Working Paper: CEPR ID: DP1449
Authors: Philip R. Lane; Roberto Perotti
Abstract: In this paper, we study the link between profitability, fiscal policy and exchange rate regimes. We are particularly interested in adding realism to the treatment of fiscal policy by looking explicitly at its individual components. We show that the different types of government spending and taxation affect profitability through two main channels, namely changes in labour costs and movements in the nominal exchange rate when the exchange rate is flexible. This also implies that the different components of fiscal policy have different effects on profitability depending on the exchange rate regime. Using a panel of OECD countries over 1960?94, we find considerable empirical support for the predictions of our model. Increases in government wage consumption lead to higher labour costs and a nominal exchange rate appreciation; hence, they have a stronger negative impact on profitability under a flexible exchange rate regime. The opposite holds for increases in labour taxation. In contrast, and in line with our model, government non-wage consumption and transfers have only minor effects on exchange rates and profitability, and regime effects are small in these cases. The implication for countries attempting a fiscal adjustment is that its impact on profitability depends critically on the composition of the fiscal adjustment and on the exchange rate policy.
Keywords: profitability; fiscal policy; exchange rate regimes
JEL Codes: E62; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increases in government wage consumption (H59) | higher labor costs (J39) |
| higher labor costs (J39) | nominal exchange rate appreciation (F31) |
| nominal exchange rate appreciation (F31) | stronger negative impact on profitability (F69) |
| increases in labor taxation (H31) | reduce profitability (L21) |
| increases in labor taxation (H31) | exchange rate depreciation (F31) |
| exchange rate depreciation (F31) | mitigate negative cost effects on profitability (L21) |
| government non-wage consumption and transfers (H59) | minor effects on exchange rates and profitability (F31) |
| reductions in wage government expenditure (H59) | positively impact profitability in a flexible exchange rate regime (F31) |
| transfer cuts or tax increases (H22) | adverse effects on profitability (G32) |