Fiscal Policy in the Aftermath of 9/11 o g a Jonas Fisher and Martin Eichenbaum c i h C f o k n a B e v r e s e R l a r e d e F WP 2004-06 Fiscal Policy in the Aftermath of 9/11 ∗ Martin Eichenbaum Jonas D.M. Fisher † ‡ March 2004 Abstract This paper investigates the nature of U.S. fiscal policy in the aftermath of 9/11. We argue that the recent dramatic fall in the government surplus and the large fall in 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. Our evidence suggests that, had tax rates responded in the way they ‘normally’ do to large exogenous changes in government spending, aggregate output would have been lower and the surplus would not have changed by much. The unusually large fall in tax rates had an expansionary impact on output and was the primary force underlying the large decline in the surplus. Our results do not bear directly on the question of whether the decline in tax rates and the decline in the surplus after 9/11 were desirable or not. WethankseminarparticipantsattheFederalReserveBankofChicagoforhelpfulcomments. ∗ The views expressed in this paper do not necessarily represent the views of the Federal Reserve Bank of Chicago or the Federal Reserve System. Northwestern University, NBER and Federal Reserve Bank of Chicago † Federal Reserve Bank of Chicago. ‡ 1. Introduction This paper investigates the nature of U.S. fiscal policy in the aftermath of 9/11. Wefocusonthequestion: Isfiscalpolicyintheaftermathof9/11wellexplainedas 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 U.S. 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 (1998). 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 consump- 1 tion, 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, al- though 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 substan- tially less well explained by the 9/11 shock. For example, the declines in average capital andlabortaxrates aremuch largerthanourconditional 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 absent othershocks, thesurpluswouldinitiallyhaverisenandthenslowlydeclinedtothe 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 a 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 statis- tical model to address the impact of systematic changes in policy. A structural model is required. The particular model that weuse is theone developed inBurn- side, 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 way they normally do after a Ramey - Shapiro episode. In the second, we assume that tax rates do not change from their pre- 2 9/11 levels. In the third, we assume that average labor and capital taxes fall by four percentage points in a very persistent way. This fall roughly corresponds to the actual decline in average taxes between 2001:2 and 2003:3. In all cases, we assume that government consumption rises in a way commensurate with what actually occurred after 9/11. Our findings can be summarized as follows. With the first and second spec- ifications, 9/11 would have been associated with a small initial rise, followed by a persistent but small decline, in the surplus to GDP ratio. In contrast and consistent with the actual post-9/11 data, the third specification implies that the surplustoGDPratiowouldhavedeclinedimmediatelyandthenstayedwellbelow itspre-shocklevel foranextendedperiodof time. TotheextentthattheBushtax cuts are viewed as highly persistent, this result provides a formal interpretation of the view that the large drop in the surplus to GDP ratio following 9/11 is due to an atypical reduction in tax rates after a large increase in military spending. Our structural model also implies that a cut in tax rates leads to a subtantial rise in output, with the precise magnitude depending on the elasticity of labor supply. Evaluating the welfare tradeoff between the rise in output and the fall in the surplus to GDP ratio associated with the cut in tax rates is beyond the scope of this paper. The remainder of this paper is organized as follows. Section 2 discusses our strategy for estimating the effects of a Ramey - Shapiro episode and presents our results. In that section we also use our statistical model to assess how unusual fiscal policy was in the aftermath of 9/11. In section three we discuss our eco- nomic model and use it to assess how the surplus and aggregate output would have behaved under alternative tax responses to 9/11. Finally, section 4 contains concluding remarks. 3 2. Evidence on the Effects of a Shock to Fiscal Policy In this section we describe our strategy for estimating the effects of an exogenous shock to fiscal policy and present our results. This strategy is very close to the one used in Burnside, Eichenbaum and Fisher (2004). 