Effectiveness of Countercyclical Fiscal Policy: Time-Series Evidence from Developing Asia

As the global crisis hit developing Asia, several countries instituted fiscal stimulus measures to create domestic demand. With the region returning to normal times, this paper draws lessons using historical data from 10 developing Asian countries to examine if countercyclical fiscal policy can still be used to stimulate growth. To do so, a sign-restrictions-based structural vector autoregression model was used.

The paper finds that expansionary expenditure shocks have an insignificant effect on output but contractionary revenue shocks have a negative effect. On the basis of those estimated effects, two policy experiments: deficit-financed tax cuts and deficit spending were performed and compared. The experiment results indicate that while deficit-financed tax cuts stimulate economic activity, the impact of deficit spending is ambiguous.

Our overall evidence thus suggests that tax cuts may be a more effective countercyclical policy instrument than government spending. However, a number of factors suggest that Asian governments should be cautious about actively using tax cuts for countercyclical purposes, in part because a big part of the revenue shocks in developing Asia are cyclical rather than discretionary.