Non-Linearities in Fiscal Policy:The Role of Debt

IMF Working Papers, November 13, 2020

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Provides a framework to examine the role of the level of government debt in the assessment of consolidation policies across the business cycle.
Allows the consolidation multiplier to depend on the level of debt at the time of consolidation.
Investigates how the initial level of debt operates as a channel explaining state-dependence of different consolidation instruments.

Fiscal multipliers depend on:
- the state of the cycle,
- the nature of fiscal policy,
- and the level of debt.
Evidence points to non-linearities in the effects of fiscal policy.
When debt is high:
- Fiscal consolidations based on tax increases are in general self-defeating, in that they result in an increase of the debt-to-GDP ratio.
- Cutting public expenditure has a less pronounced effect on economic activity and can stabilize debt.
The initial level of debt when a fiscal consolidation is implemented appears to work as a channel explaining observed state-dependence of consolidation instruments.

Subjects: Expenditure, Fiscal consolidation, Fiscal multipliers, Fiscal policy, Production, Production growth, Public debt.
Keywords include: Debt, debt level, effects of tax, evidence of state-dependency, Expansions, Fiscal consolidation, Interacted-STVAR, multiplier effect, Production growth, Recessions, regime-switching model, state indicator, state of the business cycle, state of the public finances, WP.

Source: Alexandra Fotiou, "Non-Linearities in Fiscal Policy:The Role of Debt", IMF Working Papers, November 13, 2020.