Effectiveness of Countercyclical Fiscal Policy: Evidence from Developing Asia

Effectiveness of Countercyclical Fiscal Policy: 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. Using a sign-restrictions-based SVAR framework, we find 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, we perform and compare two policy experiments – deficit-financed tax cuts versus deficit spending. 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, Asian governments should be cautious about actively using tax cuts for countercyclical purposes, in part because a big part of the revenue shocks in the region are non-discretionary rather than discretionary.