European Monetary Union Alters the Impact of National Fiscal Policy: Government Spending Is More Effective than Tax Cuts

Abstract

A country’s fiscal policy plays a central role in stabilizing its economy. Its effectiveness depends on the choice of measures and how monetary policy responds. This report compares four fiscal policy measures for a typical euro area country: increase in public investment and government consumption, reductions in consumption taxes and income taxes. Both the theoretical model and the empirical results for the euro area show that government spending has a stronger effect than tax cuts. Empirically, each additional euro of public investment or government consumption increases GDP by up to 1.30 euros in the first year, compared with about 0.30 to 0.40 euros per euro of lost tax revenue. Since the European Central Bank (ECB) generally does not respond to national fiscal shocks with adjustments to its key interest rates, monetary policy does not dampen the fiscal stimulus. To stabilize the economy in the short term, governments should give preference to well-designed spending measures. However, they should also take the risks into account, as higher government spending can jeopardize debt sustainability and weaken the economy in the long term through larger public sectors and higher tax burdens.