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

Manias, Panics, and Crashes. A History of Financial Crises

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Historical Statistics of the United States

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism

The authors evaluate the Friedman-Schwartz hypothesis--that a more accommodative monetary policy could have greatly reduced the severity of the Great Depression. To do this, they first estimate a dynamic, general equilibrium model using data from the 1920s and 1930s. Although the model includes eight shocks, the story it tells about the Great Depression turns out to be a simple and familiar one. The contraction phase was primarily a consequence of a shock that induced a shift away from privately intermediated liabilities, such as demand deposits and liabilities that resemble equity, and towards currency. The slowness of the recovery from the Depression was due to a shock that increased the market power of workers. The authors identify a monetary base rule that responds only to the money demand shocks in the model.

Mark Weder

Papers

Indeterminacy in a Small Open Economy Ramsey Growth Model

Did sunspot forces cause the Great Depression

Animal spirits, technology shocks and the business cycle

Fickle Consumers, Durable Goods, and Business Cycles

Tracing externalities as sources of indeterminacy