Karel Mertens, Cornell University, and Morten Ravn, University College London
Empirical Evidence on the Aggregate Effects of Anticipated and Unanticipated U.S. Tax Policy Shocks
Mertens and Ravn provide empirical evidence on the dynamic effects of tax liability changes in the United States. They distinguish between surprise and anticipated tax changes using a timing-convention. They document that pre-announced but not yet implemented tax cuts give rise to contractions in output, investment, and hours worked, while real wages increase. In contrast, there are no significant anticipation effects on aggregate consumption. Implemented tax cuts, regardless of their timing, have expansionary and persistent effects on output, consumption, investment, hours worked, and real wages. These results are very robust. The researchers argue that tax shocks are empirically important impulses to the U.S. business cycle and that anticipation effects have been important during several business cycle episodes.
Alan J. Auerbach and Yuriy Gorodnichenko, University of California, Berkeley and NBER
Measuring the Output Responses to Fiscal Policy
A key issue in current research and policy is the size of fiscal multipliers when the economy is in recession. Using a variety of methods and data sources, Auerbach and Gorodnichenko provide three insights. First, using regime-switching models, they estimate effects of tax and spending policies that can vary over the business cycle; they find large differences in the size of fiscal multipliers in recessions and expansions with fiscal policy being considerably more effective in recessions than in expansions. Second, they estimate multipliers for more disaggregate spending variables which behave differently in relation to aggregate fiscal policy shocks, with military spending having the largest multiplier. Third, they contrast fiscal multipliers in response to anticipated and unanticipated shocks, finding that controlling for anticipated fiscal shocks tends to increase the size of the multipliers.
Eric Leeper, Alexander Richter, and Todd Walker, Indiana University
Quantitative Effects of Fiscal Foresight
Changes in fiscal policy typically entail two kinds of lags: the legislative lag- between when the legislation is proposed and when it is signed into law- and the implementation lag- from the time a new fiscal law is enacted and when it takes effect. These lags imply that substantial time passes between when news arrives about fiscal changes and when the changes actually take place-time when households and firms can adjust their behavior. Leeper, Richter, and Walker identify two types of fiscal news-government spending and changes in tax policy-and map the news processes into standard DSGE models. They identify news concerning taxes through the municipal bond market. If asset markets are efficient, then the yield spread between tax-exempt municipal bonds and treasuries should be a function of the news concerning changes in tax policy. They identify news concerning government spending through the Survey of Professional Forecasters. They conclude that news concerning fiscal variables is a time-varying process. They also conclude that news can have qualitative and quantitative effects.
Jeffrey Clemens, Harvard University; and Stephen Miran, Harvard University
The Effects of State Budget Cuts on Employment and Income
Balanced budget requirements lead to substantial pro-cyclicality in state government spending outside of safety-net programs. At the beginnings of recessions, states tend to experience unexpected deficits. While all states ultimately pay these deficits down, differences in the stringency of their balanced budget requirements dictate the pace at which they adjust. States with strict rules enact large rescissions to their budgets during the years in which adverse shocks occur; states with weak rules make up the difference during the following years. Clemens and Miran use this variation to identify the impact of mid-year budget cuts on state income and employment. Their baseline estimates imply a state spending multiplier of 1.7 and that avoiding $25,000 in mid-year cuts preserves one job. These cuts are associated with shifts in the timing of government expenditures rather than differences in total spending over the course of the business cycle. Consequently, their results are informative about the potential gains from smoothing the path of state government spending. They imply that states could reduce the amplitude of business cycle fluctuations by 15 percent if they completely smoothed their capital spending and service provision outside of safety-net programs.
Robert Novy-Marx, University of Chicago and NBER; and Joshua Rauh, Northwestern University and NBER
Fiscal Imbalances and Borrowing Costs: Evidence from State Investment Losses
Novy-Marx and Rauh examine the effects of losses in U.S. state pension funds on state borrowing costs. Because public employee pension obligations are generally senior to state general obligation bonds, large increases in unfunded pension liabilities should be a concern for municipal bond investors. During the three months ending December 2008, losses in state pension funds amounted to between 1 oercent and 6 oercent of annual gross state product, and between 9 percent and 48 percent of annual state revenue, depending on the state. Using this cross-sectional variation, the authors find that over this period, tax-adjusted municipal bond spreads rose by 10-20 basis points for each percent of annual gross state product lost in pension funds by states in the lower half of the credit quality spectrum. A similar result holds for each 10 percent of annual state revenues lost. The effect is approximately constant over the yield curve, suggesting a constant upward shift in annual risk-neutral default probabilities. These results are robust to controls for credit ratings and other measures of the state's fiscal strength. They hold within credit rating categories and are strongest among states with the weakest ratings. The researchers conclude that U.S. state borrowing costs will likely increase if unfunded state liabilities continue to grow, making state debt more expensive to finance.
Mathias Dolls; Clemens Fuest, Oxford University; and Andreas Peichl, University of Bonn
Automatic Stabilizers and Economic Crisis: US vs. Europe
Dolls, Fuest, and Peich analyze the effectiveness of the tax and transfer systems in the European Union and the United States to act as an automatic stabilizer in the current economic crisis. They find that automatic stabilizers absorb 38 percent of a proportional income shock in the EU, compared to 32 percent in the United States. In the case of an unemployment shock, 47 percent of the shock is absorbed in the EU, compared to 34 per cent in the United States. This cushioning of disposable income leads to a demand stabilization of up to 31 percent in the EU and up to 28 percent in the United States. There is large heterogeneity within the EU. Automatic stabilizers in Eastern and Southern Europe are much lower than in Central and Northern European countries. The researchers also investigate whether countries with weak automatic stabilizers have enacted larger fiscal stimulus programs. They find no evidence supporting this view.
