To estimate the impact of a measure or package on the economy, we use a set of fiscal multipliers. This box outlines some recent research on the size of multipliers, how the multiplier varies during the economic cycle and how multipliers 'taper' over time.

Estimated fiscal impact multipliers continue to differ widely, some larger, some smaller and some in line with those used by the interim OBR in its June 2010 forecast.

In its 2012 Article IV report for the UK the International Monetary Fund (IMF) said that its “staff assumes an average multiplier during the consolidation of about 0.5 after incorporating the boost to demand from automatic stabilizers and the monetary policy reaction. This estimate is roughly in line with the OBR’s estimates.” But estimates differ widely – and not least within the IMF.

A recent IMF paper (2013a) suggests that the multipliers are likely to be below 1 by considering potential output assumptions for advanced countries. With a much higher potential output path, a larger multiplier is needed to obtain the low post crisis output levels; as such the paper concludes that it is more likely that potential growth forecasts were too optimistic than that the fiscal multipliers were too small. Another IMF paper (2012) also finds very low multipliers for the UK under fiscal contraction, even when the economy is weak. This paper estimates the government spending multiplier is at most 0.2 when the output gap is negative and zero when the output gap is positive and that the government revenue multiplier is not significantly different from zero.

The IMF’s latest synthesis of recent evidence on fiscal multipliers (2013b) argues that there is now “stronger evidence than before that fiscal multipliers are larger when monetary policy is constrained…, the financial sector is weak, or the economy is in a slump.” This echoes the conclusions in Portes and Holland (2012) and its earlier work (2013c), which argued that multipliers used across advanced economies in the April 2010 IMF World Economic Outlook were on average 1 percentage point too low for 2010-11, and were likely to be in the region of 0.9 to 1.7, compared to an assumed average of 0.5 for this same group. The paper drew similar conclusions from the errors in forecasts produced by the European Commission (EC), the Organisation for Economic Cooperation and Development (OECD), and the Economist Intelligence Unit (EIU). The IMF defines fiscal consolidations in terms of changes in cyclically adjusted budget balances, which does create an additional difficulty in identifying those correctly.

Recent studies have also looked at the tapering of multipliers. IMF (2013a) estimates that fiscal multiplier effects persist for seven years, with 80 per cent of the multiplier realised in the first year, followed by the full effect in the second year, and then gradually declining to zero. The paper looked at five-year and ten-year persistence, as well as a non-linear decline but found little difference from the central seven-year estimate when assessing the overall impact of fiscal policy on the economy.

Portes and Holland (2012) estimate that multipliers taper off more slowly under liquidity constraints, lasting over seven years compared to three years in normal times. Barrell et al. (2012) produce simulations presenting a similar time scale, with the government spending multiplier tapering down to zero after five years and turning slightly positive thereafter due to the response of interest rates. This paper suggests that the tax and benefits multipliers taper to zero after ten years.

Simulations carried out by Perotti (2004) suggest that the UK multiplier tapers to zero after around four years for government consumption and around one year for government investment, arguing the investment multiplier is very small as government investment directly crowds out private investment.

DeLong and Summers (2012) consider a “hysteresis” effect, such that costs from recessions remain and the path of potential output does not return to its previous level. This implies that the multiplier never tapers off to zero. IMF (2013a) also presents a scenario of permanently lower potential economic output from this hysteresis effect, proposing that long run fiscal neutrality might be unrealistic.

This box was originally published in Forecast evaluation report – October 2013

a Barrell et al (2012), Fiscal consolidation part 2: Fiscal multipliers and fiscal consolidations (OECD Economics Department working paper); Baum, Poplawski-Ribeiro, and Weber (IMF 2012), Fiscal Multipliers and the State of the Economy (IMF working paper); Bi, Qu and Roaf (IMF 2013a), Assessing the Impact and Phasing of Multi-year Fiscal Adjustment: A General Framework (IMF working paper); Blanchard and Leigh (IMF 2013c), Growth Forecast Errors and Fiscal Multipliers (IMF working paper); DeLong and Summers (2012), Fiscal policy in a depressed economy (Brookings Institute); IMF (2013b), Reassessing the role and modalities of fiscal policy in advanced economies (IMF policy paper); Perotti (2004), Public investment: another (different) look (Universita Bocconi and Centre for Economic Policy Research); Portes and Holland (2012), Self-Defeating Austerity? (National Institute Economic Review)