Government Consumption Stabilizes the Economy in the Short Run; Tax Cuts Have a Stronger albeit Delayed Effect

Abstract

The reform of the debt brake and the special fund for infrastructure and climate neutrality have considerably expanded Germany’s fiscal space. The associated fiscal policy shift not only opens up opportunities for additional public investment: The new funds can also be used for more government consumption. At the same time, the federal government has also provided revenue-side stimulus through tax relief for companies and private households. Since the different instruments compete for the same limited fiscal space, the question arises as to which approach yields the greatest macroeconomic effect per additional euro. The study finds that an additional euro of government consumption raises economic output by around one euro in the short run. The effect unfolds in the short run, reaching its maximum within one year. Tax changes, by contrast, have stronger albeit delayed effects: A tax cut of one euro raises economic output by around 1.80 euros over the medium run, with the maximum effect only reached after around two years. The analysis suggests that government consumption can stabilize the economy in the short run, while tax relief can generate larger macroeconomic stimulus over the longer run. When using the new fiscal space, it is therefore not only the volume that matters, but also how the measures are designed.