Fiscal Policy in the Aftermath of 9/11

By Eichenbaum, Martin; Fisher, Jonas D. M. | Journal of Money, Credit & Banking, February 2005 | Go to article overview

Fiscal Policy in the Aftermath of 9/11


Eichenbaum, Martin, Fisher, Jonas D. M., Journal of Money, Credit & Banking


THIS PAPER INVESTIGATES the nature of U.S. fiscal policy in the aftermath of 9/11. We focus on the question: Is fiscal policy in the aftermath of 9/11 well explained as the normal response of the U.S. economy to a large exogenous increase in military expenditures? In our view, the answer is no. The recent dramatic fall in the government surplus (i.e., the rise in the deficit) and the large fall in labor and capital tax rates cannot be accounted for by either the state of the U.S. economy as of 9/11 or as the typical response of fiscal policy to a large exogenous rise in military expenditures. The explanation must be sought elsewhere. The most obvious candidates are recent changes in the Federal tax code and the slowdown in economic activity around the onset of the Iraq War. Our results indicate that changes in the tax code played the primary role. Specifically, we argue that had tax rates responded in the way they 'normally' do to large exogenous changes in government spending, the government surplus would not have changed by much and might have actually risen.

To establish the 'normal' response of fiscal policy to large shocks, we build on the approach used by Ramey and Shapiro (1988). These authors identify three political events, arguably unrelated to developments in the domestic U.S. economy that led to large, exogenous increases in military expenditures. These events, which we refer to as Ramey--Shapiro episodes, coincide roughly with the onset of the Korean War, the Vietnam War, and the Carter-Reagan defense buildup. We identify, the normal response of fiscal policy to a large military shock with our estimate of the dynamic response paths of government purchases, the government surplus, and capital and labor tax rates to a Ramey--Shapiro episode.

To assess whether fiscal policy was unusual after 9/11, we use our estimated statistical model to generate forecasts of tax rates, output, government consumption. the real interest rate, and the surplus conditional on (i) the occurrence of a fiscal shock in 2001:3, (ii) the state of the economy as of 2001:2 and (iii) the assumption that fiscal policy responds to 9/11 in the same way that it did in the three Ramey-Shapiro episodes. We find that the general rise in government consumption is well explained by the 9/11 shock. So too is the rise in output, although there is clear evidence of another shock which drove output down in 2002. However, the responses of the surplus to GDP ratio and tax rates are substantially less well explained by the 9/11 shock. For example, the declines in average capital and labor tax rates are much larger than our conditional forecast. Perhaps even more striking is the difference between the actual and predicted values of the surplus to GDP ratio. Our statistical model predicts that, had the government responded to 9/11 as it typically did in the Ramey--Shapiro episodes, then in the absence of other shocks, the surplus would initially have risen and then slowly declined to the point where the consolidated budget was balanced. In reality, the surplus suffered a sharp, ongoing decline. Taken together, these results suggest that fiscal policy in the aftermath of 9/11 is not well explained as the normal response of policy to at large exogenous increase in military spending.

This leaves open the question: How would aggregate output and the surplus to GDP ratio have responded to the post-9/11 rise in government consumption had the government pursued alternative tax policies? We cannot use our statistical model to address the impact of systematic changes in policy. A structural model is required. The particular model that we use is the one developed in Burnside, Eichenbaum, and Fisher (2004). We use this model because it does well at accounting quantitatively for the consequences of the Ramey--Shapiro episodes.

We consider three possible tax responses to 9/11. In the first, we assume that tax rates responded the wily they' normally do after a Ramey--Shapiro episode. …

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