If U.S. taxes rise unexpectedly without an accompanying increase in government spending, then ... the U.S. current account -- the difference between aggregate saving and investment will rise by half of the tax increase
In Global Savings and Global Investment: The Transmission of Identified Fiscal Shocks (NBER Working Paper No. 15113), James Feyrer and Jay Shambaugh investigate how changes in U.S. fiscal policy diffuse through the world economy. They find that almost half of any change in U.S. policy will spill over to overseas economies. The authors arrive at their conclusions by looking at macroeconomic data for 113 countries between 1973 and 2005. They also cite previous research (NBER Working Paper No. 13264 by Christina D. Romer and David H. Romer), which identifies the motivation of all major tax changes since World War II, based on government documents and speeches. This approach allows them to single out tax changes that are unrelated to prospective economic conditions.
Feyrer and Shambaugh find that if U.S. taxes rise unexpectedly without an accompanying increase in government spending, then private savings will fall by only a third of the tax increase. The U.S. current account -- the difference between aggregate saving and investment will rise by half of the tax increase. Global equilibrium requires that a rise in the U.S. current account correspond to a decline in the current account balance for the rest of the world. Thus, a tax increase that raises government saving in the United States causes the rest of the worlds current account balance to fall, and increases U.S. lending to the rest of the world relative to the pre-tax setting.
The authors carefully explore the nature of the current account deficits in the rest of the world that are caused by shifts in U.S. fiscal policy. They point out that it is the movement of investment, not of saving, that drives changes in the current account in the rest of world. Changes in U.S. taxes appear to have similar effects on investment in developed and developing countries and on those with various currency regimes. Even economies with tight capital controls feel the effect of U.S. fiscal policy.
Higher taxes in the United States are often thought to put brakes on the growth of the world economy. Feyrer and Shambaugh point out that this may not necessarily be the case because higher investment may mitigate this effect. The authors warn about using this argument in the current financial crisis, though, because their predictions are made for an economy operating at full capacity. In their setting, fiscal policy does not respond to current economic conditions. This is clearly not the case with fiscal policy in the first half of 2009, they write.
-- Alex TeytelboymThe Digest is not copyrighted and may be reproduced freely with appropriate attribution of source.