The Government Spending Multiplier and Fiscal Financing: Insights from Japan

All fiscal stimulus measures must ultimately be financed, and thus their effects critically depend on the expectations of how they will be financed. This paper examines the importance of tax rules in determining the size of the government spending multiplier by estimating and simulating a New Keynesian dynamic stochastic general equilibrium model of the Japanese economy. This paper shows that the debt-stabilizing tax policies employed in Japan during the 1980s and 1990s played a role in making the short-run multipliers large. Provided that monetary policy is accommodative, fiscal stimulus becomes more effective if it is initially financed by debt and if that debt is repaid largely through a gradual increase in capital taxation. Capital taxation has the smallest dampening effect on labour input, whereas an increase in labour input is the key factor contributing to the effectiveness of stimulus. Because the prospect of future taxation considerably affects the size of the multiplier, fiscal stimulus plans should be announced alongside financing schemes.