When Is Discretionary Fiscal Policy Effective?
60 Pages Posted: 22 Feb 2017 Last revised: 28 Feb 2018
Date Written: February 27, 2018
We investigate the effects of discretionary fiscal policy using a medium-scale nonlinear vector autoregressive model with policy shocks identified via sign restrictions. Addressing a variety of concerns about robustness raised in the literature, our estimates demonstrate strong state dependence in the effects of both government spending and tax shocks on aggregate output. State dependence has important implications for the timing and effectiveness of discretionary fiscal policy. Tax cuts and spending increases have similarly large 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. Tax increases and government spending cuts 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