2.1. Identifying the Effects of a Fiscal Policy Shock Ramey and Shapiro (1998) pursue a ‘narrative approach’ to isolate three arguably exogenous events that led to large military buildups and increases in government purchases: the Korean War, the Vietnam War and the Carter-Reagan defense buildup following the invasion of Afghanistan by the Soviet Union. Based on their reading of history, they date these events at 1950:3, 1965:1 and 1980:1. The weakness of this approach is that we only have three episodes of exogenous fiscal policy shocks to work with. In our view, this weakness is more than offset by the compelling nature of Ramey and Shapiro’s assumption that the war episodes are exogenous. Certainlytheirassumptionseemsplausiblerelativetotheassumptions typically imposed to isolate the exogenous component of statistical innovations in government purchases and tax rates. See Blanchard and Perotti (1998), Ramey and Shapiro (1998) and Edelberg, Eichenbaum and Fisher (2004) for discussions of alternative approaches. To estimate the impact of exogenous movements in government purchases, G , capital and labor income tax rates, τ and τ , on the economy, we use the t kt nt following procedure. Suppose that G , τ and τ are elements of the vector t kt nt stochastic process Z . Define the three dummy variables D , i = 1,2,3, where t it 1, if t = d D = i it 0, otherwise ½ and d denotes the ith element of i d = 1950:3 1965:1 1980:1 0. ¡ ¢ 4 We assume that Z evolves according to: t 3 Z = A +A t+A (t 1973 : 2)+A (L)Z + A (L)ψ D +u , (2.1) t 0 1 2 3 t 1 4 i it t ≥ − i=1 X where Eu = 0, t 0, for all s = 0 Eutu0t s = Σ, for s = 06 , − ½ Σ is a positive definite matrix of dimension equal to the number of elements in Z , t denotes time, and A (L), j = 3,4 are finite ordered vector polynomials t j in nonnegative powers of the lag operator L. As in Ramey and Shapiro (1998) we allow for a trend break in 1973:2.1 A consistent estimate of the response of Z , the ith element of Z at time t + k, to the onset of the ith Ramey- it+k Shapiro episode is given by an estimate of the coefficient on Lk in the expansion of ψ [I A (L)L] 1A (L). i 3 − 4 − Theψ in(2.1)arescalarswithψ normalizedtounity. Theparametersψ and i 1 2 ψ measure the intensity of the second and third Ramey-Shapiro episodes relative 3 to the first. Based on the observed changes in government purchases, we set ψ 2 and ψ to 0.30 and 0.10, respectively. These weights were obtained by comparing 3 the percentage peak rise after the onset of the Vietnam and the Carter-Reagan defense buildup episodes to the analog rise after the Korea episode. Relation (2.1) implies that while the fiscal episodes may differ in intensity, their dynamic effects are the same, up to a scale factor, ψ . While arguable, this assumption is consis- i tent with the maintained assumptions in Ramey and Shapiro (1998), Burnside, Eichenbaum and Fisher (2004) and Edelberg, Eichenbaum and Fisher (1999). It is also consistent with the assumptions in Rotemberg and Woodford (1992) who identify an exogenous shock to government purchases with the innovation 1In practice we found that our results were robust to not allowing for a break in trend, i.e. to setting A =0. 2 5 to defense purchases estimated from a linear time invariant vector autoregressive representation of the data. Our specification of Z includes the log of time t per-capita real GDP, the log t of per-capita real government consumption, average capital and labor income tax rates, the real interest rate and the nominal government surplus to GDP ratio. Our measure of the government surplus is the consolidated federal, state and local budget surplus’ of revenues over expenditure, inclusive of interest payments. Below, we also consider the primary surplus to GDP ratio.2 The real interest is the interest rate associated with Moody’s Baa corporate bonds that have average maturity of roughly 20 years minus the consumer price index inflation rate over the previous year. We assume that Z depends on six lagged values of itself, i.e. t A (L) is a sixth order polynomial in L. This lag length was chosen using the 3 modified likelihood ratio test described in Sims (1980). All estimates are based on quarterly data from 1947:1 to 2001:2. Note that we purposefully do not include the data containing 9/11 and its aftermath in this stage of our empirical work. The Appendix describes the data used in our analysis. 2.2. Empirical Results In this subsection we present the results of implementing the procedure discussed above. 