The Welfare and Distributional Effects of Fiscal Volatility: A Quantitative Evaluation

By Rüdiger Bachmann, Jinhui Bai, Minjoon Lee and Fudong Zhang

This study explores the welfare and distributional effects of fiscal volatility using a neoclassical stochastic growth model with incomplete markets. In our model, households face uninsurable idiosyncratic risks in their labor income and discount factor processes, and we allow aggregate uncertainty to arise from both productivity and government purchases shocks. We calibrate our model to key features of the U.S. economy, before eliminating government purchases shocks. We then evaluate the distributional consequences of the elimination of fiscal volatility and find that, in our baseline case, welfare gains increase with private wealth holdings.

Fiscal policy has no role, how is this possible? Well, this is a standard result of the canonical real-business-cycle model, so it should not be a surprise. The difference here is that as markets are incomplete, government purchases could provide aggregate insurance that the economy needs. The government provides additional insurance through unemployment insurance and tax progressivity, but in this model, the sole source of fiscal policy volatility are the shocks to G. While G provides utility, its fluctuations are just contributing to general volatility, thus is should not be a surprise that shutting down its volatility is welfare improving. So, what is the point of the paper? One, the welfare cost is small. Two, the welfare cost is largest for the rich, an interesting departure of usual business cycle costs. This is because the after-tax return of capital fluctuations affect most the rich.

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