Expansionary Fiscal Austerity : New International Evidence

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-te...

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Bibliographic Details
Main Author: Nie, Ou
Format: Working Paper
Language:English
Published: World Bank, Washington, DC 2020
Subjects:
Online Access:http://documents.worldbank.org/curated/en/430691596113581519/Expansionary-Fiscal-Austerity-New-International-Evidence
http://hdl.handle.net/10986/34262
Description
Summary: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.