The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks

This paper investigates the impact of changes in the level of taxation on economic activity. The paper uses the narrative record – presidential speeches, executive-branch documents, and Congressional reports – to identify the size, timing, and principal motivation for all major postwar tax policy actions. This narrative analysis allows us to separate revenue changes resulting from legislation from changes occurring for other reasons. It also allows us to further separate legislated changes into those taken for reasons related to prospective economic conditions, such as countercyclical actions and tax changes tied to changes in government spending, and those taken for more exogenous reasons, such as to reduce an inherited budget deficit or to promote long-run growth. We then examine the behavior of output following these more exogenous legislated changes. The resulting estimates indicate that tax increases are highly contractionary. The effects are strongly significant, highly robust, and much larger than those obtained using broader measures of tax changes. The large effect stems in considerable part from a powerful negative effect of tax increases on investment. We also find that legislated tax increases designed to reduce a persistent budget deficit appear to have much smaller output costs than other tax increases. Christina D. Romer David H. Romer Department of Economics Department of Economics University of California, Berkeley University of California, Berkeley Berkeley, CA 94720-3880 Berkeley, CA 94720-3880 [email protected] [email protected] Tax changes have been a major public policy issue in recent years. The tax cuts of 2001 and 2003 were passed amid firestorms of debate about their likely effects. Some policymakers claimed that the cuts would both stimulate the economy in the short run and increase normal output in the long run. Others argued that they would raise interest rates and lower confidence, and thereby reduce output in both the short run and the long run. That views of the effects of tax changes vary so radically largely reflects the fact that measuring these effects is very difficult. Changes in taxes occur for many reasons. Some legislated tax changes are passed for philosophical reasons or to reduce the budget deficit. Others are passed because a war is in progress or because the economy is weak and predicted to fall further. And many major changes in revenues are not legislated at all, but occur automatically because the tax base varies with the overall level of income, or result from changes in stock prices, inflation, and other non-policy forces. Because the factors that give rise to tax changes are often correlated with other developments in the economy, disentangling the effects of the tax changes from the effects of these underlying factors is inherently difficult. A concrete example of this difficulty concerns the impact of legislated countercyclical tax changes. Suppose policymakers sometimes deliberately change taxes to prevent recessions or booms. If the policies are well timed and have the desired effects, output will grow normally following these changes. And if such changes make up an important part of overall tax changes, a statistician confronted with data on tax changes and the behavior of output will tend to underestimate the effects of tax changes on output. More generally, the central reason that estimating the effects of tax changes is so difficult is that there are pervasive possibilities for omitted variable bias. In the case of legislated countercyclical tax changes, some factor is both affecting the future path of output and causing policymakers to change taxes. In the case of the automatic response of taxes to output, any omitted factor that affects output also affects