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

This paper investigates the impact of changes in the level of taxation on economic activity. The key contribution is the use of the narrative record presidential speeches, executive-branch documents, and Congressional reports to identify the size, timing, and principal motivation for all major postwar policy actions that changed revenues. The classification of motivation allows us to separate tax changes into those taken for reasons related to prospective economic conditions, such as countercyclical actions and tax changes tied to changes in government spending, from those taken for more exogenous reasons, such as to reduce an inherited budget deficit or to promote long-run growth. We then examine the behavior of output following these more exogenous changes. The resulting estimates indicate 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. The large effect stems in considerable part from a powerful negative effect of tax increases on investment. We also find that tax changes intended to counteract projected changes in private economic activity have been largely unsuccessful, and that tax increases designed to reduce a persistent budget deficit appear to have much smaller output costs than other exogenous tax increases