There is enormous disagreement among both economists and politicians about almost every aspect of the impact of changes in taxes on the macroeconomy. A central reason for this disagreement is that it is very hard to measure the macroeconomic effects of tax changes. Tax changes occur for many reasons: some occur because the economy is predicted to move in some direction or because spending is changing; others occur for philosophical or political reasons. Estimating the effects of tax changes using episodes where taxes are responding to the state of the economy or to developments likely to affect economic growth will lead to biased or incorrect results. This project will use the vast narrative record of the arguments underlying tax changes to determine the primary motivation for all major tax changes in the United States since the passage of the Employment Act of 1946. The Economic Reports of the President, the Budgets, presidential speeches, records of congressional debates, and other sources will be used to construct a record of major tax changes, their size and nature, and their motivation. This record will be used to separate the changes into ones intended to offset factors that policymakers believed were acting to push the economy's growth rate above or below its normal level and ones undertaken for other reasons.
This information will be used to analyze the macroeconomic effects of tax changes. The behavior of output growth following tax changes not undertaken to return growth to normal will be examined to provide evidence about the size and timing of the effects of tax changes on short-run economic growth. The work will test whether the characteristics of the tax changes affect the estimated impact. The research will also examine the response of the components of output, such as consumption and inventories, to gain a better understanding of the transmission mechanism of tax changes to aggregate activity. In addition, to determine whether failing to account for the motivations for tax changes leads to important biases, the results will be compared with ones obtained using all tax changes rather than just those not taken to return output growth to normal. The project will also provide evidence about the long-run effects of tax changes by examining their impact on investment, saving, interest rates, and inflation. For example, studying the effects of tax changes on investment will provide evidence about one channel through which they could influence growth over the longer term. Furthermore, the research will test the hypothesis that tax cuts restrain government spending by investigating the behavior of spending following tax changes not taken to return output growth to normal.
Broader Impact. The choice of the overall level of taxes is a central public policy issue. By providing new evidence about the effects of tax changes, the project has the potential to provide valuable input into debates about both short-run and long-run considerations in the setting of overall taxes. With regard to the short run, evidence about the size and timing of the output effects of tax changes is clearly essential for the use of tax changes for short-run stabilization of the economy. The possibility of using fiscal policy for stabilization is particularly pressing in view of the risks of sudden major shocks to the economy (such as a stock market crash) and concern about the efficacy of monetary policy in some cases (such as the environment of very low interest rates in 2003-2004). Evidence about the effects of tax changes is probably even more important for long-run issues. The hypothesis that reductions in taxes serve to reduce future government spending is often a key motive for tax cuts. Thus evidence about the strength of this effect should be an important consideration in thinking about taxes. Even more fundamentally, evidence about the long-run impact of tax changes on saving and growth should be a central issue in the choice of the overall level of taxes.
