Using time-varying transition probabilities in Markov switching processes to adjust US fiscal policy for asset prices

This paper tests for nonlinear effects of asset prices on the US fiscal policy. By modeling government spendingand taxes as time-varying transition probability Markovian processes (TVPMS), we find that taxes significantlyadjust in a nonlinear fashion to asset prices. In particular, taxes respond to housing and (to a smallerextent) to stock price changes during normal times. However, at periods characterized by high financial volatility,government taxation only counteracts stock market developments (and not the dynamics of the housingsector). As for government spending, it is neutral vis-a-vis the asset market cycles. We conclude that,correcting the fiscal balance and, notably, the revenue side for time-varying effects of asset prices providesa more accurate assessment of the fiscal stance and its sustainability