This paper investigates the impact of tax changes on economic activity. We use the narrative record, such as presidential speeches and Congressional reports, to identify the size, timing, and principal motivation for all major post war tax policy actions. This analysis allows us to separate legislated changes into those taken for reasons related to prospective economic conditions and those taken for more exogenous reasons. The behavior of output following these more exogenous changes indicates 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. (JEL E32, E62, H20, N12) 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. Tax changes occur for many reasons. Some legislated tax changes are passed for philosophical reasons or to reduce an inherited budget deficit. Others are passed because the economy is weak and predicted to fall further, or because a war is in progress and government spending is rising. And many tax changes are not legislated at all, but occur automatically because the tax base varies with the overall level of income, or because of changes in stock prices, inflation, and other nonpolicy 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. There is pervasive omitted variable bias in any regression of output on an aggregate measure of tax changes. This paper suggests one way of dealing with this omitted variable bias. There exists a vast narrative record describing the history and motivation of tax policy changes. We first use this narrative history to separate legislated tax changes from those arising from nonpolicy develop ments. We then use the information on motivation to separate the legislated tax changes into those that are likely to be contaminated by other developments affecting output, and those that can legitimately be used to measure the macroeconomic effects of tax changes. Finally, we use the legitimate observations to derive estimates of the effects of tax changes on output that are likely to be less biased than previous estimates. Section I of the paper elaborates on the conceptual framework for this study. It emphasizes that what we seek to identify from the narrative record are tax changes that are not systematically

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

Econometric policy evaluation: A critique

are price decreases. (3) The frequency of price increases covaries strongly with inflation, whereas the frequency of price decreases and the size of price increases and price decreases do not. (4) The frequency of price change is highly seasonal: it is highest in the first quarter and then declines. (5) We find no evidence of upwardsloping hazard functions of price changes for individual products. We show that the first, second, and third facts are consistent with a benchmark menu-cost model, whereas the fourth and fifth facts are not.

/pdf/five-facts-about-prices-a-reevaluation-of-menu-cost-models-35l383bzoq.pdf

Five Facts about Prices: A Reevaluation of Menu Cost Models

This paper explores similarities and differences between the run-up of oil prices in 2007–08 and earlier oil price shocks, looking at what caused these price increases and what effects they had on the economy. Whereas previous oil price shocks were primarily caused by physical disruptions of supply, the price run-up of 2007–08 was caused by strong demand confronting stagnating world production. Although the causes were different, the consequences for the economy appear to have been similar to those observed in earlier episodes, with significant effects on consumption spending and purchases of domestic automobiles in particular. Absent those declines, it is unlikely that the period 2007Q4–2008Q3 would have been characterized as one of recession for the United States. This episode should thus be added to the list of U.S. recessions to which oil prices appear to have made a material contribution.

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Causes and Consequences of the Oil Shock of 2007–08

There has been mounting evidence that the inflation process has been changing. Inflation is now much lower and much more stable around the globe. And its sensitivity to measures of economic slack and increases in input costs appears to have declined. Probably the most widely supported explanation for this phenomenon is that monetary policy has been much more effective. There is no doubt in our mind that this explanation goes a long way towards explaining the better inflation performance we have observed. In this paper, however, we begin to explore a complementary, rather than alternative, explanation. We argue that prevailing models of inflation are too “country-centric”, in the sense that they fail to take sufficient account of the role of global factors in influencing the inflation process. The relevance of a more “globe-centric” approach is likely to have increased as the process of integration of the world economy has gathered momentum, a process commonly referred to as “globalisation”. In a large cross-section of countries, we find some rather striking prima facie evidence that this has indeed been the case. In particular, proxies for global economic slack add considerable explanatory power to traditional benchmark inflation rate equations, even allowing for the influence of traditional indicators of external influences on domestic inflation, such as import and oil prices. Moreover, the role of such global factors has been growing over time, especially since the 1990s. And in a number of cases, global factors appear to have supplanted the role of domestic measures of economic slack.

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Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation

https://www.federalreserve.gov/pubs/feds/2001/200130/200130pap.pdf

New tests of the new-Keynesian Phillips curve☆

In recent years, a broad academic consensus has arisen around the use of rational expectations sticky-price models to capture inflation dynamics. These models are seen as providing an empirically reasonable characterization of observed inflation behavior once suitable measures of the output gap are chosen; and, moreover, are perceived to be robust to the Lucas critique in a way that earlier econometric models of inflation are not. We review the principal conclusions of this literature concerning: 1) the ability of these models to fit the data; 2) the importance of rational forward-looking expectations in price setting; and 3) the appropriate measure of inflationary pressures. We argue that existing rational expectations sticky-price models fail to provide a useful empirical description of the inflation process, especially relative to traditional econometric Phillips curves of the sort commonly employed for policy analysis.

/pdf/modeling-inflation-dynamics-a-critical-review-of-recent-3a0wjodqvr.pdf

Modeling Inflation Dynamics: A Critical Review of Recent Research

Is the observed correlation between current and lagged inflation a function of backward-looking inflation expectations, or do the lags in inflation regressions merely proxy for rational forward-looking expectations, as in the new-Keynesian Phillips curve? Recent research has attempted to answer this question by using instrumental variables techniques to estimate "hybrid" specifications for inflation that allow for effects of lagged and future inflation. We show that these tests of forward-looking behavior have very low power against alternative, but non-nested, backward-looking specifications, and demonstrate that results previously interpreted as evidence for the new-Keynesian model are also consistent with a backward-looking Phillips curve. We develop alternative, more powerful tests, which find a very limited role for forward-looking expectations.

New tests of the New-Keynesian Phillips curve

We survey the evidence on CPI bias and provide our best estimate of its magnitude. We also identify a "weighting" bias that has not been quantified previously. We estimate that the CPI currently overstates the rate of change in the cost of living by about 0.9 percentage point per year, with a confidence interval ranging from 0.3 to 1.4 percentage points. Our estimate is boosted by new evidence that substitution bias has increased sharply since the mid-1990s, and is reduced by the cumulative impact of a variety of recent improvements to BLS procedures. The study discusses potential areas for further improvement.

/pdf/measurement-error-in-the-consumer-price-index-where-do-we-2rar3nwb2d.pdf

Measurement Error in the Consumer Price Index: Where Do We Stand?

The canonical inflation specification in sticky-price rational expectations models (the new-Keynesian Phillips curve) is often criticized for failing to account for the dependence of inflation on its own lags. In response, many studies employ a "hybrid" specification in which inflation depends on its lagged and expected future values, together with a driving variable such as the output gap. We consider some simple tests of the hybrid model that are derived from its closed form. We find that the hybrid model describes inflation dynamics poorly, and find little empirical evidence for the type of rational, forward-looking behavior that the model implies.

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Jeremy B. Rudd

Papers

New tests of the new-Keynesian Phillips curve☆

Modeling Inflation Dynamics: A Critical Review of Recent Research

New tests of the New-Keynesian Phillips curve

Measurement Error in the Consumer Price Index: Where Do We Stand?

Can Rational Expectations Sticky-Price Models Explain Inflation Dynamics?