We argue that the fiscal policies adopted early in World War I by the U.K. were responsible for its poor economic performance during the interwar period. In September 1915, the U.K. embarked on a set of non-tax-smoothing policies collectively known as the McKenna rule. The key dictum of the McKenna rule was to raise tax rates on labor and capital income in response to contemporaneous movements in government spending. The greater reliance on income taxation produced distortions in household and firm decision making that have not previously been studied. We construct and calibrate a real business cycle model to assess quantitatively the impact of the McKenna rule. The model generates paths for aggregate variables that resembles actual U.K. economic activity from 1916 onward
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Find related papers by JEL classification: E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
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