Berkeley Professors Christina and David Romer have an
interesting new research paper estimating the macroeconomic consequences of tax changes.
How can one use historical data to estimate the effects of tax changes on GDP? The simple idea of looking at how the two series are correlated obviously won’t do, since tax revenues would necessarily rise during an economic boom as an immediate consequence of the fact that, with a given tax schedule, people would owe more taxes if they earn more income. The correlation between tax revenues and GDP would then be telling us the effect of GDP on tax revenue rather than the effect of tax rates on GDP. The common method of calculating cyclically adjusted tax revenue could correct for this, but only partially. For example, that series, shown in red in the diagram below, shows consistent revenue gains in the 1990s, even though Congress was not changing the tax code. These revenue gains instead reflect such factors as a strong stock market which was helping to generate extra tax receipts and which in turn reflected strong economic fundamentals. The positive correlation between cyclically adjusted tax receipts and GDP growth in the 1990s thus would not tell us anything about how changes in the tax code might affect economic performance.
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The first step in the Romers’ research was to read through sources such as presidential speeches, the Economic Report of the President, and reports of legislative committees to isolate tax changes that were the direct result of intentional legislation. Macroeconomists will recognize this as similar in spirit to an earlier very influential study by the Romers to try to identify deliberate changes in monetary policy. In their current effort, the Romers take the view that isolating tax changes that were the deliberate result of legislative changes is not enough to resolve the causality question. For example, there were deliberate legislative tax increases in 1951 to pay for the Korean conflict and in 1965 to pay for Medicare. But if one looks at what happened to GDP after either of these episodes, one would be seeing the combined effect of the tax increase (which should reduce output) and the spending increase (which would be a source of stimulus). Another potential problem arises with events such as the tax surcharge of 1968, which the Romers see as intended to prevent the economy from overheating and causing inflation. If such countercyclical measures worked as intended, one would see the tax increase followed by normal growth rather than the faster than normal growth that Congress was seeking to prevent.
The Romers therefore recommended purging their series for legislated tax changes from such spending-driven and countercyclical changes, and arrived at a series they describe as “exogenous tax changes”, shown in blue in the diagram above. They then looked at the correlation between these exogenous tax changes and subsequent GDP growth, and found that exogenous tax cuts tended to be followed by unusually strong GDP growth. Their estimates imply that a tax hike that initially raises tax revenues as a percent of GDP by 1% would lead to a 3% lower value for real GDP 2-1/2 years later, a surprisingly big effect.
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The Romers shy away from then asking the question of interest for tax-cut advocates of whether, as a result of this stimulus to GDP, total tax revenues would eventually actually fall as a consequence of the initial tax hike. It is my impression that the effect reported above is so big that if one asks this question using their methodology, one might well find that they would. The Romers do not explore this question in their paper, however, and have some concerns that other changes after the initial tax change (for example, subsequent legislation undoing the original action) could account for that tax revenue effect.
The potential contribution of such other factors of course also makes it hard to trust estimates such as those displayed above for GDP. For example, the 1981 tax cut did not arrive out of a vacuum, but instead resulted from a political process for which an important determining factor was the poor economic performance under President Carter and in particular the recession of 1979-80. If one believed, as I do, that regardless of fiscal policy, an economic recession is likely to be followed by above-average economic growth as the economy starts to recover, one would attribute at least some of the rapid growth of 1983 not to the fiscal stimulus but to the fact that the economy was recovering from a recession.
Such factors make it difficult ever to be fully persuaded by statistical efforts like the Romers’ latest study. Nevertheless, I expect that the Romers’ new series may come to be as frequently used by academic researchers as their earlier series on exogenous monetary policy changes has been, and for the same reason– dicey though the approach may be, it is not clear what alternative we have.
UPDATE: Kash has much more.
Technorati Tags: macroeconomics
Nice summary, Professor; thank you!
