Uncertainty and Fiscal Cliffs

Abstract

Motivated by the US Fiscal Cli¤ in 2012, this paper considers the short- and longer term impact of uncertainty generated by scal policy. Empirical evidence shows increases in economic policy uncertainty lower investment and employment. Investment that is longer-lived and subject to a longer planning horizon responds to policy uncertainty with a lag, while capital that depreciates more quickly and can be installed with few costs falls immediately. A DSGE model incorporating uncertainty over future tax regimes produces responses to scal uncertainty that match key features of the data. The model features uncertainty over the average tax rate and rational expectations about the resolution of uncertainty with speci c outcomes and timing. Uncertainty injects noise into the economy and lowers the level of economic activity.