The Aggregate Effects of Anticipated and Unanticipated US Tax Policy Shocks

58 Pages·2008·0.82 MB·English

The Aggregate Effects of Anticipated and Unanticipated U.S. Tax
Policy Shocks: Theory and Empirical Evidence
∗
Karel Mertens Morten O. Ravn
† ‡
Cornell University EUI and the CEPR
First version: January 2008; This version: May 2008.
Abstract
We provide empirical evidence on the effects of tax liability changes in the United States. We
distinguish between “surprise” and “anticipated” tax shocks. We find that surprise tax cuts have
expansionary and persistent effects on output, consumption, investment and hours worked. Prior to
theirimplementation,anticipatedtaxliabilitytaxcutsgiverisetocontractionsinoutput,investment
and hours worked. After their implementation, anticipated tax liability cuts lead to an economic
expansion. We build a DSGE model with changes in tax rates that may be anticipated or not,
estimate key parameters and show that it can account for the main features of the data. We argue
thattaxshocksareempiricallyimportantforU.S.businesscyclesandthattheReagantaxcut,which
was largely anticipated, was a main factor behind the early 1980’s recession.
Key words: Fiscal policy, tax liabilities, anticipation effects, structural estimation.
JEL: E20, E32, E62, H30
We are grateful to Peter Claeys, Stephen Coate, Bob Driskill, Jordi Galì, Eric Leeper, Juan Rubio-Ramirez, and
∗
seminar participants at ESSIM 2008, Cornell University, Penn State University, University College London, University of
Warwick and at the Federal Reserve Bank of Chicago for comments. The responsibility for any errors is entirely ours.
Contact details: Department of Economics, Cornell University, Ithaca, NY. Email: [email protected]
†
Contact details: Department of Economics, European University Institute, Villa San Paolo, via della Piazzuola 43,
‡
FI-50133 Florence, Italy. Email: [email protected]
1 Introduction
This paper estimates the dynamic macroeconomic impact of changes in federal tax liabilities in the
U.S. during the post World War II period. We distinguish between anticipated and unanticipated tax
liability changes. This distinction is empirically relevant since tax laws often introduce changes in tax
liabilities that becomeeffectivewell outin the future. Wefind that the implementation of a tax liability
cut gives rise to a major macroeconomic expansion of the U.S. economy while the announcement of a
future tax cut is associated with a decline in aggregate activity, hours worked and investment during
the pre-implementation period. We demonstrate that a dynamic stochastic general equilibrium model
with changes in distortionary tax rates can account for the impact of anticipated and unanticipated tax
liability shocks that we estimate in the U.S. data.
OurempiricalanalysismakesuseofRomerandRomer’s(2007a)narrativeaccountofU.S.federaltax
liabilitychanges. WefocusonthetaxliabilitychangesthatRomerandRomer(2007a)deemexogenous.
These data suggest a natural approach to distinguishing between anticipated and unanticipated tax
liability changes. In particular, tax legislations are distinguished by the date at which they were signed
by the President (thus became law) and the date at which the tax liability changes were due according
tothelaw. We categorizea tax liabilitychangeas“anticipated”when itwasimplementedmorethan90
days after the legislation was signed by the President. Tax liability changes with implementation lags
below 90 days are categorized as “unanticipated”. On the basis of this definition, around half of the
tax liability changes in the U.S. during the post World War II sample are anticipated and the median
implementation lag of these legislations is 6 quarters.
We find that the implementation of a tax liability change has substantial macroeconomic impact.
In response to a one percent decrease in tax liabilities, output per capita rises by up to 2.2 percent,
consumption of nondurables and services increase by 1.1 percent, investment in capital goods rise by
more than 7 percent and hours worked rise by 1.1 percent. The responses are highly persistent reaching
their maximum impact around two and half years after the change in tax liabilities.
The implementation of a pre-announced tax liability change gives rise to a response of the economy
that is similar in shape and size to an unanticipated tax liability change. However, during the pre-
implementation period an anticipated future tax liability cut has contractionary effects. The impact
is especially sharp for investment that falls by almost 5 percent in response to a 1 percent anticipated
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tax liability cut announced 6 quarters in advance but the pre-implementation downturn is significant
also for output and for hours worked. In contrast, consumption of nondurables and services reacts little
to announcements of future lower taxes. Blanchard and Perotti (2002) instead find little evidence of
anticipation effects of tax policy changes but focus on very short anticipation horizons. Consistently
with their results, we show that the pre-implementation impact is small for short implementation lags.
However, tax announcements with the median implementation lag (6 quarters) are associated with a
significant pre-implementation response of the economy.
