Government spending shocks, wealth effects and distortionary taxes

This paper investigates the transmission mechanism of government spending shocks in an estimated dynamic general equilibrium model. I construct a New Keynesian model with distortionary labour and capital taxes and with references that allow the wealth effect on labour supply to vary in strength. I show that the interaction of these two features crucially affects the response of the economy to a government spending shock. The model's parameters are therefore estimated (including the tax policy rules) for the United States. I show that the estimated model can match the positive empirical response of key variables including output, consumption and the real wage - a challenge for many New Keynesian models. I find that the estimated importance of the wealth effect is small; that sticky prices, variable capital utilisation, investment adjustment costs and habits all play an important role; and that whilst tax rates rise following the shock, their small magnitude crucially reduces the distortions involved.