Expansionary Fiscal Austerity: New International Evidence

Owen Nie

No 9344, Policy Research Working Paper Series from The World Bank

Abstract: The expansionary fiscal contraction (EFC) hypothesis states that fiscal austerity can increase output or consumption when a country is under heavy debt burdens because it sends positive signal about the country's solvency situation and long-term economic wellbeing. Empirical tests of this hypothesis have suffered from identification concerns due to data sources and empirical methodology. Using a sample of OECD countries between 1978 and 2014, this paper combines new IMF narrative data and the proxy structural Vector Auto-regression (SVAR) method to examine whether fiscal austerities can be expansionary when debt levels are high. Fiscal austerities are measured as 1) narrative fiscal shocks and 2) structural shocks from a proxy SVAR. Additionally, this paper uses a model-based approach to determine the cutoff debt level beyond which EFC is expected to be observed. This paper finds empirical evidence in support of the EFC hypothesis for OECD countries: results for output are driven by changes in tax rates and are robust to how one defines a high-debt regime and how one measures austerity.

Keywords: Public Sector Economics; Macro-Fiscal Policy; Economic Adjustment and Lending; Public Finance Decentralization and Poverty Reduction; Taxation&Subsidies; Economic Conditions and Volatility (search for similar items in EconPapers)
Date: 2020-07-30
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Persistent link: https://EconPapers.repec.org/RePEc:wbk:wbrwps:9344

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