Agustin S. Benetrix and Philip Lane, Trinity College Dublin
International Differences in Fiscal Policy During the Global Crisis
Benetrix and Lane examine the cross-country dispersion in fiscal outcomes during 2007-9. In principle, international differences in fiscal policy may be related to differences in optimal fiscal positions, funding constraints, political economy factors, and fiscal control problems. The authors find that the decline in the overall and structural fiscal balances have been larger for those countries experiencing larger increases in unemployment and where credit growth during the pre-crisis period was more rapid. However, there is no systematic co-variation between fiscal outcomes and a larger number of other macroeconomic variables and country characteristics.
Marco Battaglini, Princeton University and NBER, and Stephen Coate, Cornell University and NBER
Fiscal Policy over the Real Business Cycle: A Positive Theory(NBER Working Paper No. 14047)
Battaglini and Coate extend their 2008 political economy to analyze the cyclical behavior of fiscal policy. The theory predicts that, in the short run, fiscal policy can be pro-cyclical with government debt spiking up upon entering a boom. However, in the long run, fiscal policy is counter-cyclical with debt increasing in recessions and decreasing in booms. Government spending increases in booms and decreases during recessions, while tax rates decrease during booms and increase in recessions. In both booms and recessions, fiscal policies are set so that the marginal cost of public funds obeys a submartingale. The correlations between fiscal policy variables and national income implied by the theory are consistent with much of the existing evidence from the United States and other countries, and data on tax rates from the G7 countries supports the submartingale prediction.
Ethan Ilzetzki, London School of Economics, and Enrique Mendoza and Carlos Vegh, University of Maryland and NBER
How Big (Small?) Are Fiscal Multipliers?
The effect of fiscal stimulus on GDP has been intensely debated in recent years. Ilzetzki, Mendoza, and Vegh contribute to this discussion by showing that the impact of a shock to government expenditures depends crucially on country characteristics. They present a novel quarterly dataset of government expenditure in 44 countries. They find that government consumption has a smaller short-run effect on output and a less persistent one in developing than in high-income countries. The short-run multiplier of government consumption shocks is small on impact, but the long-run fiscal multiplier varies considerably. In economies with high trade-output ratios or flexible exchange rates, a fiscal expansion leads to no significant output gains. In contrast, in economies with low trade-output ratios or fixed exchange rates, the long-run effect of government consumption on GDP is large. Further, they find some tentative evidence that fiscal stimulus is counterproductive in highly-indebted countries; in developing countries with debt ratios of 50 percent of GDP or higher, government consumption shocks have strong negative effects on output.
James Feyrer and Jay Shambaugh, Dartmouth College and NBER
Global Savings and Global Investment: The Transmission of Identified Fiscal Shocks (NBER Working Paper No. 15113)
Feyrer and Shambaugh examine the effect of exogenous shocks to savings on world capital markets. Using the exogenous shocks to U.S. tax policy identified by Romer and Romer (2009b), they trace the impact of an exogenous shock to savings through the income accounting identities of the United States and the rest of the world. They find that exogenous tax increases are only partially offset by changes in private savings (Ricardian equivalence is not complete). They also find that only a small amount of the resulting change in U.S. saving is absorbed by increased domestic investment (contrary to Feldstein and Horioka (1980)). Almost half of the fiscal shock is transmitted abroad as an increase in the U.S. current account. Positive shocks to U.S. savings generate current account deficits and increases in investment in other countries in the world. They cannot reject that the shock is uniformly transmitted across countries with different currency regimes and different levels of development. These results suggest highly integrated world capital markets with rapid adjustment. In short, they find that the United States acts like a large open economy and the world acts like a closed economy.
Carlo Favero and Francesco Giavazzi, IGIER, Bocconi University
VAR-Based and Narrative Measures of the Tax Multiplier
Favero and Giavazzi argue that the best approach to measure tax multipliers is to include in a fiscal VAR the structural shocks identified using information independent from the VAR– that is, the shocks constructed using a narrative method. They first show that "narrative" shocks are valid shocks in a fiscal VAR, that is, they are orthogonal to the relevant information set. They then show that the direct inclusion of narrative shocks in a fiscal VAR delivers estimates of the tax multiplier that are similar to those obtained within the traditional fiscal VAR approach. The use of narrative shocks has a big advantage: it does not require the inversion of the moving-average representation of a VAR for the identification of the relevant shocks. Therefore, within this framework, fiscal multipliers can be identified and estimated even when the MA representation of the VARs is not invertible–the relevant case in the presence of fiscal foresight, that is, when agents receive signals on the tax changes they will face in the future.
Roberto Perotti, Bocconi University
The Effects of Tax Shocks: Negative and Large
Perotti argues that on theoretical grounds the discretionary component of taxation should be allowed to have different effects on output than the endogenous component, namely the automatic response of tax revenues to macroeconomic variables. Existing approaches to the study of the effects of the Romer and Romer shocks do not allow for this difference, and he shows that as a consequence they exhibit impulse responses that are likely to be biased towards zero. On the other hand the RR specification, as Favero and Giavazzi (2009) correctly argue, is not a specification that can be derived from any representation of the data generating process. Perotti derives a VAR model that can accommodate the different impacts of the discretionary and endogenous component of taxation, and then shows that the impulse responses to a RR shock implied by this specification are about half-way between the large effects of RR and the much smaller effects of Favero and Giavazzi: in general, a single percentage point of GDP increase in taxes leads to a decline in output by about 1.5 percentage points after 12 quarters. The analysis of shocks to future taxation, instead, is complicated by two factors: the standard errors are extremely large, and the interpretation of the results is complicated once one recognizes that tax shocks can, and in general will, be associated with a negative wealth effect.