JIIA VAGHARI Rutgers University

The Private Sector’s Perception of Fiscal Actions*

This study attempts to investigate the households perception of fiscal actions by testing the ultrarationality hypothesis advanced by David and Gadding (1974). A transcendental logarithmic utility Iimction was used to present the households choice. Demand equations for private and public goods were derived directly from utility maximization and were estimated simultaneously. Empirical findings offered no sup- port for the view that households perceive government activities and adjust their behavior accordingly.

1. Introduction In recent years, the government’s role as a stabilizing agent

has been challenged. The controversy over the wisdom of utilizing the federal budget for stabilization purposes is now part of our everyday economic thinking. The controversy encompasses a the- oretical as well as empirical repudiation of the efficacy of fiscal pol- icy.

The crowding-out argument which is embedded in the recent literature is an attempt to explain the ineffectiveness of fiscal policy. It refers to the failure of government spending in stimulating the economic activities because of its displacement effect on private spending. Crowding-out models are categorized into ex-post and ex- ante theories.’ Ex-post crowding out refers to the displacement of private spending by government spending via changes in other sys- tem variables (that is, higher interest rate effects on private spend- ing). Ex-ante crowding out refers to the same effect but via the behavioral adjustments on the part of consumers.

We choose the latter category and investigate the issue by testing the ultrarationality hypothesis advanced by David and Scad- ding (1974). This proposition holds that households internalize any government activity so that government . actions are neutralized.

*I wish to thank an anonymous referee and Arnold H. Raphaelson for their helpful comments.

‘Carlson and Spencer’s article (1975) reviews alternative crowding-out models.

Journal of Macroeconomics, Spring 1987, Vol. 9, No. 2, pp. 287-292 287 Copyright 0 1987 by Louisiana State University Press 0164-0704/87/$1.50

Jilu Vaghari

Section 2 of this paper briefly presents the ultrarationality thesis. In Section 3, the model used for testing the hypothesis is stated. The empirical results and main conclusion are presented in Sections 4 and 5.

2. Households’ Ultrarationality Thesis David and Scadding assumed the ultrarationality of house-

holds-that households view the corporate and the government sec- tors as extensions of themselves. This fundamental behavioral as- sumption was made to explain Denison’s Law, which posits the stability of the gross private saving rate in the United States [Den- ison (1958)]. Under the ultrarationality assumption, households con- sider government spending and saving decisions when making their own budget allocation decisions. David and Scadding hypothesized that households regard tax-financed government expenditures as consumption and debt-financed government expenditures as invest- ment. Therefore, an increase in government taxes would reduce private consumption and an increase in government deficit would displace private investment, dollar for dollar. This argument implies that fiscal policy is rendered ineffective for stabilization purposes. Since the acceptance of David and Scadding’s view depends largely on its empirical validity, we will develop a model in the next sec- tion for testing their thesis.

3. A Model of Household Behavior A household utility model can provide valuable insights into

the thesis. David and Scadding’s proposition (1974, p. 241) assumes correspondence between public investment and deficits and be- tween government consumption and government taxes: “The pri- vate sector regards tax-financed government expenditures as be- longing to the category of consumption and bond-financed public outlays as investment.” Accordingly, to test for ultrarationality of households, either budget deficit or government investment could be used to represent future public goods in the households utility function. However, it is important to avoid the negative values of taxes or the implied need to support interest on (if not the ultimate repayment of) government deficits. To accomplish this, we use a measure of government investment as a proxy for government def- icits. For consistency in the utility function, we use government consumption goods as a proxy for tax-financed spending. We feel

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that these substitutions are supported by households’ perceptions of deficit instruments as investment and tax-financed expenditures as consumption.

We assume that all consumption, investment and saving de- cisions are made ultimately by households and use the following aggregate inter-temporal utility function:

In V = In V(X1, X,, X3, X,) (1)

where X1 and XZ are private consumption and investment goods and X3 and X4 are government consumption and investment goods, re- spectively.

The above four-commodity direct translog utility function has been introduced by Christensen, Jorgenson, and Lau (1975). Their approach is to represent the utility function by functions that are quadratic in the logarithms of the quantities consumed. The re- sulting utility functions provide a local second-order approximation to any utility function. This form of utility function provides us with demand equations that are directly derived from utility maximiza- tion conditions. Moreover, it permits a greater variety of substitu- tion patterns among commodities.

Christensen, Jorgenson, and Lau approximate the utility func- tion as presented by Equation (1) in the following form:

-In V = a0 + z ai In Xi + l/2 2 2 b, In Xi In X, t 1 f

(i,j = 1, . . . ) 4). (2)

Households maximize utility, subject to the aggregate budget con- straint of

M = x P,X, (i = 1, . . . , 4)) (3)

where M is the total GNP net of foreign sector income and Pi’s are the implicit GNP deflators of each commodity. The maximization of the utility function with the budget constraint and the imposition of the restrictions derived from utility maximization, as suggested

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by Christensen, Jorgenson, and Lau, give us the following four share equations, known as the indirect demand system.’

vi= aj + Cbji In Xi

I (i = 1, . . . ,4) M aM + z&ilnXi (j= 1,. . . ,4).

