When is discretionary fiscal policy effective?

  • 1 Washington University in St. Louis, St. Louis, USA
  • 2 University of Sydney, Sydney, Australia
  • 3 University of Texas at Dallas, School of Economics, Political, and Policy Sciences, 800 W Campbell Road GR 31, Richardson, USA
Steven M. Fazzari, James MorleyORCID iD: https://orcid.org/0000-0003-2380-6747 and Irina Panovska
  • Corresponding author
  • University of Texas at Dallas, School of Economics, Political, and Policy Sciences, 800 W Campbell Road GR 31, Richardson, TX, TX 75080, USA
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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.

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SNDE recognizes that advances in statistics and dynamical systems theory can increase our understanding of economic and financial markets. The journal seeks both theoretical and applied papers that characterize and motivate nonlinear phenomena. Researchers are required to assist replication of empirical results by providing copies of data and programs online. Algorithms and rapid communications are also published.

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