It doesn’t seem at all unreasonable to me to think that the stimulus from a tax cut would be sufficient to generate higher revenues, provided that the tax cut is accommodated by monetary policy. Romer & Romer’s results when they control for monetary policy imply that monetary policy not only accommodated but actually enhanced the effects of the tax cuts (and vice versa for tax increases). The problem with many tax-cut advocates, however, is that they act as if they can count on this accommodation for any tax cut Congress might legislate (or that it doesn’t matter). Romer & Romer also find that tax cuts increase inflation, so it’s hard to believe that the accommodation would, in general, be forthcoming (and even if it were, that it would, in general, be a good idea).
Given the hotly contested debate over the effects of tax cuts on overall tax revenue, it is disappointing that Romer & Romer decided not to carry their research through to its logical conclusion.
On the other hand, the “data smoothing” step at the beginning of their analysis seems suspect. In particular, it seems like their data has been significantly adjusted in ways that are both hard to document and easy to contest.
There may be no good way out of this sort of analysis given the demands of our political culture, but the economic empirics will always be suspect.
JDH wrote:
If one believed, as I do, that regardless of fiscal policy, an economic recession is likely to be followed by above-average economic growth as the economy starts to recover, one would attribute at least some of the rapid growth of 1983 not to the fiscal stimulus but to the fact that the economy was recovering from a recession.
Professor,
Can you give me a short description of the mechanism you believe causes economic growth following a recession?
knzn wrote:
Romer & Romer also find that tax cuts increase inflation, so it’s hard to believe that the accommodation would, in general, be forthcoming (and even if it were, that it would, in general, be a good idea).
I have not had time to review the Romer’s paper yet but it appears that here you are confusing price increases with inflation. They are not the same thing.
DickF, my view is that during a recession, factors of production are not being employed to maximum efficiency and output falls below potential output. The economy fails to find the efficient outcome because some wages and prices are temporarily sending the wrong signals and some resources are not employed in those tasks for which they currently have the greatest value. Adjustments of wages and prices and movements of labor and capital into different activities require time, but given time and an absence of new shocks, they always occur. That process is how I think of an economic recovery. Just as the recession itself is characterized by below-normal growth, the initial phase of the expansion is usually characterized by above-normal growth.
Research documenting such a tendency includes Dan Sichel’s Inventories and the Three Phases of the Business Cycle and Kim and Nelson’s Friedman’s Plucking Model of Business Fluctuations.
Romer and Romer use the word “inflation” and talk about changes in the inflation rate. The effect is too big to attribute to changes in the prices of a few goods. While tax-induced changes in the general price level may not fit a strictly monetary definition of inflation, the idea is more or less the same, but it involves bonds instead of money. When the government cuts taxes without an offsetting cut in spending, it issues bonds, which, just like money, are nominal assets denominated in dollars. So while the supply of “dollars” per se doesn’t necessarily increase, the supply of dollar-denominated assets does increase, resulting in a decrease in the general value of such assets realtive to goods and services.
Professor,
Thanks. Spot on!
knzn,
Thanks. I am still working through the paper. I am concerned that they believe they can eliminate all the “noise” surrounding tax cuts. As they state tax cuts do effect investments and that effects such things as stock prices, so by defining stock prices as exogenous tends to distort the real effect of tax changes, but I don’t want to pass judgement before I have finished reading.
It does appear that their conclusions, and even their percentages, are very similar to those determined by Aldona and Gary Robbins years ago.
knzn-
When the government issues bonds, I believe it “sells” them to someone else, who must give up dollars to “purchase” the bonds. No net creation of dollar-denominated assets. The new owner has a bond, but no longer has the dollars.
Professor,
Sorry I have to retract my spot on after reading Dan Sichel’s Inventories and the Three Phases of the Business Cycle and Kim and Nelson’s Friedman’s Plucking Model of Business Fluctuations.
I can not access JSTOR but I would remind readers that the NBER officially divides a business cycle into 3 phases that correspond to those Sichel discusses.
The 3 NBER phases are:
1. recession when the economy is falling.
2. recovery from the bottom until real gdp surpasses the prior peak — the Sichel period
of strong growth.
3. expansion from the end of the recovery till the next peak.