In order to evaluate the extent to which the empirical estimates of the impact of changes in federal
taxliabilitiesareconsistentwitheconomictheory,weconstructadynamicstochasticgeneralequilibrium
model in which variations in distortionary tax rates give rise to changes in tax liabilities. We allow for
variationsbothinlaborincometaxratesandincapitalincometaxratesandforunanticipatedaswellas
anticipatedtax shocks. The key parameters areestimated bymatchingthe theoretical impulse response
functions of the observables with those estimated in the U.S. data. We show that the DSGE model
accounts very well for the shapes and sizes of the response of the observables to implemented changes
in tax liabilities and for the announcement effects that we estimate in the U.S. data.
The potential relevance of implementation lags for understanding fiscal policy has previously been
highlighted by a number of authors. Blanchard (1981), Taylor (1993) and Ramey (2007) analyze how
anticipated changes in government purchases of goods and services affect the economy. More closely
related to our analysis are Auerbach (1989), Yang (2005), and House and Shapiro (2006). Auerbach
(1989)studiestheimpactof theTaxReformActof 1986onbusinessinvestmentinapartial equilibrium
investment model and shows that the investment response to anticipated tax changes depends crucially
on adjustment costs, a theme that we also stress in our general equilibrium set-up. House and Shapiro
(2006) and Yang (2005) consider the impact of tax changes in DSGE settings akin to ours. Yang (2005)
argues that empirical estimates of the impact of tax changes may be problematic when agents have
policy foresight. House and Shapiro (2006) use a DSGE model as a tool for analyzing the impact of
the 2001 Economic Growth and Tax Relief Reconciliation Act and the 2003 Jobs and Growth Tax
Relief Reconciliation Act taking into account the phase-ins and sunsets built into these tax laws. They
argue that anticipation effects may have been partially responsible for the slow recovery from the 2001
recession in the U.S. None of these contributions, however, has provided empirical evidence on the
relevance of such anticipation effects and, for that reason, have not assessed whether the quantitative
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effects of anticipated fiscal policy shocks can be accounted for by economic theory.1 We address both
these concerns and we also provide detailed analysis of how fiscal policy shocks affect the economy
through wealth and substitution effects which is useful for understanding the channels through which
the economy adjusts to changes in taxes.
Our empirical results complement earlier studies of the consumption impact of anticipated tax
changes. Poterba (1988) tests whether aggregate U.S. consumption reacts to announcements of future
tax changes and fails to find robust evidence in favor of this hypothesis.2 Heim (2007) studies data
from the Consumer Expenditure Survey (CEX) and tests for announcement effects of state tax rebates.
He finds no significant household consumption response to rebate announcements. Parker (1999) and
Souleles (1999, 2002) also study CEX data and test whether household consumption responds to actual
changes in taxes when these were known in advance of their implementation.3 They find significant im-
pactsoftaxchangesattheimplementationdates. Theseresultsareofteninterpretedasevidenceoflack
of forward looking behavior, the presence of binding liquidity constraints or other aspects that prevent
consumers from adjusting consumption plans to predictable changes in income. Our empirical results
are consistent with this earlier literature, but we show that the lack of a strong response of consump-
tion to announcements about future taxes, and a significant consumption response to actual changes
in taxes when these were pre-announced, are not necessarily inconsistent with a rational expectations
DSGE model that abstracts from liquidity constraints.
We examine the importance of tax shocks as impulses to the U.S. business cycle by examining
counterfactual experiments with the empirical model. We find that both unanticipated and anticipated
tax liability shocks have contributed importantly to the U.S. business cycle. Particularly interesting is
the finding that the anticipation effects associated with the Social Security Amendments of 1977 and
the Economic Recovery Tax Act of 1981 appear to explain a large fraction of the 1981-82 recession and
1MountfordandUhlig(2005)estimatetheimpactofpre-announcedfiscalpolicyshocksusingastructuralVARapproach
whereidentificationisobtainedbyimposingsignrestrictions. Theiranalysis,however,doesnotshowwhetheranticipation
effects are empirically relevant.
2Poterba (1988) identifies five such episodes: February 1964, June 1968, March 1975, August 1981, and August 1986.
We exclude the second and third of these episodes because Romer and Romer (2007a) categorize these tax changes as
endogenous.
3Parker(1999) examines the impact ofSocial Security changes during the 1980’s while Souleles (2002) investigates the
Reagan tax cut of the early 1980’s.
3
the mid-1980’s boom in the U.S.
