The Impact of Fiscal Policy on Private Consumption in Israel with Emphasis on the Fiscal Expectations Approach

Abstract

In this paper we assess the impact of fiscal policy on private consumption. We find that there is substitution between private and public consumption but that it is of very limited magnitude (approximately 20 percent). It was also found that, in contrast to the Ricardian approach, the method of financing of public expenditure has an effect on private consumption. Thus, an increase in the direct taxation of wages has a negative effect on consumption that is equal to the full amount of the tax increase while bond financing has a positive effect as long the increase in public debt is small.

Evidence was found of the importance of the expectations mechanism with regard to future fiscal developments (the fiscal expectations approach) as manifested in the existence of a public deficit or the channel of its financing:

a. The most appropriate variable for testing the degree of substitution between private and public consumption in the long run is public consumption less unilateral transfers from abroad which reduce the public’s burden of financing public expenditure.

b. Evidence was found of the negative relation between public and private consumption which was partly the result of the existence of a public deficit. It was found that if an increase in the public debt is accompanied by an increase in the ratio of the public deficit to GDP, then its effect becomes negative.

c. Also, in the short run, only partial substitution was found between public and private consumption. This primarily reflects large and persistent changes in fiscal variables that contain significant real time information on the possibility of future changes in taxation.

d. A specific test of the change in the relationship between the trends in private and public consumption following the stabilization program in 1985 showed that the degree of substitution had declined significantly as a result of the program’s success.

Finally, the testing of alternative transmission mechanisms, which may influence the degree of substitution between public and private consumption, such as inflation, the real exchange rate and the real rate of interest, showed that in general they did not have a significant influence in the short or the long run.