The Macroeconomic Effects of Fiscal Policy James S. Cloyne Department of Economics University College London Submitted for the degree of Doctor of Philosophy at University College London July 2011 Declaration \I, James Samuel Cloyne confirm that the work presented in this thesis \The Macroe- conomic Effects of Fiscal Policy" is entirely my own, except for Chapter 3 which is part of joint work with Karel Mertens and Morten O. Ravn. Where information has been derived from other sources, I confirm that this has been indicated in the thesis." James Cloyne Certified by Professor Wendy Carlin (Supervisor) 2 Abstract This thesis analyses the macroeconomic effects of changes in fiscal policy. Chapter 1 provides an overview. Chapter 2 estimates the macroeconomic effects of tax changes in the United King- dom. Identification is achieved by constructing an extensive new `narrative' dataset of `exogenous' tax changes in the post-war U.K. economy. Using this dataset I find that a 1 per cent cut in taxes increases GDP by 0.6 per cent on impact and by 2.5 per cent over three years. These findings are remarkably similar to narrative-based estimates for the United States. Furthermore, `exogenous' tax changes are shown to have contributed to major episodes in the U.K. post-war business cycle. The long appendix contains the detailed historical narrative and dataset. Chapter 3 estimates the endogenous feedback from output, debt and government spending to fiscal instruments in the United States. The central innovation is to make direct use of narrative-measured tax shocks in a DSGE model estimated using Bayesian methods. I therefore assume the tax shocks are observable, rather than latent variables. I show that the feedback from debt to the fiscal instruments is weaker than previously estimated and that the capital tax multiplier is higher. Moreover, the data are more consistent with a model with endogenous feedback than one with an exogenous fiscal policy specification. Chapter 4 examines the transmission mechanism of government spending shocks by constructing and estimating a DSGE model for the United States. I show that the endogenous response of different taxes and the strength of wealth effect on labour supply play a powerful role. Given that there is little prior information on the strength of these mechanisms, I estimate the key parameters in the model. I show that this estimated model can match the empirical responses of key variables that are a challenge for many models of this type. 3 Acknowledgements I am greatly indebted to my supervisors, Wendy Carlin, Morten Ravn and Liam Graham for all their generous advice, support and encouragement. It was a great privilege to have had access to such brilliant minds and wonderful supervision. This thesis, as well as my own knowledge and understanding, are undoubtedly richer as a result. Over the years I have also benefited from discussions with numerous individuals, many of whom kindly gave their time to talk through my ideas, to make suggestions and to read my work. At University College London I would especially like to thank Nicola Pavoni, Jeremy Lise, Nick Rau, Nick Oulton, Antonio Guarino, Rachel Griffith and Guy Laroque. My sincere thanks are also extended to Orazio Attanasio for his efforts and guidance as our placement director. Needless to say, the administrative staff at the Department of Economics provided invaluable support and assistance during my studies. In the wider academic community I would like to thank Alexis Anagnostopoulos, Martin Eichenbaum, Jeff Fuhrer, Nezih Guner, Ethan Ilzetzki, Albert Marcet, Ellen Mc- Gratten, Edward Nelson, Chris Pissarides, Helene Rey, Victor Rios-Rull, Pedro Teles and Harald Uhlig for useful discussions during my studies or for feedback on my work. A few may not recall our discussions but I nonetheless found them incredibly helpful during the course of my research. I am also grateful for comments from seminar participants at the Bank of England, the Federal Reserve Bank of Boston, the University of Edinburgh, University College London and the CESifo Money, Macro and International Finance con- ference in Munich. Finally, special thanks go to Chris Carroll for his interest, enthusiasm and encouragement during the job market process. Chapter 2 of my thesis was awarded the Distinguished Young Affiliate Award by the CESifo Group in Munich. I would like to express my sincere gratitude to the award committee and the head of the macro research area Paul De Grauwe. I was greatly honoured to receive this prize and kindly acknowledge the CESifo sponsorship I have received. The compiling of the long appendix on the history of U.K. tax policy, which accom- panies