2 Empirical Evidence
In order to identify tax shocks, we make use of Romer and Romer’s (2007a) narrative account of U.S.
federal tax liability changes. Romer and Romer (2007a) identify 49 significant legislated federal tax
acts in the period 1947-2006 and a total of 104 separate changes in tax liabilities. We focus on the
tax liability changes that Romer and Romer (2007a) classify as either “exogenous due to long-term
growth objectives” or exogenous due to “deficit concerns”. The former of these are tax changes that
were introduced with no explicit concerns about the current state of the economy while the latter
are tax changes introduced to address inherited budget deficits. Therefore, we assume that these tax
liability changes are exogenous in the sense that they are orthogonal to the current realizations of other
structuralshocks. Thisselectionleavesuswith67taxliabilitychangesderivingfrom34differentfederal
tax policy acts listed in Table A.1.
We distinguish between anticipated and unanticipated tax liability tax changes on the basis of the
difference in timing between dates at which the tax legislations were signed by the President and the
dates at which the tax liability changes were to be implemented. We define a tax liability change as
anticipated if the implementation lag exceeds 90 days. Based on this taxonomy, 36 of the tax liability
changes are deemed anticipated and 31 are defined as surprise tax shocks.4 The great advantage of
the combination of the use of the narrative approach and the timing assumption that we introduce to
identify the anticipated tax shocks is that it allows us to circumvent the non-invertibility problem of
traditional VAR approaches to estimating the impact of fiscal policy in the face of policy foresight, see
Yang (2006) and Leeper, Walker and Yang (2008).
The resulting tax shocks are illustrated in Figure 1 (in percentages of GDP). The top panel shows
the unanticipated shocks, the middle panel shows the anticipated shocks dated by the quarter of im-
plementation, and the bottom panel reports the anticipation horizon of the anticipated tax shocks
(truncated at 4 years). The Reagan tax initiative, in particular, was associated with major anticipated
tax changes. The Economic Recovery Act of 1981, signed by Reagan in August 1981, consisted of five
4Alternatively,Lustig,SleetandYeltekin(2007)useinformationon“abnormal”returntomeasureexpectedgovernment
defense spending changes.
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separate changes in tax liabilities due in 1981:3, 1981:4, 1982:1, 1983:1, and 1984:1. The first two tax
changes are defined as surprise changes according to our taxonomy while the last three initiatives are
definedasanticipatedpolicychanges. Thissequenceoftaxcutsasawholeconstitutesbyfar thelargest
anticipated tax changes in the sample that we study.
The median implementation lag in the data is 6 quarters. The longest implementation lag is asso-
ciated with the Social Security Amendments of 1983 signed by the President in April 1983 which had
tax liability changes taking place as far out in the future as 1990. We assume that the date at which
the public becomes informed about the changes in tax liabilities coincides with the date at which the
legislations were signed by the President. It is possible that in some instances the public might have
expected the tax changes prior to the date at which the President signed the tax law. Our approach
therefore, if anything, underestimates the extent to which tax policy changes were anticipated.
2.1 The Measurement of Tax Shocks
We measure surprise tax liability changes, denoted by τu, in terms of the implied dollar change in tax
t
liabilities in percentages of current price GDP at the implementation date. Anticipated tax changes are
distinguishedbytheirsize,thedateatwhichtheyweresignedbythePresident,andbytheiranticipation
horizon. Letsa,idenotetaxliabilitychangesthatweresignedbythePresidentatdatetandwhichhadan
t
anticipationhorizonofiquartersmeasuredasapercentageofGDPattheimplementationdate. Ideally,
we would like to allow for differential effects of tax liabilities that had different anticipation horizons.
Directly adopting this approach implies that the information set at date t needs to include the vector
of anticipated tax shocks sa,i=1,..M,sa,i=2,..,M,sa,M where M denotes the largest implementation lag
t t 1 t M
− −
h i
in the data.5 The large dimension of this vector makes estimation difficult due to the implied loss of
degrees of freedom. Therefore, we choose instead to distinguish between anticipated tax shocks on the
basis of their remaining anticipation horizon. We define the following anticipated tax shocks:
M i
τa = − sa,i+j (1)
t,i t j
−
j=0
X
Thus, τa measures the sum of all anticipated tax liability changes that are known at date t and
t,i
5Even for moderate values of M, this implies that a large amount of parameters need to be estimated. The largest
anticipationhorizoninthedatais20quarterswhichwouldimplythatwewouldneedtoestimate210parametersforeach
of the variables in question relating to the effects of anticipated tax shocks.
5
are to be implemented at date t +i. Using definition (1) of the anticipated tax shocks implies that
the number of anticipated tax variables that enter the information set at date t is at most equal to M,
making estimation feasible.
