Fiscal policy as a stabilization tool

Most of the focus of recent stabilization policy research and practice has been on monetary rather than fiscal policy. This paper argues that, given the limits on monetary policy, fiscal policy should play a larger role. Because of the well-known problems with fiscal policy in general, it argues that we should develop quasi-automatic stabilizers—changes in taxes or transfers triggered by an aggregate variable. It discusses design issues, in particular how to make them debt neutral, and what aggregate variable to use. It then focuses on a specific stabilizer, a variable value-added tax (VAT) rate. It shows its effect in a minimalist New Keynesian model and then discusses a number of analytical issues, both within and out of the minimalist model, such as the implications for inflation, the choice of the tax base, the implications of liquidity constraints, and the implication of anticipation effects. The paper concludes by reviewing the empirical evidence on passthrough of VAT changes and the effects on demand of VAT changes, permanent or temporary.