A Regime-Based Effect of Fiscal Policy: Evidence from an Emerging Economy

In recent years, few authors have attempted to address the question of whether the state of the economy influences the impact of fiscal policy on the economy. Key findings have often indicated that expansionary fiscal intervention tends to be more effective when the economy is in a downturn. This favorable impact is more pronounced with an increase in government spending as opposed to a tax reduction. Despite several empirical attempts, the findings on the state-dependent nonlinear relationship of fiscal policy and output growth are often limited to developed economies. Building on the current research trend of using the threshold vector autoregression methodology, this paper bridges this gap and extends the empirical body to estimate the nonlinear relationship for an emerging economy, Tunisia. The paper provides empirical evidence that fiscal policy has a different impact on economic activity depending on the business cycle, the instrument of the fiscal policy used, and the intensity of the shock. The paper argues that in a downturn phase, government spending should be privileged particularly in the short run, with a gradual increase in the tax base to reduce the risk of worsening the budget deficit. Further, the monetary authority should be less inclined to raise its policy rate in the early stage of the recessionary period, as this intervention could have an adverse impact on economic growth. In the expansion phase, a tax cut intervention appears on the contrary to have a stronger positive impact on economic activity, especially in the short run, as the monetary authority is expected to introduce gradual policy hikes more rapidly to control for the inflationary expectations.

In recent years, few authors have attempted to address the question of whether the state of the economy influences the impact of fiscal policy on the economy. Key findings have often indicated that expansionary fiscal intervention tends to be more effective when the economy is in a downturn. This favorable impact is more pronounced with an increase in government spending as opposed to a tax reduction. Despite several empirical attempts, the findings on the state-dependent nonlinear relationship of fiscal policy and output growth are often limited to developed economies. Building on the current research trend of using the threshold vector autoregression methodology, this paper bridges this gap and extends the empirical body to estimate the nonlinear relationship for an emerging economy, Tunisia. The paper provides empirical evidence that fiscal policy has a different impact on economic activity depending on the business cycle, the instrument of the fiscal policy used, and the intensity of the shock. The paper argues that in a downturn phase, government spending should be privileged particularly in the short run, with a gradual increase in the tax base to reduce the risk of worsening the budget deficit. Further, the monetary authority should be less inclined to raise its policy rate in the early stage of the recessionary period, as this intervention could have an adverse impact on economic growth. In the expansion phase, a tax cut intervention appears on the contrary to have a stronger positive impact on economic activity, especially in the short run, as the monetary authority is expected to introduce gradual policy hikes more rapidly to control for the inflationary expectations.

Introduction
Several studies have estimated the impact of fiscal policy on economic growth either from a neoclassical or a Keynesian perspective. While the former assumes that fiscal intervention can have a real effect only in the short run before wages and prices start to adjust to bring the real economy to its equilibrium, the latter has often praised government intervention to reduce any dysfunction of the free market and thus foster economic growth over the long run but more importantly in the short term. Most of these theoretical and empirical contributions have nevertheless considered this impact from a linear relationship standpoint particularly with the extensive use of the linear DSGE models. Fiscal policy was often assumed to positively (or negatively) impact economic activity regardless of the phase of the business cycle.
More recently, a few authors have attempted to address the question of whether the state of the economy matters in determining the impact of fiscal policy on the economy. Baum et al. (2012) argued that fiscal multipliers can be higher in downturns than in expansion phases of the business cycle. Using the output gap as an indicator to determine the position of the economy in the business cycle, they noted that because of excess capacities (i.e., abundance of unused factors of production) during downturns, the neoclassical argument that is built into the standard Real Business Cycle model of a crowding-out effect is less applicable. Analyzing the nonlinear impact of fiscal policy for selected G7 countries, they found that such an impact varies with the business cycle. The multipliers are on average higher in periods of negative output gap compared to periods of positive output gap. Following the same threshold VAR (TVAR) approach but using the output growth as the threshold variable, Batini, Callegari and Malina (2012) estimated a fiscal model that accounts for monetary policy as an additional dimension. The overall findings of their paper confirm previous studies. The results indicate that expansionary fiscal intervention in countries like the United States, Japan and the euro zone tends to be more effective when the economy is in a downturn. This favorable effect on economic activity is more pronounced in the case of an increase of government spending as opposed to tax reduction. Overall, they showed strong empirical evidence for their argument that fiscal policy has a different impact on economic activity depending on the business cycle, the instrument of the fiscal policy used, and the intensity of the shock.
3 Applying a regime-switch SVAR model, Auerbach and Gorodnichenko (2012) found that the fiscal multiplier varies depending on the state of the economy. The authors argue that such a regime-based impact depends also on the nature of the fiscal policy instrument. Defense spending and investment (in contrast to non-defense and consumption spending, respectively) have much stronger and faster positive impact on output in a recession. Baum and Koester (2011) used the same approach to allow for asymmetries in the fiscal shocks as a function of size, direction and timing relative to the business cycle. In addition to the argument of a small crowding-out effect in times of recession described above, the authors argued that in contrast to the period of economic expansion, in times of crisis (negative output gap and high unemployment), economic agents face an additional financial burden resulting from the tightening of credit policy by the financial institutions. Under these circumstances, creditconstrained borrowers are often inclined to adjust their spending more drastically and rapidly than in a situation of financial ease. The authors showed that for a developed country like Germany, the impact of the fiscal policy varies depending on the state of the economy with a larger government spending multiplier in times of negative output gap. Conversely, tax policy will have more impact in periods of economic expansion. Afonso et al., (2011) consider the impact of fiscal development in times of financial disruption. Using financial instability as a threshold to distinguish between periods of financial development and periods of market distress in selected OECD countries, the authors confirm that the fiscal multiplier was higher on average during the recent financial crisis of 2009 relative to the rest of the study period.
As can be seen from this literature review, all the empirical studies that have estimated the state-dependent nonlinear relationship of fiscal policy and output growth have only used advanced economies as the benchmark. In this paper, building on the current research trend using the TVAR methodology, we attempt to bridge this gap and extend the empirical body to estimate the nonlinear relationship for an emerging economy, Tunisia. This paper is structured as follows. In the next section, we describe the methodology used to estimate the differentiated impact of the fiscal policy. Section 3 presents the findings of our study. Key policy implications and concluding remarks are included in the last section.

