A survey of the effects of discretionary fiscal policy Stockholm, 29 January 2008 Roel Beetsma University of Amsterdam, CEPR and CESifo 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 2 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 3 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, 4 future taxes) neglected Fiscal expansion in the IS-LM model Interest rate IScurve LMcurve Output 5 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 6 constraint) 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 7 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) 8 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 9 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 10 • Composition of fiscal impulse important! 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 11 Impulse responses after a government purchases shock Government spending (g) Import (m) 6.0 3.0 4.0 2.0 2.0 1.0 0.0 0.0 -2.0 -1.0 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 years after shock 4 5 6 7 8 9 10 7 8 9 10 7 8 9 10 7 8 9 years after shock Cyclically adjusted net taxes (nt) Real effective exchange rate (reer) 2.0 0.5 0.0 1.0 -0.5 0.0 -1.0 -1.0 -1.5 -2.0 -2.0 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 years after shock 4 5 6 years after shock Export (x) Budget balance (constructed) 1.0 0.5 0.0 0.0 -1.0 -0.5 -2.0 -1.0 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 years after shock 4 5 6 years after shock Output (y) Trade balance (constructed) 2.0 0.5 1.5 0.0 1.0 -0.5 0.5 -1.0 0.0 -0.5 -1.5 0 1 2 3 4 5 years after shock 6 7 8 9 10 0 1 2 3 4 5 years after shock 6 10 12 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” 13 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? 14 “Closed” EU countries Government spending (g) Import (m) 6.0 3.0 4.0 2.0 2.0 1.0 0.0 0.0 -2.0 -1.0 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 years after shock 4 5 6 7 8 9 10 7 8 9 10 7 8 9 10 7 8 9 years after shock Cyclically adjusted net taxes (nt) Real effective exchange rate (reer) 3.0 1.0 2.0 0.0 1.0 -1.0 0.0 -2.0 -1.0 -2.0 -3.0 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 years after shock 4 5 6 years after shock Export (x) Budget balance (constructed) 2.0 0.5 1.0 0.0 0.0 -1.0 -0.5 -2.0 -3.0 -1.0 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 years after shock 4 5 6 years after shock Output (y) Trade balance (constructed) 3.0 0.5 2.0 0.0 1.0 -0.5 0.0 -1.0 -1.0 0 1 2 3 4 5 years after shock 6 7 8 9 10 0 1 2 3 4 5 years after shock 6 10 15 “Open” EU countries Government spending (g) Import (m) 6.0 4.0 4.0 2.0 2.0 0.0 0.0 -2.0 -2.0 -4.0 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 years after shock 4 5 6 7 8 9 10 7 8 9 10 7 8 9 10 7 8 9 16 10 years after shock Cyclically adjusted net taxes (nt) Real effective exchange rate (reer) 2.0 1.0 0.0 0.0 -2.0 -1.0 -4.0 -2.0 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 years after shock 4 5 6 years after shock Export (x) Budget balance (constructed) 1.0 0.5 0.0 0.0 -0.5 -1.0 -1.0 -2.0 -1.5 -3.0 -2.0 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 years after shock 4 5 6 years after shock Output (y) Trade balance (constructed) 2.0 0.5 0.0 1.0 -0.5 0.0 -1.0 -1.0 -1.5 -2.0 -2.0 0 1 2 3 4 5 years after shock 6 7 8 9 10 0 1 2 3 4 5 years after shock 6 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 17 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 18 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 19 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 20