In Discussion paper No. 1284 Research Fellows Francesco Giavazzi and Marco Pagano attempt to bring new evidence to bear on an old and controversial issue: what are the effects of fiscal policy on private consumption and investment. In the first part of the paper, they analyse cross-country data for 19 OECD countries. In the second part they concentrate on the Swedish fiscal expansion of the early 1990s. The cross-country evidence on private consumption confirms that fiscal policy changes – both contractions and expansions – can have non-Keynesian effects if they are sufficiently large and persistent. It also suggests that these effects can result not only from changes in public consumption, but to some extent also from changes in taxes and transfers. The latter result is also consistent with the Swedish experience, where a decrease in net taxes (with almost no change in public consumption) was associated with a dramatic fall in private domestic demand.

Their evidence and that from other studies agree that during the Swedish fiscal expansion of the early 1990s a large negative error should be interpreted. This may reflect a large downward revision of permanent disposable income, which affected the consumption choices of Swedish households over and beyond the negative effects of the drop in real asset prices. This downward revision in permanent disposable income may have been triggered by the fiscal expansion of the early 1990s.