Around the world, there is renewed interest in estimating the macroeconomic impact of fiscal policy. This is notoriously difficult, in view of the myriad two-way interactions between fiscal policy decisions and the state of the economy. Economic research offers two general approaches: (a) simulations of macroeconomic models; and (b) estimating the impact of fiscal shocks on past data.
There are quite a number of factors to consider in such exercises:
- What is the exact nature of the fiscal policy? The macroeconomic impact will differ across different types of government spending and different types of tax policy – there is no unique fiscal multiplier.
- Is the fiscal stimulus temporary or permanent in nature? If it is the latter, the prospect of higher future taxes (in line with the permanent increase in spending) will act against the short-run stimulative effect of extra spending.
- Is the increase in spending to be financed by taxes (a balanced-budget fiscal expansion) or through an increase in debt?
- The interest rate channel. Under normal conditions, a fiscal expansion will induce a country with an independent monetary policy to raise the interest rate to offset inflationary pressures, limiting the impact on output. If the level of underemployed resources is high (as at present in many countries), the interest rate may not respond such that the power of fiscal policy is enhanced.
- Monetary union. Note that under normal conditions, this suggests that fiscal policy should be more powerful for a member of a monetary union, since the ECB interest rate will not be influenced by conditions in a small individual member country.
- Trade openness. The greater the share of imports in total demand, the smaller the boost to the domestic economy from a fiscal expansion. Moreover, a fiscal expansion will typically induce real appreciation (an increase in relative price of nontradables) that squeezes the tradables sector, such that the composition of activity changes. To the extent that a thriving tradables sector is fundamental for long-term productivity growth, this compositional effect is important.
- Sovereign risk. If a fiscal expansion raises investor concerns about debt sustainability, the increase in the sovereign risk premium may neuter the stimulative impact of a fiscal expansion. This is especially the case when the sovereign risk premium also raises borrowing costs for other entities, such as the domestic banks. In addition to higher borrowing costs, an increased risk profile also leaves an economy exposed to an inability to fund its debt and the consequences of such a ‘sudden stop’ in funding can be catastrophic, with the resolution typically involving a funding package by international institutions.
- Fiscal dynamics. The fiscal package in any one year has to be interpreted in the context of past fiscal positions and expected future fiscal positions. An economy with a structural deficit must cut spending and raise taxes at some point, such that the macroeconomic impact of fiscal tightening must be absorbed – the challenge is to time the fiscal adjustment to minimise the macroeconomic damage.
- Anticipation effects. The impact of fiscal policy on private-sector consumption and investment decisions does not wait until budget day – if a fiscal tightening is anticipated, many forward-looking decisions will already have taken into account the prospect of lower public spending and higher future taxes. Doubtless, the slowdown in consumption and investment in Ireland has in part been influenced by the prospect of major fiscal tightening over 2009-2014.
- Welfare analysis. Different types of fiscal policy will have a differential impact on the relative shares of private and public consumption and public and private investment. In addition, the levels of transfer payments and the structure of the tax system will also have significant effects on the distribution of incomes across the private sector. Such distributional concerns mean that there is no uniquely optimal fiscal policy, since individuals and interest groups will have different preferences across these dimensions.
As I have written about before, it is a matter of deep regret that Ireland should have to undertake fiscal tightening during a big recession. However, given the size of the structural deficit and the substantial funding risk, it is conditionally optimal to implement such an adjustment. The goal should be to design the fiscal adjustment such that there is a shift in the composition of spending and taxation in directions that will help the economy to recover as quickly as is feasible.
Finally, it would indeed be helpful if the Department of Finance produced a report that detailed its projections concerning the macroeconomic impact of the budget. The fiscal plan for 2010-2014 surely incorporates feedback effects between fiscal decisions and macroeconomic aggregates, but the estimates of these feedback effects have not been explicitly spelled out (as far as I know).
Extension: I forgot to make a few more points:
- One of the lessons from the bubble years, is that it is important to acknowledge uncertainty in making projections – the central forecast must be supplemented by analysis of downside and upside risks to any policy decision. To me, the main risk is the downside risk of Ireland facing a funding crisis.
- In assessing the impact of fiscal policy, it is important to work out the impact on future macroeconomic variables in addition to its short-run impact.
- Given the uncertainties, it is important that fiscal policy choices are robust to changes in specific modelling choices.