Spencer,
I would add two. Prior to 1. the FED induced deflation attempting to correct the prior inflation, and either before, after or during 3. the perior of FED excess liquidity/inflation.
Rich, when the government sells bonds for money, it puts the money back into circulation by purchasing goods and services, so there is a net creation of dollar-denominated assets.
knzn-
You are not taking the entire transaction into consideration. Before the bond purchase, one party had cash. The government issues a bond and exchanges it for the cash. No new cash is created. One party (govt) wants to spend now, so it exchanges a promise to pay later to the other party. The other party is willing to defer spending, so transfers cash in exchange for the promise to be paid later.
The same thing happens when a corporation issues a bond. The only difference is the govt has the option of paying the bondholder back with money created out of thin air, but does not have to do so.
Rich, there is a big difference between a corporate bond and a government bond: the corporate bond is a liability for someone in the private sector; the government bond is not. Unless you believe that public policy is guided by profit maximization the same way as private policy, the situation is completely different. (If you want to argue that government bonds are a liability in the same way as corporate bonds, you’ll force me to point out that even base money is a liability of the Fed, so the Fed does not create any net dollar-denominated assets even when it creates money, so perhaps there is really no such thing as inflation.)
When the government decides to buy something with borrowed money, it issues a bond, takes cash from the purchaser, and hands that cash to someone else. Before these two transactions, there was just the cash; now there is the cash and a bond — an increase in the net amount of dollar-denominated assets. When a corporation decides to buy something, it does the same thing, but in this case a dollar-denominated liability appears on its own balance sheet to offset, in aggregate, the new dollar-denominated asset of the bondholder, so there is no increase in the net amount of dollar-denominated assets.
(One could argue that is the gross amount of dollar-denominated assets, not the net, that matters, so that even corporate bond issuance is inflationary. I think there would be some validity to that argument. Excessive debt issuance, even in the private sector, can cause prices to rise without adding substance to the economy. Just like you can get more inflation from the same base money if banks hold fewer reserves, even though the resulting assets created are offset with liabilities. Or you can get inflation just from credit card usage without creating any kind of new money.)
And don’t treat “the option of paying the bondholder back with money created out of thin air” as if it were innocuous. The government cannot necessarily commit not to do so, so to some extent, when it issues bonds, it is issuing future money. If people know (or suspect) that the money is coming, they will behave partly as if it were already created.
knzn,
You are making a common mistake. Simplify the transaction.
When the government sells a bond it takes currency out of circulation. The imediate impact of that single transaction on the economy is to reduce the money supply and create deflation.
If the government buys a bond it places money into the economy and creates inflation.
DickF, when the government sells a bond, it doesn’t hold on to the money for very long; the net effect of the two transactions — selling a bond and buying goods and services with the proceeds — is that the economy contains the same amount of money as originally, and it also contains a new bond, which in my view is inflationary. Think about it as if it were one transaction: suppose the government just uses the bond itself to purchase goods and services (which is the net effect of the two transactions). In that case, the government is bidding up the dollar price of those goods and services by using an asset other than money. Conversely, one could say it’s bidding down the purchase-value of a dollar, which is what’s meant by inflation. The effect is very much (not exactly) like the case where the government buys goods and services by printing money.
knzn-
You’re confusing bonds with money. If the government wanted to just buy goods and services, it would create money. Bonds are not money – to the best of my knowledge a bond is not acceptable as legal tender, but can only be exchanged for money. The purchase and sale of bonds changes the temporal distribution of money – less today for the purchaser and more today for the seller. When the bond matures, the purchaser has more money and the seller has less. Although governments may have a tendency to create more money, there is no necessity to do so. For example, the bonds can be rolled over and new bonds issued to fund those that mature.
I’m not confusing bonds with money; I’m saying that, when inflation occurs, the thing that inflates isn’t necessarily money; it could be bonds. Bonds are not legal tender, but neither are, for example, money market funds, which today are included in the most popular definition of money, and neither are credit cards, which function essentially like money.
