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Thank you for submitting a report! Submitting a report will send us an email through our customer support system. With policy lags, though, the performance of the optimal activist policy deteriorated, to the point that, with an assumed lag of 10 quarters, the optimal activist policy was no better, and under some assumptions worse, than a constantrate policy. Thus, Gordon and Jorgenson concluded, a realistic policy environment made activist use of the ITC much less attractive.
Although policy lags were not a newly-identified problem in the s, it was not until then that researchers had a period of activist fiscal policy practice sufficient to study. One might have come away from the analysis of Gordon and Jorgenson and others with the view that activist policy was more difficult that its designers had realized but not necessarily bad.
But the intellectual assault on activist fiscal policy — indeed, in the specific form of the investment tax credit — soon took a much stronger turn, in celebrated papers by Lucas and Kydland and Prescott Kydland and Prescott emphasized the dynamic inconsistency of optimal government plans. The path for the ITC that would be optimal as of one date would no longer be optimal in the future; so, under the assumption of rational expectations, investors would not find the initial announcement credible.
Hence, in addition to the policy lags that made the implementation of policy difficult, one was confronted with two major additional obstacles: first, to figure out how to evaluate potential policies and, second, to recognize that agents react not to policies that are announced, but to policies that are expected. To these three hurdles, policy lags, model instability, and dynamic inconsistency, the literature added several others.
There was, of course, the problem that estimates of behavioral responses to fiscal policy were just that — estimates of parameters, not the parameters themselves.
Even with a stable model, i. For example, there has been a long debate in the investment literature about the importance of the user cost of capital as a determinant of investment, relating to such factors as the elasticity of substitution between capital and labor and the irreversibility and adjustment costs of investment.
In another major policy area, the efficacy of tax cuts and increased transfer payments to households depends on household horizons. Finally, a growing body of the economics literature questioned whether government should wish to counteract economic fluctuations, even if it were able to do so.
An important implication of this conclusion was that observed economic fluctuations were optimal, reflecting the responses of markets to taste and technology shocks. Thus, any attempt by government to offset these fluctuations would be welfare-reducing. Simply put, if a temporary drop in production and rise in unemployment were voluntary, given exogenous economic events, then attempts to intervene would be inadvisable.
Politicians perhaps never experienced the same loss of enthusiasm for activist fiscal policy that economists did. In the United States, the investment tax credit was repealed as part of the Tax Reform Act of , and has not resurfaced.
But a close relative with similar incentive and revenue effects, partial first-year investment expensing, was introduced in and expanded in as an explicitly temporary measure and did, in fact, expire at the end of to spur equipment investment, which had fallen sharply in the years immediately before.
Perhaps politicians have not learned anything about the practice of fiscal policy since the s; or perhaps economists have. The purpose of this paper is to review what we have learned, in theory and in practice, about the use of fiscal policy as an element of stabilization 4 policy, focusing on some of the criticisms given above and taking into account changes in the policy environment that have occurred since the s, in particular, the fact that most developed countries currently find themselves on unsustainable fiscal trajectories as generous old-age transfer programs collide with rapidly aging populations.
For example, how poorly timed have policy changes been? How credible have government announcements been? To what extent have responses to policy changes followed predictions?
To what extent have policy changes been ineffectual? While each of these questions is well-posed, they are difficult to answer separately. Behavioral responses may vary from predictions because we are using the wrong parameters in our behavioral equations, but they may also vary because a policy is seen as less credible than the model assumes.
What dates should we use to mark policy changes: when actual taxes or expenditures change, when a law is passed indicating that they will change, or perhaps when agents become convinced of the change? The very problems that give rise to some of the criticisms also make clean analysis difficult, a problem not always noted in the literature. For example, there have been a number of papers analyzing the properties of fiscal policy changes — their timing, magnitude, etc. The most common approach is to equate changes in fiscal policy with changes in an adjusted measure of the government budget surplus, or perhaps with the separate tax and spending components of the surplus, from one period — typically one quarter — to the next.
The standard adjustment undertaken is for the state of the economy, either through the formal 5 calculation of a full-employment surplus or through a regression on output to control for the level of aggregate economic activity. The intuition is that, but for a change in policy, the adjusted surplus would be constant, say, as a share of GDP.
First, these measures may change for reasons unrelated to policy. The behavior of fiscal aggregates in the United States around September 11, provides a good case study to illustrate these points. As we now know, the economy had gone into recession several months prior to September 11, and the weakening economy contributed o the declining budget surplus.
