When Is Discretionary Fiscal Policy Effective?

56 Pages Posted: 22 Feb 2017 Last revised: 4 Mar 2020

See all articles by Steven M. Fazzari

Steven M. Fazzari

Washington University in St. Louis

James Morley

University of Sydney

Irina Panovska

University of Texas at Dallas

Date Written: March 3, 2020

Abstract

We investigate the effects of discretionary changes 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, while they are much less effective, especially in the case of government spending increases, when the economy is close to potential. We find that contractionary shocks have larger effects than expansionary shocks across the business cycle, but this is much more pronounced during deep recessions and sluggish recoveries than in robust expansions. Notably, tax increases are highly contractionary and largely self-defeating in reducing the debt-to-GDP ratio when the economy is in a deep recession. The effectiveness of discretionary government spending, including its state dependence, appears to be almost entirely due 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

Fazzari, Steven M and Morley, James and Panovska, Irina, When Is Discretionary Fiscal Policy Effective? (March 3, 2020). Available at SSRN: https://ssrn.com/abstract=2921667 or http://dx.doi.org/10.2139/ssrn.2921667

Steven M Fazzari

Washington University in St. Louis ( email )

One Brookings Drive
St. Louis, MO 63130
United States
314-935-5693 (Phone)
314-935-4156 (Fax)

James Morley

University of Sydney ( email )

Rm 370 Merewether (H04)
The University of Sydney
Sydney, NSW 2006 2008
Australia

HOME PAGE: http://https://sites.google.com/site/jamescmorley/

Irina Panovska (Contact Author)

University of Texas at Dallas ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

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