Ricardian equivalence in the presence of capital market imperfections

It is a common claim that Ricardian equivalence fails if capital markets are imperfect. The validity of this claim is examined for the case of informationally imperfect capital markets. We present three alternative models of adverse selection and analyze the effects of debt finance in these models. It is shown that a debt-financed tax cut can lead to Pareto improvement in some cases. In the theoretically most preferable model, however, Ricardian equivalence survives in spite of genuine imperfections in the capital market. The results point to the importance of specifying the exact nature of imperfection.