by James Cloyne (University of California, Davis), Nicholas Dimsdale (University of Oxford), Natacha Postel-Vinay (London School of Economics)
There has been a longstanding and unresolved debate over the fiscal multiplier, which is the change in economic growth resulting from a change in government spending or change in taxation. The issue became acute in the world recession of 2008-2010, when the International Monetary Fund led a spirited discussion about the contribution that fiscal policy could make to recovery.
In our research, fiscal policy is shown to have had positive impacts on growth, at least during the period surrounding the Great Depression in Britain. The implications for the potential benefits of fiscal policy in a high-debt, low-interest rate environment – and over a turbulent business cycle – may be significant.
The recent controversy follows the debate over the use of fiscal policy to counter the high level of unemployment in interwar Britain. Keynes argued that increased government spending would raise economic activity and reduce unemployment. In the General Theory (1936), he claimed that the multiplier for government expenditure was greater than unity.
A few more recent studies have confirmed that the multiplier effect is greater than unity for both the interwar and post-war period. But these results may be spurious since a rise in government expenditure that raises income may also result from a rise in income. Thus, changes in taxes and changes in income may not be independent. What we observe is a strong co-movement of GDP and fiscal measures in which it is hard to isolate the direction of causation.
What is needed is a source of exogenous variation, so that the impact of fiscal changes on GDP can be observed. Fiscal policy may take the form of changes in taxes or expenditure. The problems of endogeneity are generally greater for expenditure than for taxes, since it should be possible to find changes in taxes that are truly exogenous.
Romer and Romer (2010) have developed the so-called ‘narrative technique,’ which has been designed to overcome the problem of endogeneity of tax changes. This involves carefully distilling the historical record in order to infer Chancellors’ motivations behind each fiscal policy move, and isolate those that may be seen as more independent from the contemporaneous fluctuations of the economy.
One may thus be able to distinguish, for example, between taxes that arise from a direct will to stimulate the economy, as compared with changes that are more motivated by a Chancellor’s longstanding ideology. The latter may include, for example, a will to improve transport efficiency within the country, or a desire to make society less unequal.
Interwar Britain is a particularly appropriate period to apply this approach, since the potential for fiscal policy was great on account of the high level of unemployment. In addition, this was a period in which Keynesian countercyclical policies were generally not used, in contrast to the use of demand management policies in the post-war period.
By examining changes in taxes in interwar budgets, we have been able to produce a sample of 300 tax changes. These have been classified into changes in taxes that are endogenous or exogenous. We have been able to test the backward validity of our classification.
The outcome of this work has been to show that changes in taxes that are exogenous had a major impact on changes in GDP. The estimated value of the multiplier for these tax changes is greater than unity and as much as two to three. This is in accordance with results reported in post-war studies of the United States and a study of tax changes in post-war Britain (Cloyne, 2013).
In contrast to earlier work on measuring the multiplier, we concentrate on changes in taxes rather than changes in government expenditure. This is done to reduce problems of endogeneity.
While Keynes argued for using government spending to stimulate the economy, it was only when post-war fiscal policies were being formulated that the potential benefits of fiscal policies via changes in taxes were recognised. While this research does not argue in favour of tax changes over spending policies, it provides evidence that tax policy is a relevant part of the policy toolkit, especially in times of economic difficulty.