DP1449 | Profitability, Fiscal Policy, and Exchange Rate Regimes

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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.