Fiscal Policy in the Aftermath of 9/11∗

This paper investigates the nature of U.S. fiscal policy in the aftermath of 9/11. We argue that the recent dramatic fall in the government surplus and the large fall in tax rates cannot be accounted for by either the state of the U.S. economy as of 9/11 or as the typical response of fiscal policy to a large exogenous rise in military expenditures. Our evidence suggests that, had tax rates responded in the way they ‘normally’ do to large exogenous changes in government spending, aggregate output would have been lower and the surplus would not have changed by much. The unusually large fall in tax rates had an expansionary impact on output and was the primary force underlying the large decline in the surplus. Our results do not bear directly on the question of whether the decline in tax rates and the decline in the surplus after 9/11 were desirable or not. ∗We thank seminar participants at the Federal Reserve Bank of Chicago for helpful comments. The views expressed in this paper do not necessarily represent the views of the Federal Reserve Bank of Chicago or the Federal Reserve System. †Northwestern University, NBER and Federal Reserve Bank of Chicago ‡Federal Reserve Bank of Chicago.