How Do Fiscal Adjustments Work? An Empirical Investigation

Abstract

Recent empirical evidence suggests that fiscal consolidation mainly based on tax hikes has a more recessionary impact on economic growth than those based on expenditure cuts. This paper evaluates the effects of fiscal adjustment plans identified through the narrative approach on macroeconomic activity. I incorporate fiscal plans into the vector autoregression model to investigate transmission channels of fiscal consolidation and accompanying policy. I check whether monetary policy, uncertainty, or financial markets can explain the heterogeneous effects of fiscal adjustment plans. I find that the financial market and macro uncertainty are the most important, explaining about 90% of the total difference.

Keywords: fiscal adjustment plans, output, risk, financial market, uncertainty, monetary policy

JEL Classification: E60, E62