Identification Method
Similar to the recent trend in the literature, we adopt the Threshold Vector autoregression (TVAR) method to estimate our model. Baum et al. (2012) define TVAR as a 4 "simple method to model changing dynamics for a set of variables over two or more distinct regimes".
In its standard form, the TVAR can be written as follows; Where is the vector of covariates composed of total government spending defined as the sum of government consumption and investment, net taxes calculated as total tax revenues less current transfers and interest payments, GDP growth rate and central bank policy rate (which is included only in the augmented SVAR model). B (L) is the lag polynomial matrices and is the threshold variable (Balke, 2000). and capture the contemporaneous relationship between variables, which has a recursive structure following the Cholesky decomposition ordering, i.e., government spending, real GDP and tax revenues. The intuition behind this ordering is that (i) because it is unrelated to the business cycle, government spending does not react instantly to shocks to other economic aggregates but only with certain lags (Caldara and Kamps, 2008), (ii) output is affected contemporaneously by government spending's shocks but only with a lagged shock to tax policy, (iii) tax revenue responds instantly to all other shocks in the benchmark model. Notice that, in the augmented model, the interest rate is ordered last to capture the reaction function of the Tunisian central bank (Bouzid, 2016).
All variables included in the model, except for the policy rate, are expressed in annual growth rate of the log values. The period under study in this paper spans from year 2000:Q4 to 2015:Q4.
Similar to Batini et al. (2012), we use output growth as the threshold variable, with one major difference. In contrast to the authors, who set the threshold value at 0 to distinguish between positive and negative growth, we determine the value of the threshold endogenously as advised by Baum et al (2012). We adopt two distinct techniques widely used in the literature to estimate the threshold value. First, we follow Balke's (2000) approach to estimate the threshold by the least squares method for all possible values and then test the hypothesis of no differences between the two regimes, i.e., upper regime (defined by output growth above the threshold value) and lower regime (defined by output growth being below the threshold value). We use the Wald-Statistic with three separate tests: Sup-Wald, Avg-Wald and Exp-Wald. 1 Based on this procedure, the value of the threshold ( in equation (1)) that is found to maximize the log determinant of the structural residuals is estimated at 0.191. The second technique we rely upon to determine the value of the threshold value is the multivariate procedure as developed by Tsay (1998). This procedure assumes a null hypothesis of linearity in the data throughout the entire period.  (2000) procedure as mentioned above.
We use a nonlinear impulse response function (NIRF) to analyze the reaction of the model's variables to various shocks. 3 The NIRF is very useful for this type of analysis, as it allows for measuring the size, the direction, and the initial condition of the shock under each of the two regimes. The impulse function is constructed by assuming that the reaction of the model to various shocks is nonlinear between the two states of the economy (as separated by the threshold variable), while full linearity is assumed within each regime.

