What are the effects of fiscal policy shocks

TL;DR: In this paper, a new approach for analyzing the effects of fiscal policy using vector autoregressions was proposed and applied to US quarterly data from 1955 to 2000, and the impulse responses to three linear combinations of these fiscal shocks, corresponding to the three scenarios of deficit-spending, deficit-financed tax cuts and a balanced budget spending expansion were constructed.

Abstract: We propose and apply a new approach for analyzing the effects of fiscal policy using vector autoregressions. Specifically, we use sign restrictions to identify a government revenue shock as well as a government spending shock, while controlling for a generic business cycle shock and a monetary policy shock. We explicitly allow for the possibility of announcement effects, i.e., that a current fiscal policy shock changes fiscal policy variables in the future, but not at present. We construct the impulse responses to three linear combinations of these fiscal shocks, corresponding to the three scenarios of deficit-spending, deficit-financed tax cuts and a balanced budget spending expansion. We apply the method to US quarterly data from 1955 to 2000. We find that deficit-financed tax cuts work best among these three scenarios to improve GDP, with a maximal present value multiplier of five dollars of total additional GDP per each dollar of the total cut in government revenue 5 years after the shock. Copyright © 2009 John Wiley & Sons, Ltd.

Figures

Figure 10: The deficit spending policy scenario where government spending is raised by 1% for four quarters with government revenues remaining unchanged. These impulses are linear combinations of a sequence of the basic shocks displayed in Figures 4 and 7.

Figure 5: The announced or anticipated basic government revenue shock, identified by orthogonality to the business cycle shock and monetary policy shock as well as a zero impulse response for the first four quarters and a positive impulse response function for the next four quarters of government revenues. The restriction is indicated by the shaded area on the graph.

TABLE 5 MAXIMUM AND MINIMUM IMPACT MULTIPLIERS OF FISCAL POLICY SCENARIOS

Figure 6: A comparison of the median responses of an anticipated - solid line - and unanticipated - dashed line - government revenue shock, where the impulses are plotted so that the time period of the implementation of the tax rise is the same.

Figure 1: The shocks identified by the VAR: The business cycle shocks is identified first first, the monetary policy shocks is identified second and the government revenue and government spending shocks are identified third. The shaded areas represent NBER recessions in the business cycle plot and a change of president in the fiscal plots

Figure 9: A comparison of the median responses of an anticipated - solid line - and unanticipated - dashed line - government spending shock, where the impulses are plotted so that the time period of the implementation of the increase in government spending is the same.

Figure 2: The business cycle shock ordered first. The shaded areas indicate the impulses directly restricted by the identification procedure.

Figure 13: The present value of the impulses for GDP and the changing fiscal variable for the deficit spending policy scenario and the deficit financed tax cut policy scenario which are displayed in Figures 10 and 11.

Figure 12: The balanced budget policy scenario where government spending is raised by 1% for four quarters and government revenues raised so that the increased revenue matches the increased spending. These impulses are linear combinations of a sequence of the basic shocks displayed in Figures 4 and 7.

Figure 7: The basic government expenditure shock, identified by orthogonality to the business cycle shock and monetary policy shock as well as a positive impulse response function of government expenditures for four quarters after the shock. The restriction is indicated by the shaded area on the graph.

Figure 3: The monetary policy shock ordered second. The shaded areas indicate the impulses directly restricted by the identification procedure.

TABLE 3 IMPACT MULTIPLIERS OF DEFICIT FINANCED TAX CUT POLICY SCENARIOS

Table III. The multiplier represents the effect in dollars of a one dollar cut in taxes at the first quarter. For the Mountford and Uhlig results this is calculated with the formula: multiplier for GDP

TABLE 2 PRESENT VALUE MULTIPLIERS OF THE POLICY SCENARIOS

Figure 11: The deficit-financed tax cut policy scenario where government spending remains unchanged and government revenue is reduced by 1% for four quarters. These impulses are linear combinations of a sequence of the basic shocks displayed in Figures 4 and 7.

Figure 8: The announced or anticipated basic government expenditure shock, identified by orthogonality to the business cycle shock and monetary policy shock as well as a zero impulse response for the first four quarters and a positive impulse response function for the next four quarters of government expenditures. The restriction is indicated by the shaded area on the graph.

TABLE 1 IDENTIFYING SIGN RESTRICTIONS

Figure 4: The basic government revenue shock, identified by orthogonality to the business cycle shock and monetary policy shock as well as a positive impulse response function of government revenues for four quarters after the shock. The restriction is indicated by the shaded area on the graph.

TABLE 4 IMPACT MULTIPLIERS OF A DEFICIT SPENDING POLICY SCENARIO