4.2 Impulse response functions

This section presents empirical results for pure government spending and tax shocks. Impulse responses trace out the responsiveness of the dependent variables in the VAR to shocks to the error term. The impulse responses of output and the fiscal variables are normalised to have a contemporaneous impact of one-percent by dividing each shock by the standard deviation of the respective fiscal shock. These impulse responses are then divided by the ratio of the shocked fiscal variable and the responding variable, where the ratio is evaluated at the sample mean. Therefore, the rescaled impulses for the responses of output to the fiscal shocks can be interpreted as constant dollar multipliers[4] and can be interpreted as giving the reaction of the responding variable, in percent of real GDP, to a fiscal shock of size 1 percent of real GDP. For inflation and interest rates, the responses give the percentage points change in response to a one-percent fiscal shock.

The impulse responses are calculated following the methodology outlined in FG as follows;

1. Set all the shocks to zero and solve (3) dynamically forward to generate a baseline simulation for all variables up to the horizon which impulse responses are needed,
2. repeat step one for all variables by setting the relevant shock under consideration to one,
3. compute the impulse responses to the structural shocks as the difference between step 2 and step 1,
4. compute the one-standard deviation confidence intervals by using a bootstrap methodology (1000 bootstraps).

4.2.1  Government spending shock

Figure 10 displays the responses of the endogenous variables to a positive spending shock. The government spending shock is highly persistent and turns insignificant after 2.5 years. The persistence of government spending shocks is a typical finding in the majority of the fiscal VAR studies (Blanchard and Perotti, 2002; Perotti, 2005; Fatas and Mihov, 2001).

The government spending shock has a positive impact on output for 7 quarters but the estimated impulse responses are mostly insignificant. The immediate impact of a one percent of GDP increase in spending on output is around 0.26 percent. The peak impact occurs in the third quarter after the shock with a multiplier of 0.33. The cumulative output multiplier is approximately 0.42 in the first year. The GDP response turns slightly negative after 2 years possibly due to the persistently higher level of real interest rates.

Net taxes respond positively to the spending increase with the response peaking in the second quarter. Inflation picks up slightly as a result of the higher demand pressures but the impulse responses are statistically insignificant. Following a one percent increase in government expenditure, the long-run interest rate (10-year government bond yield) increases initially by approximately 7 basis points. The effect is persistent and mostly significant within the first 7 quarters. The overall impact is a slight increase in real interest rates.

The initial government spending increase exceeds the increase in taxes and the primary budget balance deteriorates. The deficit is financed by issuing debt which puts upward pressure on the long-term interest rates. Taxes start picking up after 10 quarters which helps to balance the budget in the long-run.

Figure 10: Responses to an increase in government spending

Source: Authors' calculations

4.2.2  Government revenue shocks

Figure 11 displays the endogenous responses of each variable following an increase of net taxes. The tax shock is relatively less persistent compared to the expenditure shock and becomes insignificant after 7 quarters. Following a slight initial increase, government spending starts to decline and the effect is precisely estimated. This result is in line with the results reported by Blanchard and Perotti (2002) and Claus et al. (2006) although the effect here is stronger. As a result, the primary balance improves and starts fading afterwards.

The immediate response of a one percent of GDP increase in net tax is to decrease GDP by 0.23 percent and the effect is statistically significant. This is very close to the estimate of 0.24, reported by Claus et al. (2006). GDP increases in the following two quarters and becomes negative throughout the whole horizon.

As expected, the medium and long-run impact of a positive tax shock on GDP is negative. The positive and significant increases in GDP in the second and third quarters are counter-intuitive but are a common finding in fiscal VAR literature.

For example, Perotti (2005) finds that tax cuts have a negative and significant impact on the outputs of UK, Germany and Australia. The effect is quite dramatic for the cases of UK and Australia where the negative impacts are sustained throughout a 5-year horizon. Using Spanish data, De Castro and Hernandez de Cos (2008) find that increase in net taxes have a positive and significant impact on output both in the short and medium term. Similarly, Giordano et al. (2007) find that positive tax shocks have positive and statistically significant effect on GDP in Italy. Similar findings are reported for several East Asian countries by Tang et al. (2011). The existence of similar tax puzzles is also highlighted in various studies for New Zealand.

Using the sign-identification methodology, Dungey and Fry (2009) identify fiscal and monetary shocks for New Zealand for the period 1982-2006. They find that tax increases have a small but positive impact on output both in the short and long-term. Using different models and sample periods with New Zealand data, Fielding et al. (2011) conduct an extensive analysis of the effects of fiscal policy in New Zealand. They show that the puzzle of positive effects of tax revenue shocks on GDP is fairly robust across various specifications. They suggest rising productivity in response to the unanticipated rise in tax revenues as a possible explanation.

It is important to note that our results do not show any sustained positive impact of tax increases on output. In this sense, they are similar to the findings of Claus et al. (2006) for New Zealand. In Section 6, we show that the response of output to a revenue shock is highly sensitive to the assumption on the elasticity of tax revenue with respect to GDP. Figure 24 show that the responses of GDP to a positive tax shock in the second and third quarters turn negative as the output elasticity exceeds 2. This is consistent with the findings of Caldara and Kemps (2008) who report similar findings using US data. A more in-depth analysis of the tax puzzle is left as an area for future research.

The inflation response to a net tax increase is small and negative. The effect is barely significant after the initial quarter. The long-term interest rate (10-year government bond yield) falls after two quarters with significant uncertainty around the estimated impact.

Figure 11: Responses to an increase in taxes net of transfers

Source: Authors' calculations