As Figure 1 shows, the full-employment surplus was relatively stable through the second quarter of , while the unadjusted surplus was declining. However, the sharp drop in the surplus during the third quarter of is only slightly weakened by the full-employment adjustment, suggesting that a major expansionary policy change occurred during this quarter, either just before or just after September There were few changes in spending programs during the period, but there were two factors, other than the economic slowdown, contributing to a decline in revenues.
Thus, the large apparent change in discretionary policy that occurred during the third quarter of derives largely from two sources; one was a policy change adopted earlier in the year, another was not a policy change at all. Clearly, the second source should not be counted as a change in policy; a collapse in the stock market is not an expansionary fiscal policy! As to the first, some of the effects of policy might have been delayed until tax payments actually were reduced, but we would typically not expect all responses to have been delayed; moreover, if we are considering the timing of policy decisions, we would like to know when these decisions occurred.
It is difficult to know how typical this case is. Major, unannounced policy changes may still dominate the series being considered, but one should consider the resulting analysis with some caution. With this caveat in mind, we note what the literature has found regarding the responsiveness of policy to the state of the economy, at a quarterly frequency.
Thus, the view that discretionary policy is so poorly timed that it cannot be an effective tool for stabilization is not supported. As to the degree of policy activism, this actually appears to have increased over the years, with the period since the mids showing more than twice the responsiveness of the full period since the s, and the period since the first year of the Clinton Administration, , showing a responsiveness again more than double that of the period since the mids Auerbach , Table 1.
These changes appear to go against the trend in economic thinking away from activist policy, and are all the more remarkable in the United States, given the introduction beginning in the s of various budget rules viewed as making revenue and spending changes more difficult.
Moreover, this general pattern does not appear unique to the United States, as Gali and Perotti have found a similar recent increase in cyclical responsiveness in the European Union, following the adoption of the Growth and Stability Pact imposing restrictions on deficit-oriented fiscal policies.
One can conclude, it appears, that policy changes can be countercyclical, and that they have become more so, in spite of professional skepticism and the apparent constraints of budget rules.
To address the two caveats mentioned above with respect to using changes in the fullemployment surplus as a measure of fiscal policy changes, in Auerbach , I construct an alternative measure, based on explicit policy changes as reported over the years by the Congressional Budget Office. As explained in more detail in these earlier papers, the resulting semi-annual measure excludes changes in the surplus not attributable to policy changes such as declines in revenues due to the stock market drop of , and its dating convention is based on the timing f legislation, recording changes immediately upon announcement, rather than when the revenue or spending changes occur.
This measure, it must be admitted, suffers from other problems of interpretation, for example that it treats announced future policy as certain to occur, even when this is not viewed as likely.
Sunset provisions call for policy changes — such as the large Bush tax cuts of — to apply only for a certain number of years, even when the stated policy objective is that they be permanent.
Nevertheless, the alternative measure of discretionary fiscal policy, like the full-employment surplus, exhibits significant responsiveness to the output gap, with both expenditures and revenues moving in the right direction, appearing to confirm the previous finding that recent discretionary fiscal policy in the United States, in the aggregate, has at least pointed in the countercyclical direction.
Perhaps the most important illustration of these differences in tax policy effects concerns investment. How should we measure the policy changes affecting investment incentives? The challenge of doing so once again brings together different strands of the critique of activist fiscal policy.
The effects of policy changes depend not only on the timing of policy actions, but also on what these actions portend regarding future policy actions. To begin, consider the standard Hall-Jorgenson user of cost of capital, which provides a measure of the required gross, before-tax return to capital and hence a measure of the.
Asako et al. They find that Japan practiced countercyclical fiscal policy during the period If one modifies the assumptions to incorporate changes in tax policy, the user cost of capital becomes see Auerbach : q? The presence of the additional term on the right-hand side of 2 means that there is now a second way in which tax policy may affect investment. But expression 2 applies only under the assumption of instantaneous capital stock adjustment.
In Auerbach , I used this framework to measure the determinants of U. I constructed time series for tax-related changes in the user cost of capital for equipment investment under two extreme assumptions about expected tax law changes, either that investors are myopic and expect the tax law to be constant in the future expression 1 or that investors have perfect foresight with respect to changes expressions 2 and 3.
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