2.2.1. The Data Figure 1 displays the data used in our analysis. Column 1 displays the log of real military spending, real government consumption and our measure of the real interest rate. In all cases we include vertical lines at the dates of Ramey-Shapiro episodes and 2001:3 which encompasses 9/11. Notice that the time series on real 2The response of both surplus to GDP ratio measures to a Ramey - Shapiro epsiode is very similar. 6 defense expenditures is dominated by three events: the large increases in real defense expenditures associated with the Korean war, the Vietnam war, and the Carter-Reagan defense buildup. The Ramey-Shapiro dates essentially mark the beginning of these episodes. There also appears to be a significant buildup in real defense expenditures around the period of 9/11. In our economic model, it is total government consumption, rather than military purchases that is relevant. As Figure 1 reveals, the Ramey-Shapiro and 9/11 episodes also coincide with rises in real government consumption. For completeness, Figure 2 displays the data on the ratio of government consumption to GDP. Notice that ratio rises significantly in the four episodes of concern. Turning to the real interest rate, two interesting features are worth noting. First the real interest rate is consistently higher in the post-1980 period than in the pre-1980 period. Second, there is not a consistent pattern of a rise in the real interest rate in the immediate aftermath of the four episodes of exogenous increases in military spending. Column 2 displays our measures of labor and capital tax rates as well as the ratio of nominal primary (dashed line) and total (solid line) government fiscal surpluses to nominal GDP. Tax rates were constructed using quarterly data from the national income and products accounts and the method employed by Jones (2002).3 Note that labor taxratesrise substantiallyafter all three Ramey-Shapiro dates while capital tax rates rise after the first two episodes. In contrast to the Ramey - Shapiro episodes, tax rates fall sharply around the 9/11 episode. Turning to the surplus to GDP ratio, two features are worth noting. Unlike theRamey-Shapiroepisodes, thereisasharpdeclineinthisratiointheimmediate aftermath of 9/11. In addition, the real interest rate and the surplus-GDP ratio 3See Burnside, Eichenbaum and Fisher (2004) for a discussion of how these tax rates were computed and how they relate to other measures used in the literature. 7 arenegativelycorrelated,withacorrelationcoefficientof 0.53. Whilecertainlyof − interest, this last correlation does not bear directly on the Ricardian Equivalence hypothesis which, among other things, pertains to the response of real interest interest to a rise in the surplus, holding government consumption constant. 2.2.2. The Dynamic Response of the Economy to A Fiscal Shock Recall that we normalize the first episode (Korea) to be of unit intensity and we set the intensities of the second and third episodes to 0.30 and 0.10, respectively. Belowwereportthedynamicresponsefunctionofvariousaggregatestoanepisode of unit intensity. This simply scales the size of the impulse response functions. In interpreting these results it is important to recall that we do not include the 9/11 episode in estimating the response of the economy to a fiscal shock. Elsewhere we have documented the response of private sector aggregates to the onset of a Ramey - Shapiro episode.4 Here we focus on aggregate output as a simple summary measure of overall economic activity. In addition we examine the behavior of the real interest rate since this plays a potentially important role in determining the size of the overall government surplus. The first row of Figure 3 reports the dynamic responses of real government consumption and output to a fiscal shock.5 The solid lines display point estimates while the dashed lines correspond to 95% confidence interval bands.6 As can be 4See Ramey and Shapiro (1998), Edelberg Eichenbaum and Fisher (1999) and Burnside, Eichenbaum and Fisher (2003). 5The impulse response functions for output and government consumption are reported as percentage deviations from a variable’s unshocked path. The response functions of labor and capital tax rates, the real interest rate and the Surplus-GDP ratio are reported as deviations from their unshocked levels, measured in percentage points. 6These were computed using the bootstrap Monte Carlo procedure described in Edelberg, Eichenbaum and Fisher (1999). The Monte Carlo methods that we used to quantify the im- portance of sampling uncertainty do not convey any information about ‘date’ uncertainty. This is because they take as given the Ramey and Shapiro dates. One simple way to assess the importanceofdateuncertaintyistoredotheanalysisperturbingtheRameyandShapirodates. 8