Blog: How Tax Increases and Spending Adjustments Will Affect the World's Short-Run Economy
During the Covid-19 pandemic crisis and related Great Lockdown, governments chose to counter economic contractions by offering various degrees and types of fiscal and monetary stimuli. While research has yet to fully assess the effects of these choices, policies have begun to shift to respond to the call to either pay for continued stimulus plans or scale them back.
The crux of this debate considers a topic I am well familiar with, which addresses whether tax increases and/or government spending reductions will adversely impact the economy. In the following I am copying a short section of my doctoral thesis discussing the effects of policies that choose to address growing deficits by adjusting current fiscal policy, through various compositions.
In short, tax increases nearly always have a strong contractionary (negative) effect on GDP in the short-term, while spending cuts (scaling back fiscal stimuli) may have an expansionary (positive) effect.
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Section 2 – Effects based on composition
As addressed in the review of prior literature results, in the long-run there is general agreement that the implementation of fiscal consolidations to ameliorate government debt trajectories is beneficial to economic growth. However, the distinction between theories based on Keynesian and Neoclassical economics is important when considering and discussing various compositions of fiscal plans that policymakers deem necessary in the short-run. Traditional Keynesian theory predicts a direct and negative effect on both aggregate demand and GDP components in the short-run, but, as can be observed in the above results as well as in related research, there seem to be occasions when this response is not observed. Neoclassical economic theory counters that there may be different responses based on the composition of a fiscal plan. To test whether there are heterogeneous effects on economic performance, fiscal consolidations have been labeled as tax-focused or spending-focused, depending on whether the plan is mostly comprised of government spending reductions or increases in taxation. Chart 5 below lists the coefficients on the regression tests on this distinction, using the IMF Narrative identification method, while Chart 6 provides the same coefficients for the Alesina Narrative.
Comparing the two, there are some clear results: both align with prior literature as well as diverge in various components. Under both of the Narrative methods, GDP responds negatively to tax-focused fiscal consolidation plans, significantly in both year 0 and in the first lag (not significant, but negative in lag 2), as well as negative in the total short-term effect. They also offer parallel results under spending-focused fiscal policies, in which these types of fiscal consolidations relate to a negative effect on GDP contemporaneously, turning positive in the lags. It is notable that the negative effect under spending-focused plans is far smaller than that under the tax-focused plans, becoming positive in the lagged effects, as well as in the combined short-term effect.
The impact from tax-focused plans is distinct under the two models in the components of GDP as well. Household consumption seems to respond more positively in the years and under the method used in the IMF Narrative model, especially significant and positive in the second lag. Though insignificant, household consumption in the Alesina Narrative under tax plans generally follows the same pattern. Tax-focused plans also have a significantly negative effect on private investment under the Alesina Narrative, while coefficients trend negative under the IMF version as well. Per these coefficients, investors do not have a favorable response to plans based on tax increases, yet households may react more favorably. These results are slightly surprising as the investment response is predicted by a general consensus in the literature, yet the movement in household consumption does not confirm traditional Keynesian effects.
Spending-focused plan coefficients suggest a different outcome, following the trend of small contemporaneous negative effects in the components, moving to positive in the lags where statistical significance also increases. The IMF model does not provide significant coefficients to this effect, but follow the pattern in the signs on the coefficients; however, both household consumption and investment follow the pattern of a small, negative response in year 0 to a larger, positive response in the second lag under both of the individual components. Per the Alesina Narrative regressions, both household consumption and private investment are also associated with a negative response to such plans in the year in which they are enacted. However, the components follow the pattern of GDP under these plans, turning positive in the lagged coefficients. The coefficients on household consumption and investment move from negative to positive after two years, with increased significance. It is notable that private investment seems to have both the largest initial negative response to spending-focused fiscal consolidations as well as the largest positive coefficients in the second lag.
Considering the two models together, there are some clear patterns. First, spending-focused plans clearly offer better returns to GDP than taxation-focused plans, which aligns with much of the literature, though the negative response under taxation plans seems to fade in the lags. Similarly, if spending-focused plans contribute to a contracting economy initially, they seem to not only offer the best results over time, but may even have a positive contribution to GDP. As it relates to prior studies, the Narrative models continue to predict the Keynesian response in the tax channel (aligned with the majority of prior findings), a Neoclassical response in spending (aligning with many prior studies), and an overall negative response in GDP (aligns with literature), but offers contradictory results under spending-focused plans in that they may lead to expansionary effects.
In an attempt to confirm these results using prior identification techniques . . .
Feel free to contact me if interested in learning or reading more, or check back as I update results and future research.