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How Does Fiscal Policy React to Wealth Composition and Asset Prices?

  • Luca Agnello

    (Banque de France and University of Palermo)

  • Vitor Castro

    (University of Coimbra and NIPE)

  • Ricardo M. Sousa

    (University of Minho, NIPE, London School of Economics and FMG)

We assess the response of fiscal policy to developments in asset markets in the US and the UK. We estimate fiscal policy rules augmented with aggregate wealth, wealth composition (i.e. financial and housing wealth) and asset prices (i.e. stock and housing prices) using: (i) a linear framework based on a fully simultaneous system approach; and (ii) two nonlinear specifications that rely on a smooth transition regression (STR) and a Markov-switching (MS) model. The linear framework suggests that, while primary spending does not seem to react to wealth composition or asset prices, taxes and primary surplus are significantly: (i) cut when financial wealth or stock prices rise; and (ii) raised when housing wealth or housing prices increase. The smooth transition regression model shows that primary spending and fiscal balance are adjusted in a nonlinear fashion to both wealth and price effects, while the Markov-switching framework highlights the importance of tax cuts (in the US) and spending hikes (in the UK) to offset the decline in wealth during major recessions and financial crises. Overall, our results provide evidence of a non-stabilizing effect of government debt, a countercyclical policy and a vigilant track of wealth developments by fiscal authorities.

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Paper provided by GEMF - Faculdade de Economia, Universidade de Coimbra in its series GEMF Working Papers with number 2011-18.

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Length: 46 pages
Date of creation: Sep 2011
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Handle: RePEc:gmf:wpaper:2011-18
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