3.2  Dynamic effects

Next, the dynamic effects of fiscal shocks are assessed using impulse response functions, which trace out the response over time of variables to an exogenous shock. Here, the responses of net tax, government spending and GDP to both a discretionary net tax shock and a discretionary government spending shock are considered.

In the deterministic model, variables grow along a long-run equilibrium path and only temporarily deviate from this set path. Impulse responses, which capture these transitory deviations from steady state, therefore eventually converge back to zero. For example, a government spending shock may cause GDP to temporarily move away from its long-run growth path, but eventually GDP returns to the level implied by its long-run growth path. Therefore, if the model is stationary, while shocks may have long-lasting effects they are not permanent.

In the case of the stochastic specification, the interpretation of the impulse responses is somewhat different. Because the endogenous variables are believed to be non-stationary, and are therefore transformed and modelled as first differences less a moving average of past first differences, in contrast to the deterministic specification, fiscal shocks have a permanent impact on the level of these variables. This means that the impulse responses do not converge back to zero following a fiscal shock. For example, a government spending shock causes GDP to converge to a new, higher or lower, level.[5]

Figures 2 and 3 show the responses of net tax, government spending and GDP to two fiscal shocks. The first shock is to net tax (Figure 2) and the second shock is to government spending (Figure 3). Both shocks are temporary; that is, net tax and government spending unexpectedly increase by one dollar for one quarter. All impulses are normalised to show the constant dollar shock of the response variables to the respective fiscal shock. Sixty-eight percent symmetric confidence bands, which were computed using 1000 bootstrap simulations, are shown by dotted lines in Figures 2 and 3.[6]

For the deterministic specification, Figure 2 shows the immediate response of a one dollar increase in net tax is to decrease GDP by 0.24 dollars. This negative impact on GDP persists for a couple of quarters, after which it is partly reversed with GDP increasing above trend, before the impact of the net tax shock dissipates. One possible explanation for the increase in GDP, after the decrease in GDP, is that other macroeconomic variables (such as interest and exchange rates) adjust in response to the initial fall in GDP, eventually stimulating the increase in GDP after the first year. To confirm this explanation it would be necessary to include these additional variables within the fiscal VAR model.[7] The response of government spending to the net tax shock is minimal.

Figure 2 – Responses to a net tax shock

For the stochastic specification, Figure 2 shows that in response to a one dollar increase in net tax, GDP falls by almost the same magnitude as in the deterministic specification. This negative impact on GDP persists for a couple of quarters, after which it is temporarily reversed with GDP increasing above trend, before converging to a lower long-run level. Like the corresponding deterministic specification, the response in government spending from the net tax shock is small. The permanent impact on net tax of the initial shock is to increase net tax by around 0.55 dollars per quarter.

Figure 3 – Responses to a government spending shock

For the deterministic specification, a one dollar increase in government spending leads to an immediate 0.14 dollar increase in GDP (see Figure 3). This positive effect persists for around one year, before the impact of the government spending shock on GDP becomes negative. Net tax also increases in response to the government spending shock. Note, however, that while net tax immediately increases by around 0.03 dollars, the peak response occurs after about a year and a half. This most likely reflects lags in the collection of tax revenue and the lagged impact of changes in GDP on the labour market (and hence transfer payments like unemployment benefits). The initial increase in government spending persists for over two years, although the stimulus reduces from the initial one dollar increase in the first quarter to around 0.36 dollars by the second quarter.

For the stochastic specification, the initial one dollar shock to government spending has a permanent positive impact on itself, net tax and GDP. The immediate one dollar increase in government spending diminishes over the first year, eventually resulting in a permanent 0.67 dollar increase in government spending per quarter. The peak response in output occurs during the first year, eventually leading to a permanent increase in GDP of around 0.26 dollars. Net tax permanently increases by around 0.04 dollars.

Results reported in this section show that for both the deterministic and stochastic specifications an increase in government spending leads to an increase in GDP. In the case of the deterministic specification, the positive stimulus to GDP lasts just over one year. For the stochastic specification, the government shock results in a permanent increase in the level of GDP.

To assess the individual effects of tax revenue and transfer payments we re-estimate the stochastic model by splitting net tax into tax revenue and transfer payments. The fiscal VAR now includes four variables; GDP, government spending, tax revenue and transfer payments. Government spending shocks were identified as outlined in Section 2.1. Transfer payments were cyclically adjusted using an elasticity of -0.3. Total tax revenue were cyclically adjusted using an elasticity of 1. The fiscal variables were ordered as follows: total tax revenue, transfer payments, and finally government spending. Sensitivity analyses suggested impulse responses were fairly insensitive to the ordering of government spending, transfer payments and total tax revenue.

Figure 4 shows the impulse responses of GDP, government spending, tax revenue and transfer payments to a government spending, tax revenue and transfer payments shock, respectively. The results show that following a tax revenue shock, GDP declines and remains at a lower level. But the decline is small. In contrast, following a rise in transfer payments GDP initially rises and then falls. Moreover, GDP falls by more following the rise in transfer payments than it falls following the increase in tax revenue.

The finding of a negative effect of tax revenue on output is in line with recent international literature that finds distortionary taxes have a negative long-run impact on economic growth (e.g. Widmalm, 2001, Padovano and Galli, 2002, and Li and Sarte, 2004). The result of a negative effect on output of an increase in transfer payments, on the other hand, is supportive of the empirical finding that transfer payments are unproductive government spending (e.g. Kneller, Bleaney and Gemmell, 1999, and Bleaney, Gemmell and Kneller, 2001). Increased transfer payments may reduce economic growth because of adverse labour supply incentives, for example.