Do Government Debt Thresholds Impact the Transmission of Tax Shock Effects to GDP Growth?

Abstract

This chapter examines the role of government debt thresholds in the transmission of tax policy shocks to GDP growth and inflation. Using the Balke (2000) approach, we establish government debt thresholds below 10 per cent for gross and net government debt growth. Both measures of government debt have been above the thresholds since 2009Q1. Empirical evidence shows that the output multiplier is large and negative when government debt is allowed to transmit tax policy shocks to GDP growth. The debt dynamics post-2008Q3 accentuated the decline in GDP growth due to a positive (increase) tax policy shock. However, the negative effects of government debt, despite worsening the decline in GDP growth, did not lead to significant differences in inflation responses to positive tax shocks.