Fiscal and Monetary Policy Interaction during the Age of ZIRP: Part 3

A Mark Sadowski post

In Part 3 we will add general government consumption and investment and general government net taxes to the trivariate baseline Vector Auto-Regression (VAR). Parts 1 and 2 can be found here and here.

With Government Wage and Salary Disbursements and Total Public Construction Spending (GWSDTPC) and Net Personal Taxes (monthly frequency proxies for general government consumption and investment and general government net taxes respectively) added to the baseline VAR model, most information criteria suggest a maximum lag length of four. The LM test suggests that there is no problem with serial correlation at this lag length. An AR roots table shows the VAR to be dynamically stable.

The Johansen’s Trace Test and Maximum Eigenvalue Test both indicate that there exists two cointegrating equation at this lag length. But this is expected, since we have evidence that the the monetary base is cointegrated with industrial production, and that net personal taxes is cointegrated with both PCEPI and industrial production. As discussed in the posts where the baseline VAR model was developed, since there is cointegration we should probably estimate a Vector Error Correction Model (a VECM), since it can generate statistically efficient estimates without losing long-run relationships among the variables as a VAR in levels (a VARL) might. However, in cases where there is no theory which can suggest the true cointegrating relationship or how it should be interpreted, it is probably better not to estimate a VECM.

I am using a recursive identification strategy (Cholesky decomposition). Such a strategy means that the order of the variables affects the results. I will follow the practice of Fatas and Mihov (2001) in ordering general government consumption and investment spending first, the output level second, the price level third, general government net tax revenue fourth and the monetary policy instrument last.

This ordering assumes that government consumption and investment spending is not affected contemporaneously by shocks originating in other sectors of the economy, and that changes in government consumption and investment spending, unlike changes in net tax revenue, are largely unrelated to the business cycle. Ordering the output level and the price level before net tax revenue can be justified on the grounds that shocks to these two variables have an immediate impact on the tax base and, thus, a contemporaneous effect on net tax revenue.

Thus this ordering of variables captures the effects of automatic stabilizers on net tax revenue. This ordering also assumes that the Federal Open Market Committee (FOMC) sees the current output level and price level when it sets the policy instrument, but that the output level and price level respond to a policy shock with one lag.As before, the response standard errors I will show are analytic, since Monte Carlo standard errors change each time an Impulse Response Function (IRF) is generated. Here are the responses of the output level and the price level to government spending, net taxes and the monetary base in the five-variable VAR.

sadowskif3_1

The response of the level of industrial production and the price level to a positive shock to general government consumption and investment spending is statistically insignificant in every month. Similarly, the response of the level of industrial production and the price level to a positive shock to general government net tax revenue is statistically insignificant in every month.

In contrast, a positive shock to the monetary base in month one leads to a statistically significant positive response in the level of industrial production in months five through 12. Furthermore, a positive shock to the monetary base in month one leads to a statistically significant positive response in the price level in month three.

The IRFs show that a positive 2.1% shock to the monetary base in month one (first line above) leads to a peak increase in the level of industrial production of 0.19% in month ten (second line above). They also show that a positive 2.1% shock to the monetary base in month one (second line) leads to a peak increase in the price level of 0.050% in month three (first line).

The bottom line is that there is no evidence that general government consumption and investment spending and general government net tax changes have had a statistically significant effect on either the output level or the price level from December 2008 through May 2015, or during the Age of Zero Interest Rate Policy (ZIRP). This is consistent with the Granger causality and bivariate VAR evidence presented in Part 2. On the other hand there is evidence that monetary base changes have had a statistically significant effect on both the output level and the price level in the Age of ZIRP. This is consistent with the evidence which I presented in the twelve part series on the Monetary Base and the Channels of Monetary Transmission which concluded here.

Since we can conclude that fiscal policy has had no statistically significant effect on the output level or the price level in the Age of ZIRP, and that monetary policy has, it might be useful to investigate the effect that fiscal policy changes have had on monetary policy. Here are the responses of the government spending, net taxes and the monetary base to each other in the five-variable VAR.

sadowskif3_2

The response of the monetary base to a positive shock to general government consumption and investment spending is statistically insignificant in every month. However, the response of the monetary base to a positive shock to general government net tax revenue is statistically significant in months three through eight. The IRFs show that a positive 4.0% shock to general government net tax revenue in month one leads to a peak increase in the monetary base of 1.7% in month six.

In other words, there is evidence that general government net tax changes have had a statistically significant effect on the monetary base in the Age of ZIRP.

Given the events surrounding the implementation of QE3 in particular, this shouldn’t be too surprising.

In mid-2012, several FOMC members (e.g. Evans, Rosengren and Williams) specifically mentioned the then forthcoming “fiscal cliff” as a motivation for additional monetary stimulus. An increase in income tax rates applicable to high income tax payers, and an increase in payroll taxes went into effect on January 1, 2013. These tax increases constituted approximately 70% of the budgetary effect of going over the “cliff” and are clearly visible in the graph of Net Personal Taxes in Part 2 of this post.

Between April 2012 and April 2013, Net Personal Taxes increased from $726.5 billion to $1,021.0 billion at an annual rate, a staggering 40.5% increase year-on-year. Given the above elasticity, and the five month lag to peak effect, this suggests that a substantial proportion of the increase in the monetary base under QE3 from September 2012 to September 2013 was in response to the fiscal cliff tax increase.

