When Is Discretionary Fiscal Policy Effective?

60 Pages Posted: 22 Feb 2017 Last revised: 28 Feb 2018

See all articles by Steven M. Fazzari

Steven M. Fazzari

Washington University in St. Louis

James Morley

University of Sydney

Irina Panovska

Lehigh University

Date Written: February 27, 2018

Abstract

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

Fazzari, Steven M and Morley, James and Panovska, Irina, When Is Discretionary Fiscal Policy Effective? (February 27, 2018). 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)
Sydney, NSW 2006 2008
Australia

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

Irina Panovska (Contact Author)

Lehigh University ( email )

621 Taylor Street
Bethlehem, PA 18015
United States

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