Optimal fiscal policy under learning

This paper characterizes optimal fiscal policy when agents learn about future taxation. A benevolent and fully rational government chooses taxes on labor income and state-contingent bonds to finance public spending, considering that private agents form their expectations through a learning algorithm. Facing a trade-off between distortionary taxes and distorted expectations, the Ramsey planner chooses the policy that minimizes the total cost of distortions. The analysis produces two main results. First, the government will use fiscal variables to manipulate expectations, reducing taxes and issuing debt at times of pessimism and doing the opposite at times of optimism. This speeds up learning. Second, the expectation-dependent fiscal plan is also history-dependent, and it prescribes taxes that are not as smooth and more persistent than under rational expectations. These findings are robust to alternative learning algorithms.     

Measuring the effects of fiscal policy

Measuring the effects of discretionary fiscal policy is both difficult and controversial, as some explicit or implicit identifying assumptions need to be made to isolate exogenous and unanticipated changes in taxes and government spending. Studies based on structural vector autoregressions typically achieve identification by restricting the contemporaneous interaction of fiscal and non-fiscal variables in a rather arbitrary way. In this paper, we relax those restrictions and identify fiscal policy shocks by exploiting the conditional heteroscedasticity of the structural disturbances. We use this methodology to evaluate the macroeconomic effects of fiscal policy shocks in the U.S. before and after 1979. Our results show substantive differences in the economy׳s response to government spending and tax shocks across the two periods. Importantly, we find that increases in public spending are, in general, more effective than tax cuts in stimulating economic activity. A key contribution of this study is to provide a formal test of the identifying restrictions commonly used in the literature.     

Learning about fiscal policy and the effects of policy uncertainty

In this paper we ask how uncertainty about fiscal policy affects the impact of fiscal policy changes on the economy when the government tries to counteract a deep recession. The agents in our model are uncertain about the conduct of fiscal policy and act as econometricians by estimating fiscal policy rules that might change over time.We find that assuming that agents are not instantaneously aware of the new fiscal policy regime in place leads to substantially more volatility in the short run and persistent differences in average outcomes. We highlight issues that can arise when a policymaker wants to announce a policy change. From a methodological perspective, we introduce a novel way to model learning in the face of discrete policy changes.     

Optimal fiscal policy with robust control

This paper analyzes how consumer uncertainty affects optimal fiscal policy in the Lucas and Stokey (1983) framework. The consumers, lacking confidence in their knowledge of the stochastic environment, endogenously tilt their subjective probability model away from an approximating probability model. The government, though, is confident that the approximating probability model characterizes the stochastic environment. This confidence dichotomy reveals a range of possible objective functions for an altruistic government. I assume that the government maximizes the consumers' expected utility under the consumers' own subjective probability model. It is found that this government relies less heavily on labor taxes to absorb the fiscal shock than would be optimal if consumers were fully confident in their probability model. This policy helps mitigate the direct welfare cost associated with consumer uncertainty. I compare this policy to the one implemented by a government that maximizes the consumers' expected utility under the approximating probability model.     

Energy intensity and directed fiscal policy

This paper assesses the effects of fiscal policy on economy-wide energy intensity within an endogenous growth framework. To this end, we first develop a two-sector (investment good and consumption good) augmented AK model by integrating the Uzawa model with Rebelo’s AK model, and assume that a non-renewable resource is one of the factors of production. Using this framework, we solve the model for the short and long run, identifying the sufficient parameter conditions that ensure higher energy intensity in the investment goods sector. We then introduce a balanced budget government, whose objective is to decrease the economy-wide energy intensity by levying tax on the energy-intensive investment goods sector and subsidizing the consumption goods sector. Contrary to our expectations, we find that this fiscal policy design increases economy-wide energy intensity as it leads to a decline in real GDP without changing total energy consumption. On the basis of this model, we propose the concept of a ‘directed fiscal policy’, which connotes a reduction of the economy-wide energy intensity by following a heterogeneous taxation policy across sectors.     

Demographic forecasts and fiscal policy rules

All quantitative evaluations of fiscal sustainability that include the effects of population ageing must utilize demographic forecasts. It is well known that such forecasts are uncertain, and some studies have taken that into account by using stochastic population projections jointly with economic models. We develop this approach further by introducing regular demographic forecast revisions that are embedded in stochastic population projections. This allows us to separate, for each demographic outcome and under different policy rules, the expected and realized effects of population ageing on public finances. In our Finnish application, demographic uncertainty produces a considerable sustainability risk. We consider policies that reduce the likelihood of getting highly indebted and demonstrate that, although demographic forecasts are uncertain, they contain enough information to be useful in forward-looking policy rules.     

Fashions and continuity in British fiscal policy

Fiscal policy in the UK has reflected changing intellectual influences from Keynesianism in the 1960s to monetarism in the 1970s and early 1980s. New Labour's rules hark back to pre-war Treasury orthodoxies, despite their claims to modernity.     

