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Prepared by Roberto Cardarelli and Ayhan Kose.
The Staff report contains a detailed description of the Administration’s original FY 2004 Budget proposals and of the tax legislation that was passed in May 2003.
The studies employ different assumptions regarding the baseline scenario. Further, while the CBO study examines the implications of the entire FY 2004 Budget proposals, the other studies focus only on the Economic Growth Package. Finally, the study by the CEA does not report which model is used, but notes that “the particular values of the numerical estimates presented reflect judgments regarding the implementation of the proposals” (CEA, 2003)
In the textbook growth model, labor supply increases because of lower marginal tax rates, but output declines because higher government and private consumption crowds out capital accumulation. It is only when expectations of higher taxes after 2013 induce additional savings that the tax cuts have a positive impact on savings, investment and output (as in the two models with forward-looking agents). This effect is larger in an infinite-horizon model, since agents take into account the higher tax burden on their descendants. In all models, maximum effect is achieved if the future increase in taxation is through higher lump-sum taxes. Estimates assuming an increase in future marginal tax rates fall between those presented in Table 3.
For a brief description of some of these models in the context of a dynamic scoring analysis of fiscal policy measures (including two large-scale structural models of the U.S. economy used by the Federal Reserve), see Mauskopf and Reifschneider (1997).
Among the studies that find no statistically significant relationship between fiscal deficits and interest rate are the ones by Plosser (1987) and Evans (1987), which proxied expected fiscal deficits using forecasts from vector autoregressive models (VAR). However, the usefulness of this method to capture actual expectations is subject to a series of limitations (Elmendorf, 1993).
A caveat on these results is that the reduced-form relationship between expectations of future budget deficits and interest rates could be driven by changes in the expectations of output growth. However, Elmendorf (1996) shows that this relationship is robust to the explicit introduction of a variable capturing expectations on the future state of the business cycle.
The assumption made by CEA (2003) is that, while private savings do not respond at all to the increase in public debt, around a third of the decrease in national savings is offset by larger capital flows from abroad.
Using panel data techniques, Gagnon and Unferth (1995) show that national real interest rates do not exhibit persistent deviations from a common world interest rate, defined as the simple average of the rates of nine OECD countries. The only exception seems to be the United States, a result that the authors suggest may be reflecting the lower trade integration of this country with the rest of the world. On the correlations reported in Table 4, it should be noted that since 1999 the European countries that joined the Euro have essentially shared the same interest rate.
This captures the two channels through which fiscal policy is supposed to crowd out private investments, the “portfolio” channel (via higher public debt) and the “transaction” channel (via higher government spending). Following Ford and Laxton (1999), the change in real government consumption is also used as a regressor. As economic theory suggests that both the fiscal variables (expressed as a share of GDP) and the real interest rates are stationary, no attempt is made to estimate a long-run relationship between these variables using a cointegration approach.
This approach improves the efficiency of the estimators, if disturbances are correlated across countries, and also increases significantly the degrees of freedom, as it allows estimating the coefficients of the fiscal variables using a much larger number of observations.
The list of instruments consists of the lagged values of the world net government debt to GDP ratio, plus the other fiscal regressors which are taken as predetermined. The Wu-Hausman test reported in Table 7 supports this choice, as it failed to exclude the exogeneity of the world net public debt to GDP ratio in the interest rates OLS regressions, while it could not rule out the exogeneity of government consumption. This may reflect the fact that government consumption does not include interest paid on the stock of debt.
A Chow test on the stability of the coefficients in two equally sized sub-samples rejects the null of stability.