4. Estimates and Empirical Results In estimating the model, we imposed the summability, equal-

ity, and symmetry restrictions on parameters, as suggested by Christensen, Jorgenson, and Lau:

a M=Zai= -1 (i = 1 , . . . , 4) ; (5)

b,i = Cb/ci I

(k = 1 ) . . . , 4) ;

b, = bji (i #j;i,j= 1, . . . ,4). (7)

Consequently, only three equations are needed to be estimated, and the parameters of the fourth budget share can be derived from Equations (5), (6), and (7). We have chosen the first three equations (private consumption, private investment, and government con- sumption expenditure shares) for estimation.

Time series (1947-1982) data for private consumption expen- ditures (Xi) and for private investment expenditures (X,) were col- lected from national income and product accounts (NIPA). For gov- ernment (federal, state and local) investments (X4), we used NIPA and Bureau of Economic Analysis (BEA) data. Government con- sumption expenditures (X3, were derived by deducting government investment expenditures from total government expenditures, as re- ported in NIPA.

We estimated the model by employing an iterative version of the three-stage least squares estimator. This estimator is asymptot- ically equivalent to the maximum likelihood estimator [see Chris- tensen and Jorgenson (1973), p. 391. Thus, the estimates of the pa-

‘Since the model is developed in detail in Christensen, Jorgenson, and Lau’s article (1975), we only briefly outline its major features and results here.

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rameters of all four behavioral equations would be invariant with respect to the choice of the three equations to be estimated. Es- timation results are shown in Table 1. For ultrarationality to hold, b,, and bN, which show the relationships between private and gov- ernment consumption and between private and government in- vestment expenditures, respectively, should take negative values. In the empir&al results, b,, does not take a negative value, thus

TABLE 1. Zterative 3SLS Estimates of the Parameters of the Zndirect Demand Sustem

Parameters Estimates Standard Error

al -0.66 b 11 0.043 b 12 0.023 b 13 0.028 b 14 0.0068” a2 -0.18 b, -0.01 b, 0.01 b, 0.002” a3 -0.12 b 33 -0.02 b, -0.001” b‘s‘, -0.005 a4 -0.04b b Ml 0.101 b M2 0.023 b M3 0.012 b M4 0.002

“Estimates were obtained from the following restriction:

b,, = & (k = 1, , 4).

0.0095* 0.021* 0.008* 0.0029* 0.010” 0.019* 0.016 0.0053 0.027” 0.03* 0.017

0.008 0.002 0.01 0.002

*Estimates were obtained from the following restriction:

C@i = -1 (i = 1, . . ) 4)

“Standard error was obtained by generalization of the following formula [see Kmenta (1971), p. 4401:

Var(6, + 6,) = Var(LJ + Var(&) + 2 Cov(& 6,)

*t ratio significant at 5% level.

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rejecting the crowding-out effect of government taxes. Moreover, this positive and significant coefficient suggests that an increase in government consumption expenditures may stimulate consumption demand. Also, b, is insignificant, rejecting the hypothesis that gov- ernment investment expenditures crowd out private investment.

5. Summary and Conclusion The model in this paper uses government consumption and

investment expenditures as proxies for tax-financed and deficit-fi- nanced spending to test for the ultrarationality hypothesis. The em- pirical results do not support the underlying hypothesis: the house- hold sector internalizes government actions. The ultrarationality assumption should be rejected, for the substitutability propositions between private and government consumption expenditures and be- tween private and government investment expenditures do not hold. In short, it can be argued that households view the government sector as an autonomous sector and that fiscal actions can be said to be effective.

Receioed: August 1984 Final version: September 1986

References Carlson, K., and R. W. Spencer. “Crowding Out and Its Critics.”

Monthly Review (Federal Reserve Bank of St. Louis) 57 (Decem- ber 1975): 2-17.

Christensen, L.R., and D.W. Jorgenson. “Transcendental Logarith- mic Production Frontiers.” Review of Economics and Statistics 55 (February 1973): 28-45.

Christensen, L.R., D. W. Jorgenson, and L. J. Lau. “Transcendental Logarithmic Utility Functions.” American Economic Review 65 (June 1975): 367-83.

David, P.A., and J. L. Scadding. “Private Savings: Ultra-Rationality, Aggregation, and ‘Denison Law.“’ Journal of Political Economy 82 (March/April 1974): 225-49.

Denison, E.F. “A Note on Private Saving.” Review of Economics and Statistics 40 (August 1958): 261-67.

Kmenta, J. Elements of Econometrics. New York: MacMillan, 1971.

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