2.2 Estimating the Impact of Tax Liability Changes
We estimate the impact of tax liability changes from the following regression model:
K
X =A+Bt+C(L)X +D(L)τu+F (L)τa + G τa +e (2)
t t 1 t t,0 i t,i t
−
i=1
X
where X is a vector of endogenous variables, A and B control for a constant term and a linear trend,
t
C(L) is P-order lag polynomial, and D(L) and F (L) are (R+1)-order lag polynomials.6 We allow
the maximum anticipation horizon in equation (2), K, potentially to differ from the maximum imple-
mentation lag observed in the data, M.
This regression model can be viewed as a vector autoregression for X treating the tax variables as
t
exogenous. Since we do not include actual tax rates in the vector X , in order to allow for persistence in
t
the tax liability changes, the VAR includes moving average terms of implemented tax liability changes,
τu and τa (the D(L) and F (L) lag polynomials).7 We evaluate the impact of tax liability changes
t t,0
on the basis of the implied impulse response functions to changes in τu and in τa . The anticipation
t t,K
effects of pre-announced tax liability changes are introduced through the terms G G (the coefficient
1 K
−
vectors on the pre-announced but not yet implemented tax liability changes).
Our treatment of the tax shocks contrasts with the standard “dummy variable” measurement of
the policy interventions usually adopted in the narrative approach, see e.g. Ramey and Shapiro (1998)
or Burnside, Eichenbaum and Fisher (2004).8 Our approach imposes a linearity constraint on the
measurement of the tax shock (by measuring them in terms of percentage of GDP) but allows us to
aggregate the evidence on the effects of tax shocks across different episodes. Romer and Romer (2007b)
adopt the same strategy to the measurement of the tax policy shocks.
6The results are robust to allowing for a break in the trend in 1973:2, see Ramey and Shapiro (1998) and Burnside,
Eichenbaum and Fisher (2004). The results are also robust to first differencing the X vector.
t
7Alternatively, one might include estimates of actual tax rates in the VAR, see e.g. Burnside, Eichenbaum and Fisher
(2004), but in our application this would require one to introduce a mapping between estimates of average marginal tax
rates and tax liability changes.
8See Perotti (2007) for an insightful discussion of the narrative approach to fiscal policy.
6
We study U.S. quarterly data for the sample period 1947:1 - 2006:4. We consider the following set
of endogenous variables:
0
Xt = yt, ct, dt, it, ht
∙ ¸
where y denotes the logarithm of U.S. GDP per adult in constant (chained) prices, c is the logarithm
t t
of the real private sector consumption expenditure on nondurables and services per capita, d is the
t
logarithm of private sector consumption expenditure on durables per capita, i is the logarithm of real
t
aggregate gross investment per capita. h is the logarithm of average hours worked per adult. Precise
t
definitions and data sources are given in Table A.2 in the appendix.
2.3 Empirical Results
We assume that K = 6 which corresponds to the median implementation lag in the data that we
study, that R = 12, and that P = 1 (the results are robust to assuming longer lag structures). We
report the impulse response functions to a one percent decrease in the tax liabilities (relative to GDP)
along with 68 percent non-parametric non-centered bootstrapped confidence intervals computed from
10000 replications. The impulse response functions are shown for a forecast horizon of 24 quarters for
unanticipatedtaxliabilityshocks, and for 6quartersbefore itsimplementationto24 quartersthereafter
in the case of anticipated shocks.
The left column of Figure 2 reports the impact of an unanticipated tax liability cut. The decrease
in taxes sets off a major expansion in the economy and the effects on the endogenous variables are very
persistent and follow hump shaped dynamics. Investment and consumer durables purchases display by
far the largest elasticity to the cut in tax liabilities. Upon impact, investment increases by around 1
percent point and continues to rise until 10 quarters after the change in tax liabilities where it peaks
at 7.6 percent above trend. Consumer durables purchases respond much the same way and peaks at
7.25 percent above trend 9 quarters after the tax cut. Output increases gradually and reaches a peak
increaseof2.17percentabovetrend10quartersafterthetaxcut. Theimpactonhoursworked, instead,
isestimatedtobeclosetozerountilaroundayearandahalfafterthechangeintaxes. Afterthat,hours
worked increase gradually and peak at 1.16 percent above trend 12 quarters after the tax shock. The
impact on consumption of nondurables and services is qualitatively different from the other variables.
In particular, the increase in private consumption stabilizes at a new higher level already 6 quarters
after the tax cut. The peak response of consumption of nondurables and services corresponds to a 1.07
7
percent rise above trend.
