The State-Dependent Effects of Tax Shocks∗

This paper studies the state-dependent effects of shocks to distortionary tax rates in a dynamic stochastic general equilibrium (DSGE) model augmented with a number of real and nominal frictions. The tax output multiplier is defined as the change in output for a one dollar change in tax revenue caused by a shock to distortionary tax rates on consumption, labor income, or capital income. We find that magnitudes of each tax multiplier vary considerably across the state of the business cycle. Tax cuts are typically least effective at stimulating output in states where output is low. To evaluate the desirability of tax cuts as a tool to combat recessions, we also consider the state-dependence of what we define as the tax welfare multiplier. Welfare multipliers for each tax are highest in states where output is low, in contrast to the cyclicality of the output multipliers. We consider the robustness of these baseline results to several alternative modeling specifications which have been shown to impact the magnitude of tax multipliers. These include alternative fiscal adjustment methods, rule-of-thumb households, and anticipation. JEL Codes: E30, E60, E62