Effects of Fiscal Policy: A Survey

1. A survey of the effects of discretionary fiscal policyStockholm, 29 January 2008 Roel Beetsma University of Amsterdam, CEPR and CESifo

2. Active fiscal policy is regaining popularity… • Fiscal stimulation packages to revive the Japanese economy • Most recently in the U.S. • Total of 150 billion • 100 billion lump-sum transfers • 50 billion business tax cuts

3. What are the effects? • Theoretical • Closed economy • Open economy • Empirical effects • “Internal” variables • Open economy • Own estimates for the EU • Many different potential instruments • Wide variations in findings

4. Theory – closed economy • Standard textbook model: IS – LM • Short-run model: price level fixed • Goods market: interest rate  → investment  → output  to restore equilibrium • Money market: interest rate  → money demand  → output  to restore demand (and equilibrium) • Fiscal expansion → demand  → given interest rate, output  to restore equilibrium • Problems IS-LM • Ad hoc: no optimisation • Consequences of fiscal expansion for debt (hence, future taxes) neglected

5. Fiscal expansion in the IS-LM model Interest rate LM-curve IS-curve Output

6. Theory – closed economy • Neo-classical: • Government spending  → (future) taxes  (“wealth effect”)→ output , consumption  and labour supply  → real wage  and investment  • New-Keynesian (with price rigidity) • Wealth effect→ real wage  • Government spending  → goods demand → for given price, output  → labor demand  → real wage  • Overall real wage effect ambiguous • Consumption still  • Additional imperfection needed to strengthen link disposable income and consumption (e.g. credit constraint)

7. Theory – open economy • Mundell-Fleming • Flexible exchange rate • Fiscal expansion → shifts IS out → rH > rF → capital inflow → e.r. appreciates → net exports  → IS shifts back → output unchanged • Fixed exchange rate • Fiscal expansion → shifts IS out → rH > rF → capital inflow → money supply to prevent exch rate appreciation → output higher • Same disadvantages as IS-LM

8. Theory – open economy • Various factors are relevant: • Neo-classical vs new-Keynesian (price rigidities) • Credit restrictions / non-Ricardian consumers • Shock persistence (size of wealth effect) • Market completeness (possibilities for risk-sharing) • Small or large open economy • Home bias in spending • Elasticity of substitution domestic and foreign goods • Degree of openness of economy (amount of international trade)

9. Empirics – “internal” effects • Blanchard & Perotti (2002) for U.S. • govt purchases  → output  (multiplier close to unity), consumption  and investment  • net taxes  → output  and investment  • Mountford & Uhlig (2005) for U.S. • govt purchases  → small positive effect on output and consumption; negative effect on investment; costly effect of higher future taxes • tax-cut best way to stimulate economy • Romer and Romer (2007): official documents to identify “exogenous” legislated tax changes • 1% of GDP rise in tax revenues → 3% fall in GDP ; 2.6% fall in consumption

10. Empirics – open economy • Kim and Roubini (2004) for U.S.: budget deficit  → real exch rate depreciation and current account improvement • Müller (2006) find increase in net exports for U.S. • Monacelli and Perotti (2006) and Ravn et al. (2007) for Australia, Canada, U.K. and U.S.: govt purchases  → cons , output , trade balance , real exch rate depreciation • Lane and Perotti (1998, 2003): wage govt cons  → undermines competitiveness traded sector → trade balance  , especially under flex exch rates • Composition of fiscal impulse important!

11. Own estimates for EU • Following Beetsma et al. (2008, JEEA) • Panel SVAR approach • 14 EU countries • Period 1970-2004, annual data • Estimate system with government purchases, cyclically-adjusted net taxes (tax – transfers), exports, output, imports, real effective exchange rate (fall = appreciation) • All real and in natural logarithms

12. Impulse responses after a government purchases shock

13. Findings • 1% of GDP increase in government purchases • Impact increase in GDP is 1.2% • Peak rise is 1.6% • Cyclically-adjusted net taxes fall • Exports rise (domestic prices rise relative to foreign) • Imports rise • Real effective exchange rate appreciates • Primary budget falls by 0.5% on impact, -0.8% peak • public budget falls by 0.7% on impact • “twin deficits”

14. Closed versus open economies • Split based on average over time of (Exports+imports)/GDP • Closed: Finland, France, Germany, Greece, Italy, Spain, U.K. • Open: Austria, Belgium, Denmark, Ireland, The Netherlands, Portugal and Sweden • More “leakage effects” in open economies?

15. “Closed” EU countries

16. “Open” EU countries

17. Findings: • Output impact closed 1.43 • Output impact open 0.83 • Normalised responses imports or exports: divide own response by response of output • Normalised import response closed vs open is 0.72 vs 0.49 • Normalised export response closed vs open is -0.41 vs -0.99 • Larger trade balance deterioration for open • Stronger and longer-lasting public budget deterioration for open

18. Conclusions • Bulk of evidence consistent with positive effect net tax  or government purchases  on output and consumption • Output cost of future tax increase may dominate gain of government purchases rise • Strong disagreement about magnitudes of effects • Empirical analysis hampered by • Identifying truly exogenous shocks • Anticipation effects

19. Conclusions • Active fiscal stabilization policy seems beyond capabilities of governments • Uncertainty about size (often even sign) of effects • Time lag between identification slowdown and implementation of measures • Current macroeconomic situation difficult to measure (large data revisions). • Fatas and Mihov (2003): discretionary fiscal policy induces macro-economic instability, which, in turn, affects growth negatively

20. Conclusions • In open economies (Sweden) a substantial part of increase in government purchases leaks away • Effect of increase in government purchases unevenly distributed → export sectors in particular hurt, because competitiveness  • Best is to let automatic stabilisers work freely • However, they do not distinguish source of shock, nor whether it is temporary or permanent • Complement with automatic link between debt and taxes or cyclically adjusted primary deficit