IMF Survey: Making Fiscal Stimulus Effective During Downturns

IMF News, October 2, 2008

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Tax cuts or spending increases that make debt unsustainable are likely to cause output to fall, not rise.
Key challenge: ensure discretionary fiscal policy measures—changes in spending and taxation—are delivered quickly and do not cause concerns about future debt sustainability.
Discretionary fiscal measures:
- Typically slower to arrive than monetary policy responses.
- Often become permanent, implying that public debt creeps upward.
Automatic stabilizers:
- Respond naturally as the economy fluctuates (for example, increases in spending on unemployment benefits during downturns).
- Provide a symmetric response over the cycle, avoiding the easing bias seen in discretionary measures.

Fiscal stimulus is a potential tool for countering economic slowdowns, but it must be timely, targeted, and temporary to be effective.
Historical patterns:
- Advanced economies: discretionary fiscal policy has typically been countercyclical (taxes cut and spending increased during downturns).
- Emerging economies: fiscal policy has often been procyclical (stimulus added during good times and removed during downturns), tending to destabilize rather than smooth fluctuations.
Example of policy action: the United States responded with the Economic Stimulus Act, passed in February 2008.

The three "Ts" policymakers should assess: timely, targeted, and temporary.
Common practical problems:
- Discretionary fiscal policy has usually been used less frequently than monetary policy during downturns and has taken longer to arrive—often after it is needed.
- Discretionary policy typically shows an easing bias—more tax cuts and spending increases during downturns than tax increases and spending cuts during upturns—causing debt to creep upward.
- Automatic stabilizers have the advantage of responding symmetrically and immediately.

New evidence finds discretionary fiscal policy can have moderately countercyclical effects, with important caveats and differences between advanced and emerging economies.
Key quantitative finding:
- On average, for all economies, a discretionary stimulus package equivalent to 1 percent of country's GDP is associated with GDP increases of about 0.1 to 0.2 percent.
Longer-term effects:
- Advanced economies: longer-term effects are positive and possibly higher.
- Emerging economies: longer-term effects are typically negative.
Channels explaining weaker outcomes in emerging economies:
- Debt sustainability concerns may lead households and firms to anticipate higher taxes or inflation in the future.
- International capital markets may impose higher interest rates to insure against these risks.
- Resulting behavior: households save more (reducing demand) and firms invest less.

Preconditions for using discretionary fiscal policy:
- Improve fiscal positions during good times.
- Credibly commit that stimulus packages are temporary.
Composition matters:
- Policy changes based on cutting taxes appear to be more successful at stimulating growth than those based on increased spending.
- Fiscal changes need coordination with monetary policy goals—particularly because increased spending can create pressure on prices.
Strengthening automatic stabilizers:
- Automatic stabilizers respond immediately and symmetrically, keeping public debt stable over the business cycle.
- Policymakers could design tax, transfer, or spending programs to be linked directly to the state of the economy to strengthen stabilization effects.
Enhancing credibility of discretionary measures:
- Changes in fiscal governance could reduce debt bias, including placing more emphasis on transparent evaluations of the state of the economy and longer-term implications of fiscal measures.

Source: IMF Survey: Making Fiscal Stimulus Effective During Downturns, Alasdair Scott, IMF Research Department, October 2, 2008