Growth effects of fiscal policy: an application of the unobserved common factor model

Abstract We study the long-run effects of fiscal policy on growth in a panel of twenty-eight European countries using annual data over the last 25 years. We draw on recent developments from the panel time series econometrics literature and introduce the unobserved common factor framework for the estimation of the growth effects of fiscal policy. This approach accounts for the country-specific impact of global macroeconomic shocks and other sources of unobserved time-varying heterogeneity. Our results indicate that fiscal policy has a significant impact on growth and highlight the importance of tax policy instruments. We furthermore demonstrate that the commonly used estimation approaches lead to a significant underestimation of the effects of fiscal policy changes on growth in our sample. Lastly, our empirical results are robust to substantial changes to the sample.