As Scott Sumner pointed out, recent estimates of Real GDP (RGDP) growth rates, Q4 over Q4, show that RGDP growth was only 1.7% and 1.3% in 2011 and 2012 respectively, before QE3 and the fiscal cliff, and was a more substantial 2.45% and 2.525% in 2013 and 2014, after QE3 and the fiscal cliff. It’s not hard to draw a connection between the improvement in RGDP growth rates after QE3 and the fiscal cliff and the VAR evidence that net tax changes have had no statistically significant effect on either the output level or the price level, that positive monetary base changes have had a statistically significant positive effect on both the output level and the price level, and that positive net tax changes have had a statistically significant positive effect on monetary base changes.

And the slow RGDP growth in 2011 and 2012 can itself be connected to this phenomenon.

Prior to the fiscal cliff, the largest discretionary changes in net taxes were those implemented as part of the “fiscal stimulus”. According to BEA estimates (via FRED), between 2008Q4 and 2010Q1, due to the American Reinvestment and Recovery Act (ARRA) Federal personal current taxes were reduced by $130.9 billion at an annual rate, and refundable tax credits to persons were increased by $29.7 billion at an annual rate. Thus Net Personal Taxes were reduced by $160.6 billion at an annual rate. This persisted through 2010Q4, and most of this reduction in Net Personal Taxes was maintained in the form of the 2% “payroll tax holiday” until the advent of the 2013 fiscal cliff.

The $160.6 billion discretionary cut in Net Personal Taxes meant that Net Personal Tax revenue was only $444.1 billion in March 2010, instead of $604.7 billion, a reduction of 26.6%. March 2010 also happened to be the month that QE1 was concluded. Thus the VAR estimates suggest that QE1 was probably substantially smaller in response to the cut in Net Personal Taxes enacted under the 2009 fiscal stimulus.

I suspect that the FOMC had expected a much larger economic response to the tax changes than actually occurred in 2010, and this is the main reason why they grudgingly acquiesced to the ad hoc $600 billion in monetary stimulus under QE2. It wasn’t until the specter of the 2013 fiscal cliff that a substantial amount of open ended quantitative easing was finally unleashed, and in turn it wasn’t until this act that RGDP growth was anything other than pathetically stagnant during the recovery from the Great Recession.

The upshot of all this is that the FOMC has behaved as though taxes have a substantial fiscal multiplier. They have reacted to tax cuts by reducing monetary stimulus, and to tax increases by increasing monetary stimulus. Since the time series econometric evidence shows that the tax cut multiplier is not statistically different from zero, and that quantitative easing has statistically significant effects on the output level and the price level, this means that tax cuts have had the perverse effect of leading to less economic growth and, similarly, that tax increases have led to increased economic growth.

Thus, in the Age of ZIRP, the monetary offset of fiscal policy has effectively meant that the fiscal multiplier has not only been zero, it has been negative.

8 thoughts on “Fiscal and Monetary Policy Interaction during the Age of ZIRP: Part 3

  1. “…tax cuts have had the perverse effect of leading to less economic growth and, similarly, that tax increases have led to increased economic growth.”

    Maybe you should see if the WSJ is interested in publishing an op ed about this.

  2. Great blogging. One question about your conclusion regarding tax cuts. Given the Sumner critique, wouldn’t it mostly apply in a discretionary regime or flexible inflation targeting rather than a regime that follows a rules-based nominal target?

    • Let me see if I understand your question.

      Let’s assume that fiscal policy has a statistically significant effect on aggregate demand (NGDP). This will cause changes in the price level as well. So the central bank will offset fiscal policy whether it is following a flexible IT regime or an NGDPLT regime. The differences will be due to NGDP vs prices as a target, the fact that one is level target and the other is a rate target, and the degree of flexibility in each. But the effective fiscal multiplier will tend towards zero the more inflexible the regime.

      The situation I am portraying is one where the Fed has apparently been offsetting tax changes even though the effect of tax changes on output and prices has not been significantly different from zero. In other words, they are reacting to what they believe about the effect tax changes will have on the economy, rather than to what is actually happening. The tax change multiplier will effectively be negative in such a situation regardless of whether the central bank is following a flexible IT or an NGDPLT regime.

      However, suppose the effect of tax changes on output and prices is not significantly different from zero, and that the central bank ignores tax changes when implementing policy, and instead strictly focuses on market based measures of the expected value of its target variable, whether it be the inflation rate or the level of NGDP. Then the fiscal multiplier will not be effectively negative, but instead will be the zero value we are assuming it to be in this scenario.

      The perverse outcome (a negative fiscal multiplier) that I’ve described in this post seems to be the result of the FOMC reacting to its beliefs about the effects of tax changes, rather than to market based measures of the expected value of its target variable, as it really should be doing.

      • Thank you for the very through explanation. I think the bottom line, as in your answer is that this data applies to an errant reaction function, because if the central bank is level targeting inflation or NGDP, the impact of tax change would be zero because it would be offset more or less automatically. But if the regime is growth rate targeting, or some form of discretionary, then tax changes would be more noticeable. So it depends on what the central bank is doing at the time the changes occur.

        The ECB’s behavior during the Great Recession and the ensuing austerity, I think, is a good example of what happens with straight up IT growth rate regime, where higher taxes did not lead to higher growth.

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