Figures 1-4 below plot the nonlinear impulse responses of the variables conditional on
the history of the model and the size and direction of the shocks (Balke, 2000). The tax variable has slightly different reactions to government spending shocks depending on where the position of the economy is. Under the lower regime, the tax return reacts instantly and positively to the spending shock for the first 2 quarters before it becomes negative in the following 4 quarters. Local government tends to increase contemporaneously its tax base to reduce the fiscal deficit that may arise from a government spending intervention. Further, the automatic response of tax revenue to the government spending cut can be explained by the reduction of the aggregate domestic taxable income that results from the drop of the output growth. In the upper regime however, the tax reaction appears to revert its direction almost immediately starting from quarter 1 and become marginally positive over the long run. This reaction accompanies the limited increase of output in the expansion phase. The frontloaded fiscal consolidation in the upper regime, compared to a more gradual approach when the economy is in downturn (spread over the first 3 quarters) has no noticeable impact on output. One interesting finding worth noticing is that figure 1 A-B does not provide strong evidence for asymmetries between small (1SD) and large (2SD) shocks, particularly with respect to the response of output to a spending shock. In the lower regime, the output appears to reverse course after an initial positive reaction to a 1 SD negative shock of the tax policy (tax reduction), with a negative response starting from the end of the first quarter through quarter 5. In contrast, the reaction of output to a discretionary tax cut remains positive throughout the period under study for the case of the upper regime. This finding provides support to the conclusion of Baum and Koester (2011). Government spending retains a relatively similar response under both regimes, with an initial decrease during 2 quarters (with a more pronounced effect under the upper regime) before the response turns positive and fades away around quarter 6.
From a policy perspective, figures 1 and 2 indicate that in a recession period, government spending policy seems to have higher positive impact on economic activity than a tax reduction.
This impact is more pronounced over the long run than in the short-term period. This finding, Baum et al. (2012) argued, followed the Keynesian theory where government spending is more effective in boosting economic activity than tax cuts, since households, under the latter intervention, may choose to save a portion of the additional after-tax income. Conversely, in the upper regime, a tax reduction will maintain economic growth over the long run, while an increase in government spending is ineffective at best.
In contrast to the findings above, figure 2 A-B, provides some evidence for asymmetries between small and large shocks with, for instance, the response of output to a negative 1SD and 2SD of tax shock coinciding after 5 quarters in the upper regime. Further, over the long run, a positive shock of tax policy in the upper regime appears to have a more proportional impact on output than the corresponding negative impact. 4 This finding is reversed in the case of the lower regime, with a larger effect for negative shocks. Evidence of asymmetries between small and large shocks can also be depicted in the response of government spending in the upper regime starting from quarter 3. Like other studies, we find strong evidence for a policy mix intervention under both regimes. A positive government spending shock is associated with a relatively slightly delayed  while the central bank intervenes almost instantly to offset the increased government spending by raising the policy rate, in the case of a tax cut policy, the policy rate starts to rise gradually only from quarter 3. Additionally, in contrast to the government spending intervention described above, where the policy rate tends to return to its steady state level after 7 quarters, the central bank appears to maintain a higher rate over the long run. These results may be explained by the fact that the authorities anticipate more rapid inflationary pressure occurring as a result of the government spending while at the same time expect the economy to heat up only after a certain delay (and with certain persistence) if the tax cut is used for the fiscal intervention.

Policy Implications and Concluding Remarks
This paper attempts to analyze the nonlinear impact that fiscal policy may have on the economy based on various phases of the business cycle. Using a TVAR method, we demonstrate that the impact of a government intervention in our emerging market varies depending on the instrument used as well as the timing of such an intervention.
Overall, our paper suggests the following policy advice that local government would need to consider when formulating its fiscal policy;  In the downturn phase, government spending as a vehicle for economic growth should be privileged, particularly in the short run. A gradual increase of the tax base starting from the second quarter following the expansionary spending intervention (when output impact reaches its maximum) can help limit any negative impact on the fiscal deficit.
Further, our findings suggest that the monetary authority should be less inclined to raise its policy rate in the early stage of the recessionary period, as this intervention could have 13 an adverse impact on economic growth. Gradual increase of the policy rate starting from the second year of the fiscal intervention can be more effective in maintaining low inflationary expectations while at the same time ensuring that the fiscal policy reaches the peak of its positive impact at the end of the 4 th quarter.
 In the expansion phase, our findings suggest a strong positive impact of a tax cut on output, particularly in the first year of the intervention. Frontloaded fiscal consolidation during this period should maintain positive economic growth with no adverse impact on the fiscal deficit. Overall government should be aware that in contrast to the recession period, the tax intervention appears relatively ineffective beyond the second year of implementation. In this phase, and in parallel to a tax cut policy, the monetary authority is expected to introduce gradual policy hikes more rapidly. This frontloaded policy mix should ensure more control on the inflationary pressure in the economy.