And the distinction between bonds and money is not entirely clear-cut. There is base money, and then there are bank deposits of various kinds, and then there are money market funds, and then there are bond funds — plus there are credit cards, which aren’t even controlled indirectly by the government. If I wanted to, I could move my liquid assets into a checkable bond fund and make all my small purchases with credit cards, thus avoiding money (in the strict sense) almost entirely. (Money would be required very briefly by my mutual fund company for the purpose of clearing my checks; but if everyone did this, the economy would require only a little bit of money, and a small amount of money could be associated with a large amount of inflation.) In that case, if the government issued more bonds, it would increase the supply of what I use as money.
Another way to think about this is to look at the money demand function. For that purpose one would normally define money only to include its non-interest-bearing forms. If you increase the supply of bonds, the interest rate rises, and the demand for money associated with any given level of nominal national income declines. One of the effects will be for nominal prices to rise, not because the supply of money increases, but because that supply is more inflationary when the demand is lower. Decreases in the demand for money have just as much claim to the term “inflation” as do increases in the supply of money. Indeed, it is theoretically possible to have a hyperinflation — with money ultimately becoming worthless — without any increase in the supply for money, provided that the demand for money declines sufficiently. If that were to happen, I don’t think anyone would be saying, “Don’t worry; it’s not inflation; it’s just price increases.”
The bottom line is: bonds are not money, but bonds are a substitute for money (certainly not a perfect substitute, but certainly more a substitute than a complement). Just as an increased supply of nuclear power would decrease the value of coal, so an increased supply of bonds would decrease the value of money.
knzn-
Your confusion is due to a failure to look at both sides of the transaction closely. Bonds are not money – you must first sell them to someone else if you want money. The conversion process is essential. The transaction leaves the total supply of money unchanged; the only thing that has changed is ownership.
Money-market funds are included in M2 and M3, but I wonder if they should be. An individual can convert a MM balance into cash, but can all the balances be converted into cash? If everyone converted the balances into cash, don’t the underlying assets have to be sold to raise the cash? And wouldn’t the sale of those assets reduce cash holdings of the purchasers?
On the other hand, if bonds are money, then my car is money, my house is money. What asset isn’t money? I notice that bonds are not included in any of the major monetary aggregates.
Rich, Your confusion is due to a failure to consider the demand for money as well as the supply. Inflation (even hyperinflation, theoretically) can result in a drop in the demand for money as well as from an increase in the supply. Bonds are not exactly like money, but they are substitutes, for various reasons, in particular because bonds (unlike, for example, your car) can be converted into money easily and quickly and with some confidence about the price. When there are more bonds around, people have less need to hold money, so the demand for money goes down. When the supply of one good increases, the value of substitutes goes down: when the supply of bonds increases, the value of money goes down. That, in my opinion, meets the definition of inflation. I decided to do a whole blog post about this subject.
Think of it this way: the money that’s sitting in you wallet doesn’t cause inflation; it’s only when you spend the money that it can cause inflation. Most of the money in the world, most of the time, is not in the process of being spent. The total supply of money only matters because people choose to hold that money roughly in proportion to how much they intend to spend. But if I find that I don’t need to hold as much money, because I can hold bonds instead and just quickly sell them (via a mutual fund check, for example) when I need to spend the money, then I’ll stop holding all money in proportion to my spending and instead hold partly bonds. In terms of the relation between holding and spending (which is responsible for the relation between money and inflation), it’s just as if the bonds were a form of money.
knzn-
I see that we each remain unpersuaded by the other’s argument. But it has been a very polite and cordial discussion, so all I can say is have a nice weekend.
Rich
I meant to say, “Inflation (even hyperinflation, theoretically) can result FROM a drop in the demand for money as well as from an increase in the supply.”
Anyhow, have a nice weekend.
Rich,
If Bonds don’t cause inflation, then how come we have inflation now ? 😉
I think he’s going to say that we don’t have inflation now; we just have rising prices. (See the anonymous comment at April 17, 2007 05:03 AM.) Actually, in this particular case, I would agree, because I think the government deficit is being offset by weak private investment and a large trade defcit — but now I’m getting way too Keynesian for this discussion.