When Do Discretionary Changes in Government Spending or Taxes Have Larger Effects?

We investigate when discretionary increases and decreases in government spending or taxes have larger effects using a nonlinear vector autoregressive model with fiscal shocks identified via sign restrictions. We confirm previous empirical findings of state dependence in the relationship between fiscal policy and aggregate output, with the nonlinearity related to a broad measure of economic slack that displays strong asymmetry across the business cycle. This state dependence has important implications for the timing of stimulus or austerity measures. We find that tax cuts and spending increases have similarly large stimulative effects in periods of excessive slack, but are much less effective, especially in the case of spending increases, when the economy is close to or above potential. In terms of austerity measures designed to reduce the debt-to-GDP ratio, we find that tax increases and spending cuts are most contractionary and largely self defeating in periods of excessive slack, while only spending cuts lead to any significant reduction in the debt-to-GDP ratio when the economy is close to or above potential. The effectiveness of discretionary spending, including its state dependence, appears to be due almost entirely to the response of aggregate consumption, while the responses of both consumption and investment to discretionary taxes are state dependent, but investment appears to play the larger role in terms of their effectiveness.