Non-linearities and fiscal policy

Abstract

Empirical evidence shows that fiscal multipliers depend on the state of the cycle, the nature of fiscal policy and the level of debt. In other words, evidence points to non-linearities in the effects of fiscal policy. This paper provides a framework to simultaneously assess the relevance of the fiscal space of the government together with other sources of non-linearities. The empirical analysis, which uses a panel of 13 countries between 1980 and 2014, finds that fiscal consolidations based on tax increases are in general self-defeating, in that they result in an increase of the debt-to-GDP ratio. Increasing taxes in periods of expansion has the most recessionary effect on the economy. Cutting public expenditure has a less pronounced effect on economic activity and can stabilize debt. This paper also discusses the econometrics of non-linearities. Though the literature has often adopted the local projections approach to derive impulse response functions, I address the potential pitfalls of this method both analytically and econometrically.