Fiscal Sentiment and the Weak Recovery from the Great Recession

That is a new paper (pdf) by Finn Kydland and Carlos Zarazaga, the abstract is here:

The U.S. economy isn’t recovering from the deep Great Recession of 2008-2009 with the anticipated strength. A widespread conjecture is that this weakness can be traced to perceptions of an imminent switch to a higher taxes regime. The paper explores quantitatively this fiscal sentiment hypothesis. The main finding is that the hypothesis can account for a significant fraction of the decline in investment and labor input in the aftermath of the Great Recession, relative to their pre-recession trends. These results require, however, a qualification: The perceived higher taxes must fall almost exclusively on capital income.

In general I don’t buy it, mostly because I don’t think the higher taxes on capital income are coming that soon.  I see the higher risk premium from the crisis itself, the fracturing of the intangible capital behind credit relationships, slow underlying productivity growth, the labor-saving nature of recent innovation, and a growing sense of the dysfunctionality of U.S. government as the main culprits behind the slow recovery.  Still, the Kydland and Zarazaga paper brings us further down its stated path than I would have thought possible.


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