When Is Discretionary Fiscal Policy Effective?
66 Pages Posted: 22 Feb 2017 Last revised: 14 Sep 2019
Date Written: September 12, 2019
We investigate the effects of discretionary increases and decreases in government spending and taxes using a medium-scale nonlinear vector autoregressive model with policy shocks identified via sign restrictions. Tax cuts and spending increases have larger stimulative effects when there is excess slack in the economy, but they are much less effective, especially in the case of government spending increases, when the economy is close to potential. We find that negative demand shocks have larger effects than positive demand shocks across the business cycle, but this is much more pronounced during periods of slack. Tax increases are contractionary and largely self-defeating in reducing the debt-to-GDP ratio during periods of excess slack. The effectiveness of discretionary government spending, including its state dependence, appears to be due almost entirely to the response of consumption. The responses of both consumption and investment to discretionary tax changes are state dependent, but investment plays the larger quantitative role.
Keywords: Government spending; austerity; nonlinear dynamics; Bayesian; sign restrictions; vector autoregression
JEL Classification: E32; E62; C32
Suggested Citation: Suggested Citation