Fiscal Policy in a Financially and Economically Interconnected World: Essays on Financial Sector Taxation and Regional Public Expenditure
The increasing degree of financial-macro linkages in advanced economies as demonstrated by the recent Great Recession in the United States and Europe raises new challenges for fiscal policy making, in that it expands the potential impact of both tax and expenditure reforms through uncharted channels. In addition, we are faced with an increasingly globalized world, with substantial spillovers of economic policy between states and countries being driven not only by shifts in the demand for goods and services (as understood in the classic international trade literature), but also by movement of labor and highly mobile capital flows. This interdependence conditions the efficiency of domestic fiscal policy in unprecedented ways not captured by most standard closed economy macroeconomic models or traditional optimal tax theory. This dissertation is motivated by the combination of these two forces and investigates the reform of the financial sector and countercyclical new Keynesian fiscal stimuli as policy responses in the aftermath of the latest financial crisis and recession.
The first chapter analyzes the effect of the introduction of financial transaction taxes in equity markets in France and Italy in 2012 and 2013, respectively, on asset returns, trading volume and market volatility. Using two natural experiments in a difference-in-differences design, I identify bounds on elasticity estimates for three categories of avoidance channels: real substitution away from taxed assets, retiming (anticipation of transaction realizations and portfolio lock-in), and tax arbitrage (cross-platform and financial instrument shifting). I find large responses on all margins, that account for significantly lower revenues than projected. By far the strongest behavioral response comes from high-frequency trading lock-in on regulated exchanges, with a high tax elasticity of this type of turnover in the order of -9. The results shed light on features of optimal FTT design, suggesting they may be poor instruments for both revenue-raising and Pigouvian objectives.
The second chapter complements the empirical analysis of the first chapter by analyzing the welfare implications of a linear financial transactions tax in a multi-period portfolio selection model with heterogeneous agents. Under certain conditions over the redistribution of government revenues, with no Pigouvian motives, I find such a tax may induce first-order losses due to the distortion of idiosyncratic risk-sharing (an implication which differs importantly from other literature on the role of taxation under uncertainty). A transaction tax induces both a contemporaneous inaction region and intertemporal shifting of transaction realizations. Given a segmented market over multiple trading platforms and the choice of at least two different tax instruments, I develop sufficient statistic formulas that differ from standard optimal commodity tax theory in that they account for untaxed capital accumulation, market structure rents, and uncertain returns. Furthermore, I explicitly consider retiming responses in transaction realizations and tax arbitrage in the form of shifting across trading platforms by allowing investors to choose trading in two different markets, and am able to match such parameters to empirically measured elasticities from my the first chapter, thus informing optimal FTT policy rates. In the case of a linear tax with a single market, the simplest model in this chapter suggests a cash equity transaction tax of 0.67% on the notional value of transactions purely to maximize revenue. A transaction tax induces both a contemporaneous inaction region and intertemporal shifting of transaction realizations.
The third and final chapter deals with more aggregate effects of fiscal policy. It primarily contributes to the open economy local fiscal multiplier literature by estimating regional output and employment responses to federal expenditure shocks in the European Union. Specifically, I use a novel methodology and dataset on fiscal transfers from the European Commission to subnational regions. Mimicking the literature on foreign aid and growth, I use shocks to the supply of federal transfers (European Commission commitments) of structural fund spending by subnational region as instruments for annual realized expenditure in a panel from 2000-2013. By correctly isolating these fiscal shocks, I find significantly larger fiscal multipliers than the existing literature - a large, contemporaneous multiplier of 1.7, which translates into a cumulative multiplier of 4 three years after the shock. Furthermore, using a novel dataset on bilateral trade between EU regions, I find evidence of demand-driven spillovers up to three years after a shock. In addition to direct implications for federal public finance management globally, these results represent an important step in our understanding of the effect of fiscal stimulus and austerity measures in countries undergoing financial and sovereign debt crises.
Overall, this dissertation aims at answering key questions brought about by the increasing complexity and dynamism of financial and economic interdependence of agents across states and countries. The implications of the results presented here are broad, including the development of comprehensive global financial regulation, the characterization of banking and fiscal unions in the Eurozone, and the incorporation of financial markets into new macroeconomic policy making.