1  Introduction

This paper examines the effects of fiscal policy, as measured by government spending and net tax, on New Zealand GDP. The focus is on the temporary, business cycle effects of fiscal policy on GDP.[1] The work provides a basis for evaluating the impact of fiscal policy on New Zealand GDP, thereby complementing existing fiscal indicators, such as the cyclically adjusted fiscal balance and other measures of fiscal impulse. This paper also furthers previous work examining the sources of fluctuations in New Zealand GDP (Buckle, Kim, Kirkham, McLellan and Sharma, 2002; Buckle, Kim and McLellan, 2003) by analysing the contribution of fiscal policy to New Zealand business cycles.

Different approaches have been used to measure the effects of fiscal policy on key economic aggregates, like GDP, inflation and interest and exchange rates. One approach is to simulate fiscal policy changes using large-scale structural macroeconomic model. An alternative approach is to estimate smaller empirical models, such as vector autoregression (VAR) models to assess the effects of changes in fiscal policy on the economy. A variety of techniques have been used to identify the effects of fiscal policy using these smaller empirical models. For example, Blinder (1981) and Ramey and Shapiro (1998) examine the effects of fiscal policy on the United States economy by identifying particular fiscal episodes or events, such as the temporary income tax reductions in 1968 and 1975 or increases in defence spending associated with the military build-up during the Korean and Vietnam wars. Blanchard and Perotti (2002) and Perotti (2004), who examine fiscal policy in the United States and a selection of OECD economies, use a structural VAR model to measure the dynamic impact of fiscal shocks to output. Their innovation is to use institutional information on the tax and transfer system to identify the effects of fiscal policy shocks on output.

This paper builds on Blanchard and Perotti (2002). It replicates Blanchard and Perotti’s three-variable vector autoregression (VAR) model, which was originally estimated using United States data, for New Zealand. The model, which includes gross domestic product (GDP), net tax (i.e. tax revenue less transfer payments) and government spending, is then used to examine the effects of changes in net tax and government spending and their historical contributions of fiscal policy to New Zealand business cycles. Blanchard and Perotti’s model is also extended by examining the separate impact of taxes and government transfers.

The remainder of the paper is organised as follows. Section 2 outlines the model and data. Section 3 discusses the instantaneous (contemporaneous) dynamic effects of shocks in both net tax and government spending. Section 4 reports sensitivity analysis, robustness testing, and compares the New Zealand results to that from other models and economies. The historical contributions of net tax to New Zealand business cycles are examined in section 5. Key conclusions are discussed in section 6.