How does fiscal policy react to wealth composition and asset prices?

Abstract

We assess the response of scal policy to developments in asset markets in the US and the UK. We estimate scal policy rules augmented with aggregate wealth, wealth composition (i.e fi nancial and housing wealth) and asset prices (i.e. stock and housing prices) using: (i) a linear framework based on a fully simultaneous system approach; and (ii) two nonlinear speci cations that rely on a smooth transition regression (STR) and a Markov-switching (MS) model. The linear framework suggests that, while primary spending does not seem to react to wealth composition or asset prices, taxes and primary surplus are signi cantly: (i) cut when fi nancial wealth or stock prices rise; and (ii) raised when housing wealth or housing prices increase. The smooth transition regression model shows that primary spending and scal balance are adjusted in a nonlinear fashion to both wealth and price effects, while the Markov-switching framework highlights the importance of tax cuts (in the US) and spending hikes (in the UK) to offset the decline in wealth during major recessions and nancial crises. Overall, our results provide evidence of a non-stabilizing e¤ect of government debt, a countercyclical policy and a vigilant track of wealth developments by scal authorities.