Some Fiscal Calculus

What is the impact of fiscal policy on the economy? How large are the “multipliers” of government spending and tax cuts? This old question has recently received considerable attention, in particular in the context of the American Recovery and Reinvestment Act (ARRA) of 2009. I contribute to answering that question by calculating fiscal multipliers in a baseline neoclassical growth model with endogenous labor supply and fiscal policy, allowing for government spending transfers, government debt and distortionary taxes on labor and capital income. The policy experiments are conducted holding transfers, consumption taxes and capital income taxes fixed, i.e., changes in taxation require changes in the distortionary labor tax. The model is simple and fairly standard. As an additional contribution, I provide the model in an elegant and tractable form, starting from a fairly general formulation and pointing out the key functional form properties for characterizing the dynamics. The formulation of the model here or versions thereof may be useful for a variety of purposes. I shall argue that short run fiscal multipliers can be dramatically misleading. In the model here, the initial effect of a government spending as in the ARRA stimulates output, see Figure 3, initially generating net present fiscal multipliers well in excess of unity, see Figure 2. However, this turns into a prolonged below trend performance of output, as the tax increases necessary to repay the increased debt impact on the economy, see figures 4 and 5. The net present fiscal multiplier for government spending turns negative too, as the horizon increases. Indeed, according to this model and its parameterization, Understanding the impact of fiscal policy