5  Contributions of fiscal policy to New Zealand business cycles

In section 3 we investigated the dynamic response of output to net tax and government spending shocks via impulse response analysis. In this section, we use the three variable fiscal VAR to measure the historical contribution of fiscal policy to New Zealand business cycles. The aim is to assess the extent to which fiscal policy has added to or subtracted from GDP growth or percentage deviations in GDP from trend. The section also compares the fiscal VAR measures of fiscal impulse with another indicator of fiscal impulse developed by Philip and Janssen (2002).

5.1  Fiscal policy and New Zealand business cycles

We use the first difference and Hodrick-Prescott specifications, two specifications that are commonly used, to represent business cycles. The Hodrick-Prescott specification measures deviations in GDP from its trend growth path, the output gap. Historical decompositions thus assess the contributions from discretionary net tax and government spending shocks to the output gap. The first difference specification, also known as the growth cycle, measures the effect of discretionary fiscal policy on GDP growth, which is approximated by logarithmic first differences of GDP.

Historical decompositions are derived from the structural shocks and impulse responses as follows:

(5)    

In equation (5) Z_t measures the output gap or GDP growth rate at time t, is the i^th impulse response associated with the j ^th structural shock, where the structural shocks correspond to discretionary net tax, government spending and output shocks.

Figure 7 shows the contribution to New Zealand business cycles from net tax and government spending, and the combination of both for the period 1983 to 2005. Results are presented for both the first difference and Hodrick-Prescott specifications. Figure 7 shows that the business cycles for each specification are somewhat different. The volatility of the growth rate tends to be larger than for the Hodrick-Prescott specification. The zero line in each chart represents the point where each respective shock is making no contribution to the business cycles. Therefore, when the grey bars are positive, this implies the respective component is making a positive contribution to the output gap or GDP growth rate.[10]

For the first difference specification, which have been presented as the contribution to annual GDP growth to aid interpretation, shows the contribution from net tax to GDP growth is relatively small compared to the contribution of discretionary government spending. Over the period 1983 to 2005 it is difficult to determine whether discretionary changes in government spending were pro- or counter-cyclical. During the recession in the early 1990s the combined contribution of net tax and government spending (i.e. the total contribution from discretionary fiscal policy) was to generally exacerbate the recession, albeit that the impact was somewhat small. Discretionary fiscal policy tended to add to output growth during the mid- to late-1990s, when New Zealand had relative high growth rates, but again the size of the impact was small. During the past five years, the contribution from discretionary fiscal policy has tended to accentuate movements in output, i.e. fiscal policy has been procyclical.

Figure 7 – Contribution of fiscal policy to New Zealand business cycles – first difference specification (left) and Hodrick-Prescott specification (right)

Note: The series represented by bars on Figure 7 are contributions from net tax, government spending and fiscal impulse. The series represented by lines are deviations in GDP from the Hodrick-Prescott trend and annual GDP growth.

Turning to the Hodrick-Prescott specification, net tax appears to play a greater role, compared with the first difference specification. Furthermore, over the entire period 1982 to 2005, the contribution from net tax is generally pro-cyclical; more so than the pro-cyclicality between the contribution from discretionary government spending and the output gap. Looking at the total contribution from discretionary fiscal policy, during the 1991 to 1992 recession, discretionary fiscal policy accentuated the negative output gap according to the Hodrick-Prescott trend specification. As the economy recovered and the output gap became positive, discretionary fiscal policy made a positive contribution to the output gap. Discretionary fiscal policy contributed little to deviations in output from trend during the 1998 recession, and since then has tended to have a pro-cyclical effect.