Chapter 2, was an extensive task. On starting the project, I was lucky enough to have the advice and knowledge of Carl Emmerson at the Institute for Fiscal Studies whose detailed understanding of U.K. fiscal policy proved an invaluable aid. During the data collection I was greatly helped by librarians at the London School of Economics who pointed me in the direction of electronic archives, which greatly sped up the process (relatively!), and the librarians at Her Majesty's Treasury. Chapter 3 of this thesis is part of joint work I have been undertaking with Morten Ravn and Karel Mertens. I am therefore greatly indebted to my co-authors for all our on-going discussions as well as their ideas and suggestions during the project. Needless to say, any errors or omissions in the thesis chapter itself are my own. 4 I would also like to thank my former colleagues at the Cabinet Office and 10 Down- ing Street, particularly my former managers Julian McCrae, Axel Heitmueller and Hugh Harris, for giving me the opportunity to apply my research to policy and juggling my aca- demic schedule. It was a unique and unusual experience to be at the heart of government while also working on my PhD. I joined the Cabinet Office as a macroeconomist in the immediate aftermath of the U.K.'s fiscal stimulus and at a time when deficit reduction was rapidly becoming the number one macroeconomic policy question. My part-time work in the policy world complemented well the research I was undertaking. I had very useful discussions with colleagues and access to information which proved particularly valuable while working on Chapter 2. I hope the research presented in this thesis re- flects my general policy interests and the questions that stimulated me while working in government. Finally, I must thank my family and friends | in particular my partner Laurel and my parents John and Elizabeth | for their unflinching support through the good times and the bad. They put up with the erratic working hours, the disappearing-off to my computer at obscure times and my mind often being elsewhere. They reassured in times of doubt and provided an invaluable rock throughout. Without the support of my supervisors, colleagues, friends and family I have little doubt this thesis would have been immeasurably harder to write and it is for this reason that it must be dedicated to them. James S. Cloyne July 2011 5 Contents 1 Introduction 13 1.1 Identifying the effects of exogenous discretionary tax changes . 13 1.2 The impact and determinants of endogenous tax changes . 15 1.3 The macroeconomic effect of government spending shocks . 16 2 What are the effects of tax changes in the United Kingdom? 18 2.1 Introduction . 18 2.2 The new U.K. post-war tax dataset . 21 2.2.1 Identification . 21 2.2.2 Constructing the exogenous series . 23 2.2.3 Properties of the new tax dataset . 29 2.2.4 Testing the predictability of the `exogenous' tax changes . 32 2.3 The macroeconomic effects of tax shocks: baseline specification . 34 2.3.1 Baseline results for output and its components . 35 2.3.2 The labour market response . 39 2.4 Robustness . 41 2.4.1 Estimation of a first differences model . 41 2.4.2 Controlling for other shocks to revenues . 41 2.4.3 Controlling for other structural shocks . 43 2.4.4 Excluding anticipated shocks . 46 2.4.5 Comparison with the Romer and Romer method . 47 2.4.6 Using all discretionary policy changes . 47 2.4.7 Retroactive components and the alternative classification . 47 2.4.8 Outliers . 48 2.4.9 Making use of observations back to 1948 . 48 2.5 Effects of differently motivated shocks . 49 2.6 Tax shocks and the U.K. business cycle . 52 2.7 Conclusion . 55 6 3 The importance of endogenous tax changes: narrative measures in an estimated DSGE model 56 3.1 Introduction . 56 3.2 The model . 59 3.2.1 Households . 59 3.2.2 Firms . 61 3.2.3 Monetary policy . 63 3.2.4 Fiscal policy rules . 63 3.2.5 Incorporating the narrative measures . 65 3.2.6 Equilibrium and model solution . 65 3.3 Estimation . 66 3.3.1 Calibration and priors . 68 3.3.2 Estimation results . 69 3.3.3 Measurement error in the narrative endogenous tax changes . 74 3.4 The effect of tax and spending shocks . 74 3.4.1 Impulse response analysis . 75 3.4.2 Fiscal multipliers . 78 3.4.3 A comparison with Romer{Romer . 80 3.5 Model comparisons and robustness . 81 3.5.1 Depreciation allowances and sticky prices . 81 3.5.2 Exogenous or endogenous fiscal policy? . 82 3.6 Conclusion . 84 4 Government spending, wealth effects and distortionary taxation 86 4.1 Introduction . 86 4.2 The empirical effects of government spending shocks . 89 4.2.1 Identification . 89 4.2.2 The data . 91 4.2.3 Results . 91 4.3 The model .