Uncertainty and Fiscal Cliffs

Fiscal uncertainty arises in many forms. Expiring temporary stimulus measures, projections of rapid debt growth, and oscillating political concerns over general levels of taxation are examples that all contribute to fiscal uncertainty. Motivated by anecdotal evidence associated with the US Fiscal-Cliff episode near the end of 2012, we empirically investigate the impact of economic policy uncertainty on investment and employment, especially with regard to the type of investment project. Increases in policy uncertainty lower investment and employment, with some investment dropping immediately and some more gradually, depending upon the ease of installation of types of capital. Based upon this empirical evidence, we then present a DSGE model of expiring tax provisions, and show that the model generates responses to fiscal uncertainty that match key features of the data. The framework captures a few unique elements of fiscal uncertainty. First, fiscal uncertainty is over the average tax rate, rather than a mean-preserving shock to the future tax rate. Second, households obtain information that tax rates may change at a particular date in the future, though whether tax rates do ultimately change is uncertain. As a result, information indicating that a policy change may occur in the future immediately sets in motion partial adjustments toward the new policy. The degree of adjustment households undertake depends on the probability attached to the outcome that actually does result in a change in fiscal policy. Unsuccessful reforms inject noise into the economy and lower the steady state level of the capital stock and output.