Non-Linearities in Fiscal Policy:The Role of Debt

WP/20/246 Non-Linearities in Fiscal Policy: The Role of Debt by Alexandra Fotiou IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. © 2020 International Monetary Fund WP/20/246 IMF Working Paper Fiscal Affairs Department Non-Linearities in Fiscal Policy: The Role of Debt0F∗Prepared by Alexandra Fotiou Authorized for distribution by Catherine Pattillo November 2020 Abstract Empirical evidence shows that fiscal multipliers depend on the state of the cycle, the nature of fiscal policy and the level of debt. In other words, evidence points to non-linearities in the effects of fiscal policy. This paper provides a framework to examine the role of the level of government debt in the assessment of consolidation policies across the business cycle, allowing for the consolidation multiplier to depend on the level of debt at the time of consolidation. The empirical analysis, which uses a panel of 13 countries between 1980 and 2014, finds that when debt is high, fiscal consolidations based on tax increases are in general self-defeating, in that they result in an increase of the debt-to-GDP ratio. Instead, cutting public expenditure has a less pronounced effect on economic activity and can stabilize debt. The initial level of debt in an economy, when a fiscal consolidation is implemented, appears to work as a channel in explaining evidence of state-dependence of the different consolidation instruments. JEL Classification Numbers: C33, E62, H60, H63 Keywords: Debt, Recessions, Expansions, Fiscal consolidations, Interacted-STVAR Author’s E-Mail Address: afotiou@imf.org ∗ This paper was previously circulated under the title “Non-Linearities and Fiscal Policy". I am grateful to my PhD supervisor Carlo Favero. In addition, I thank for their suggestions and advice Fabio Canova, Petros Dellaportas, Juan Dolado, Vitor Gaspar, Francesco Giavazzi, Luigi Iovino, Christophe Kamps, George Kapetanions, Ekaterini Kyriazidou, Paolo Mauro, Tommaso Monacelli, Evi Pappa, Catherine Pattillo, Luca Sala, Abdelhak Senhadji, Susan Yang, participants of the ECB Forum on Central Banking in Sintra, and seminar participants at Bocconi University, EUI, University of Amsterdam, Athens University of Economics and Business, ECB, Bank of Lithuania, ESRI, King's College London, New Economic School, UCD, University of Leipzig, ADEMU group, and participants in the seminars of the Fiscal Affairs Department. I also acknowledge financial support from the ERC INDIMACRO project. The views expressed here are those of my own and do not necessarily represent those of the International Monetary Fund. IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. Contents1 Introduction42 The General Model83 Data and Non-Linearities93.1 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93.2 Non-Linearities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .143.2.1State of the Economy. . . . . . . . . . . . . . . . . . . . . . . . . .143.2.2Type of Fiscal Consolidation. . . . . . . . . . . . . . . . . . . . . .173.2.3Government Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . .184 Model Specification204.1 An Interacted Smooth Transition VAR . . . . . . . . . . . . . . . . . . . . .204.2 Generalized Impulse Response Functions . . . . . . . . . . . . . . . . . . . .235 Results245.1 The Interacted-STVAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .246 Concluding Remarks283 1 IntroductionThe Global Financial Crisis and the Great Recession have triggered a renewed inter-est in the effects of fiscal policy. At the same time, discussions have increased regardingcountries with high public debt under fiscal austerity programs. One of the main topics ofpolicy debates relates to the implications that these fiscal austerity measures have for themacroeconomy, especially when a country is in an economic downturn and is experiencing ahigh level of debt. This paper assesses the role of the level ofpublic debtin determining thesize of state-dependent fiscal multipliers and the extent that fiscal consolidations are able tostabilise, decrease, or not the debt-