax cuts as future tax burden. According to theseindividuals, present tax cut financed by issuing government debt only shifts the timing oftax collection. In this case individuals take the reverse actions suggested by theKeynesian Theory.Knowing which one of these two approaches is valid in an economy is importantbecause of the implications for fiscal policies. The primary purpose of this study is toexamine the validity of RET for Turkey, by employing cointegration techniques. In thisstudy, the validity of RET is firstly tested by estimating a consumption function, becauserejecting the validity of twin deficit hypothesis indicates the validity of RET, the validityof the twin deficit hypothesis is tested by using the quarterly observations covering theperiod 1994:1 to 2005:4.As well as the classical cointegration techniques, the cointegration techniques thattake into consideration the structural breaks, bounds test and ARDL approaches areemployed in the study. The overall findings of the study indicates that RET is not a validtheorem for Turkey. According to this result, budget deficits have unfavorable effects onTurkish Economy.