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

Abstract

We assess the response of fiscal policy to developments in asset markets in the US. We estimate fiscal policy rules augmented with aggregate wealth, wealth composition (i.e. financial and housing wealth) and asset prices (i.e. stock and housing prices) using two nonlinear specifications that rely on a Smooth Transition Regression (STR) and a Markov-Switching (MS) model and show that they outperform the linear framework that is based on a fully simultaneous system approach. In particular, the smooth transition regression model shows that primary spending and fiscal balance are adjusted in a nonlinear fashion to both wealth and price effects, while the Markov-switching framework highlights the importance of tax cuts to offset the decline in wealth during periods of major financial distress. Overall, our results provide evidence of a countercyclical policy and a vigilant track of wealth developments by fiscal authorities.