Government spending shocks, wealth effects and distortionary taxes

Cloyne, James S (2011): Government spending shocks, wealth effects and distortionary taxes.

Abstract

This paper investigates the transmission mechanism of government spending shocks in an estimated dynamic general equilibrium model. I construct a New Keynesian model with distortionary labour and capital taxes and with references that allow the wealth effect on labour supply to vary in strength. I show that the interaction of these two features crucially affects the response of the economy to a government spending shock. The model's parameters are therefore estimated (including the tax policy rules) for the United States. I show that the estimated model can match the positive empirical response of key variables including output, consumption and the real wage - a challenge for many New Keynesian models. I find that the estimated importance of the wealth effect is small; that sticky prices, variable capital utilisation, investment adjustment costs and habits all play an important role; and that whilst tax rates rise following the shock, their small magnitude crucially reduces the distortions involved.

• Item Type: MPRA Paper
• Language: English
• Keywords: fiscal policy, government spending shocks, government spending multiplier, business cycles
• Subjects: E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations ; Cycles; N - Economic History > N1 - Macroeconomics and Monetary Economics ; Industrial Structure ; Growth ; Fluctuations > N10 - General, International, or Comparative; H - Public Economics > H2 - Taxation, Subsidies, and Revenue > H20 - General; E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy > E20 - General

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