Monetary and fiscal policy under deep habits

Allowing habits to be formed at the level of individual goods – deep habits - can radically alter the fiscal policy transmission mechanism as the counter-cyclicality of mark-ups this implies can result in government spending crowding-in rather than crowding-out private consumption in the short run. We explore the robustness of this mechanism to the existence of price discrimination in the supply of goods to the public and private sectors. We then describe optimal monetary and fiscal policy in our New Keynesian economy subject to the additional externality of deep habits and explore the ability of simple policy rules to mimic fully optimal policy. We find that the presence of deep habits at empirically estimated levels can imply large externalities that significantly affect the conduct of monetary and tax policy. However, despite the rise in government spending multipliers implied by deep habits, government spending is barely used as a stabilisation tool under the optimal policy.     

Implications of productive government spending for fiscal policy

The standard assumption in macroeconomics that government spending is unproductive can have substantive implications for tax and spending policy. Productive government spending introduces a positive feedback between the tax rate, the productive capacity of the economy, and tax revenue. We allow marginal tax revenue to be optimally allocated between productive subsidies to human capital and utility-enhancing government consumption and calculate Laffer Curves for the US. Productive government spending yields higher revenue-maximizing tax rates, steeper slopes at low tax rates and higher peaks. The differences are particularly pronounced for the labor-tax Laffer curve. The use of tax revenue is an important determinant of the actual revenue that a tax rate increase generates.     

Risk‐weighting debt implies more fiscal space

• ? Markets are more tolerant of fiscal expansion than governments typically fear. The composition of major economies' government debt has become safer and this is reflected in our estimates of a new indicator – risk‐weighted debt (RWD). Using RWD to measure debt provides a relatively benign indication of risks to sustainability in the major economies since 2004.
• ? Our RWD measures consist of six categories of debt holders, with weights allocated to their risk‐to‐flight potential. Debt holders range from riskier foreign banks and non‐banks (highly weighted), which would be most inclined to sell when times get tough, to safer entities such as central banks (zero weight).
• ? RWD looks less alarming than unweighted measures. Major economies' total public debt rose by 10% of GDP on average since 2011; RWD was up by just 1% of GDP.
• ? Japan and Italy show the biggest relative improvements when the focus shifts to RWD from debt‐to‐GDP. The two countries' RWD has fallen significantly since 2011.
• ? RWD improvements limit the extent to which indebtedness threatens sustainability.

     

What are the effects of fiscal policy shocks?

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.     

Democratic transition and fiscal policy in the Arab world

This paper investigates the relationship between democracy and public debt in the Arab world over the period 2002–2013. The results show strong evidence of an inverted U-shaped relationship between democracy and public debt. This means that democratization is associated with lower debt only when a certain level of democracy is reached. In an attempt to explain these findings, we assume that the effect of democracy on public debt operates mainly through its impact on government spending and government revenue. Our results show that the inverted U-shaped relationship between democracy and public debt stems from the inverted U-shaped democracy-government spending path and the U-shaped democracy-government revenue pattern. This implies that, at the earlier stages of democratization, democracy is associated with an increase in government spending and a decrease in government revenue, which stimulates public debt. However, beyond a certain level of democracy, further democratization reduces government spending and enhances government revenue, leading to lower levels of public debt. Hence, achieving some level of democracy is a key prerequisite to improve the effectiveness of public spending, enhance tax compliance, and thereby control public debt.     

Optimal fiscal policy for a state or local government

State and local government services are enjoyed by, and taxes borne by, two groups, residents and non-residents. This paper addresses the question: if state and local governments maximize their residents' welfare, and cannot distinguish between individual residents and non-residents but know the aggregate characteristics of the two groups, what set of taxes (subsidies) and public goods should they choose? Some of the results obtained are: (i) even when all commodities are taxable and equity is ignored, the existence of non-resident consumption makes uniform taxation non-optimal; (ii) in some cases, whether a commodity should be taxed or subsidized is independent of its own-price elasticity; (iii) central cities may be subsidized by suburban residents; and (iv) the ability of state and local governments to redistribute is inversely proportional to the openness of the economy.     

Determination of Long‐run and Short‐run Dynamics in EC‐VARMA Models via Canonical Correlations

This article studies a simple, coherent approach for identifying and estimating error‐correcting vector autoregressive moving average (EC‐VARMA) models. Canonical correlation analysis is implemented for both determining the cointegrating rank, using a strongly consistent method, and identifying the short‐run VARMA dynamics, using the scalar component methodology. Finite‐sample performance is evaluated via Monte Carlo simulations and the approach is applied to modelling and forecasting US interest rates. The results reveal that EC‐VARMA models generate significantly more accurate out‐of‐sample forecasts than vector error correction models (VECMs), especially for short horizons. Copyright © 2015 John Wiley & Sons, Ltd.