OurestimatesoftheimpactofunanticipatedtaxliabilitychangesaresimilartotheresultsofRomer
and Romer (2007b) who find large and protracted responses to changes in tax liabilities. The shape of
the responses are similar to the impact of a “basic government revenue shock” estimated by Mountford
and Uhlig (2005). Relative to the estimates of Blanchard and Perotti (2002), the response of output to
tax liability shocks occurs more gradually than the output response to the tax shock that these authors
identify with a structural VAR approach. However, our results are similar to theirs in terms of the
persistence of the output response.
The right column of Figure 2 shows the impact of anticipated tax liability changes. There is strong
evidence in favor of anticipation effects: The announcement of a future tax liability reduction sets
off a downturn in the economy that lasts until the tax cut is eventually implemented. The most
dramatic result pertains to investment which falls 4.9 percent below trend one year before the tax
cut is implemented. Output drops by up to 1.16 percent three quarters before the tax liability cut
is implemented. The decrease in output is statistically significant from zero during much of the pre-
implementation period. Hours worked also drop below trend throughout the announcement period
peaking at 1.9 percent below trend 4 quarters beforethe tax cut. The response of consumers’ purchases
of durable goods to the announcement of a future tax cut is not very precisely estimated. We find a
3.5 percent drop in consumer durables purchases 5 quarters before the tax cut is implemented but the
confidence interval is quite wide throughout the announcement period. Consumption of nondurables
and services are instead approximately unaffected by the announcement of a future tax cut and is
basically at trend when the tax cut is eventually implemented. Thus, the anticipation effects on the
consumption variables are very different from the other variables that we investigate.
Theactualimplementationoftheanticipatedtaxcutisassociatedwithanexpansionintheeconomy
similar to the impact of an unanticipated tax cut. Apart from hours worked, the increase in activity
occursslightly faster than in response to unanticipated tax cuts. Atforecast horizons beyond two years,
anticipated and unanticipated changes in taxes have very similar effects. The maximum increase in
output (a 1.5 rise above trend) occurs 9 quarters after the tax cut is implemented, while investment
booms at 7.1 percent above trend (also 9 quarters after the cut in the taxes). As in the case of unantic-
ipated tax cuts, the consumption response reaches its new higher level relatively quickly. The response
of hours worked is somewhat weaker than the other variables in the post-implementation period (and
8
imprecisely estimated). The sizes of the implementation-to-peak responses of the endogenous variables
in response to the anticipated tax cut are very similar to the peak impacts in response to unanticipated
taxcuts. Thus, themaindifferencesbetweentheimpactofananticipatedandanunanticipatedchanges
in taxes is that the peak response occurs earlier in the latter case.
Our estimation approach gives strong support to the presence of anticipation effects. Romer and
Romer (2007b) examine whether the expected present value of future not yet implemented tax changes
affect the current level of key macroeconomic aggregates. They find that the pre-implementation re-
sponse is oppositely signed of the post-implementation response. They conclude that there is mild
evidence in favor of expectational effects. The advantage of our approach is that we analyze the full
path of the adjustment of the economy from when the tax liability changes are announced until several
quarters after its implementation. Mountford and Uhlig (2005) identify the impact of a pre-announced
government revenue shock using an “ex-post” identification approach based on sign restrictions. In
particular, they examine the impact of an government tax revenue shock which takes place one year out
in the future with the restriction that the shock is orthogonal to “business cycle” shocks and monetary
policy shocks. In contrast to us, they find that a pre-announced revenue increase is associated with
a pre-implementation increase in output while their estimates of the impact on investment agree with
our results. Their identification strategy is fundamentally different from ours since they do not include
currently available information about future tax liability changes. For that reason, it is perhaps not
surprising that they find a different impact of pre-announced fiscal policy shocks.9
Our results are consistent with the line of papers that have examined how anticipated tax changes
affect consumption choices. Poterba (1988) and Heim (2007) fail to derive a significant consumption
response to announced future tax cuts while Parker (1999) and Souleles (2002) find that consumption
reactstotheimplementation ofpre-announcedtaxchanges. Theseresultsareconsistentwithoursgiven
the lack of response of consumption of nondurables and services during the pre-implementation period
and the increase in consumption when the tax cut is implemented.
9Moreover, as discussed by Leeper, Walker and Yang (2008), their identification is applied to government tax revenue
rather than to tax liabilities relative to GDP. Thus, to the extent that tax revenue is derived from income taxation, the
pre-implementation increase in output that they estimate in response to a future tax revenue increase implies that tax
rates must adjust during the pre-implementation period.
9