Phased-In Tax Cuts and Economic Activity

This paper uses a dynamic general equilibrium model to analyze and quantify the aggregate effects of the timing of the tax rate changes enacted in 2001 and 2003. The 2001 law called for a sequence of successive rate reductions from 2001 until 2006. The 2003 law made immediate the tax rate cuts scheduled for 2004 and 2006 under the earlier law. The phased-in nature of the tax cuts under the 2001 law contributed to the slow recovery from the 2001 recession, while the elimination of the phase-in in 2003 helps explain the sharp increase in economic activity in the second half of 2003. The simulations suggest that while the tax policy was initially a drag on the economy in 2001 and 2002, it increased economic growth by roughly 0.9 percent in 2003 once the phase-ins were eliminated. Christopher L. House Matthew D. Shapiro Department of Economics Department of Economics University of Michigan University of Michigan Ann Arbor MI 49109-1220 Ann Arbor MI 48109-1220 and NBER and NBER tel. 734 764-2364 tel. 734 764-5419 [email protected] [email protected] Phased-In Tax Cuts and Economic Activity Christopher L. House and Matthew D. Shapiro Legislating predictable changes in tax rates violates one of the cardinal principles of public finance: changes in tax rates should be permanent and immediate. Taxation typically distorts economic behavior and, because the deadweight burden of taxation is a convex function of the tax rate, there are efficiency gains to equalizing tax rates over time. As Robert J. Barro (1979) argues, this logic implies that changes in tax rates should be unpredictable, that is, tax rates should follow random walks. In practice, however, government policy frequently ignores these principles and often specifies that tax rates should follow various phase-ins and sunsets. The 2001 and 2003 tax laws both featured changes in the tax code at prescribed times. The 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) called for a scheduled sequence of rate reductions in the top four tax brackets. The law cut tax rates for all brackets above the 28 percent tax bracket by 1/2 percentage point immediately and provided for further reductions effective in 2002, 2004, and 2006. By 2006, the top marginal tax rate was scheduled to fall by more than 4 percentage points. Under the 2001 tax bill, the tax changes sunset in 2011 and so, absent further legislation, tax rates will revert to their pre-EGTRRA levels at that time. Two years later, the 2003 Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) legislated further changes in the tax system. Reductions in income tax rates that were scheduled to occur in 2004 and 2006 under EGTRRA 1 As intuitive as Barro’s principle is, it is not universal. Kenneth L. Judd (1985) and Christophe Chamley (1986) show that, in economies with capital, the optimal tax rate on capital income must be zero in the steady state. Because it is often optimal to tax the initial capital stock heavily, the optimal tax rate on capital income should be phased-in.