Understanding the Aggregate Effects of Anticipated and Unanticipated Tax Policy Shocks

48 Pages·2009·0.71 MB·English

Understanding the Aggregate Effects of Anticipated and
Unanticipated Tax Policy Shocks
∗
Karel Mertens1 and Morten O. Ravn2,3,4
Cornell University1, University College London2, University of Southampton3, and CEPR4
February 12, 2009
Abstract
We evaluate the extent to which a dynamic stochastic general equilibrium model can account for
theimpactof“surprise”and“anticipated”taxshocksestimatedfromU.S.time-seriesdata. Mertens
and Ravn (2009) show that surprise tax cuts have expansionary and persistent effects on output,
consumption, investment and hours worked. Prior to their implementation, anticipated tax liability
taxcutsgiverisetocontractionsinoutput,investmentandhoursworked. Aftertheirimplementation,
anticipated tax liability cuts lead to an economic expansion. A DSGE model with changes in tax
rates that may be anticipated or not, is shown to be able to account for the empirically estimated
impactoftaxshocks. Theimportantfeaturesofthemodelincludeadjustmentcosts,variablecapacity
utilizationandconsumptionhabitsbutwedonotrelyonpreferenceswithlowshortrunwealtheffects
onlaborsupplythathavebeenhighlightedinthetechnologynewsliterature. WealsoderiveHicksian
decompositions of the consumption and labor supply responses and show that substitution effects
are key for understanding the impact of tax shocks.
Key words: Fiscal policy, tax liabilities, anticipation effects, structural estimation.
JEL: E20, E32, E62, H30
Partsofthispaperwasearliercirculatedunderthetitle“TheAggregateEffectsofAnticipatedandUnanticipatedU.S.
∗
TaxPolicyShocks: Theoryand EmpiricalEvidence”. WearegratefultoPeterClaeys, StephenCoate,BobDriskill,Jordi
Galì, Eric Leeper, Juan Rubio-Ramirez, and seminar participants at SED 2008, ESSIM 2008, Cornell University, Penn
State University, University College London, Universite’ Catholic de Louvain, University of Warwick and at the Federal
Reserve Bank of Chicago for comments. The responsibility for any errors is entirely ours.
1 Introduction
In this paper we ask how changes in taxes affect the economy in a dynamic stochastic general equi-
librium model. We contrast a DSGE model with U.S. postwar time-series evidence on the impact of
unanticipated and anticipated changes in taxes. The distinction between anticipated and unanticipated
tax changes is based upon the use of timing assumptions that we apply to Romer and Romer’s (2007,
2008) narrative account of federal U.S. tax liability changes. We show that implemented exogenous tax
cuts give rise to a prolonged expansion of the economy while announced but yet not implemented tax
cuts are associated with a decline in aggregate activity, investment and hours worked. This evidence on
anticipation effects is particularly helpful in evaluating economic theory because it allows us to evaluate
the impact of tax “news” shocks.
We follow Mertens and Ravn (2009) and measure tax shocks using Romer and Romer’s (2007a)
narrative account of legislated federal tax liability changes in the U.S. Based upon official government
reports, presidential speeches and Congressional documents, these authors provide a detailed account
of all significant federal tax bills during the post-war period. We study the impact of those tax changes
that according to Romer and Romer (2007a) can be assumed to be exogenous. We make a simple
yet informative classification of tax changes into anticipated and unanticipated tax shocks by using
information on the timing differences between the dates of the announcement of tax changes and the
implementation of these tax changes. Specifically, tax liability that were to take place within (later
than) 90 days of the law being signed by the president are classified as unanticipated (anticipated).
These tax shocks are embedded in a vector autoregressive analysis in order to derive estimates of
the dynamic effects of tax policy shocks assuming that the tax liability changes are exogenous. We
study the impact of the tax shocks on aggregate output, consumption of nondurables and services,
purchases of durable consumption goods, investment, and hours worked. We find that unanticipated
tax cuts give rise to significant increases in output, consumption, and investment which peak around
2.5 years after the introduction of the tax cut. There is also a rise in hours worked but it occurs more
gradually. Assuming thatanticipated tax shocks are announced 6 quarters before their implementation,
themediananticipationhorizoninthedata, wefindthatananticipatedtaxcutisassociatedwithapre-
implementation drop in output and investment while consumption remains roughly constant during the
pre-implementation period. Once the tax change is implemented, its impact on these variables becomes
1
similar to the effects of an unanticipated tax change. There is also a significant pre-implementation
drop in hours worked.
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
variations both in labor income tax rates and in capital income tax rates and for unanticipated as well
as anticipated tax shocks. Key parameters are estimated by matching the 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. Interestingly, we find that the anticipation effects can be accounted for using a model
with standard preferences and without liquidity constraints. These results are interesting because the
literature on “news shocks” to technology, c.f. Beaudry and Portier (2004, 2006, 2007) and Jaimovich
and Rebelo (2006), has shown that wealth effects on labor supply must be weak in order to generate an
“anticipation expansion” of the economy in response to current good news about future productivity.
This literature, however, provides no direct empirical evidence on such news effects in the data. Our
empirical results show that good news about taxes lead to a pre-implementation decline in aggregate
activity and that this effect can be accounted for by standard preference models. On the other hand,
consistently with the technology news literature, we find that adjustment costs and variable capacity
utilization are pertinent to account for the impact of tax shocks. The importance of adjustment costs
shows the relevance of Auerbach’s (1989) analysis of the impact of anticipated tax changes on aggregate
investment.
Another important insight relates to the anticipation effects on consumption of nondurables and
services. 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.1 Heim (2007) studies
data from the Consumer Expenditure Survey (CEX) and tests for announcement effects of state tax
1Poterba (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.
2
rebates. He finds no significant household consumption response to rebate announcements. Parker
(1999)andSouleles(1999,2002)alsostudyCEXdataandtestwhetherhouseholdconsumptionresponds
to actual changes in taxes when these were known in advance of their implementation.2 They find
significant impacts of tax changes at the implementation dates. These results are often interpreted
as evidence of lack 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 consumption 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 also extend the literature in terms of understanding the impact of tax changes. First, we show
that, in contrast to e.g. Yang (2005), that the impact of anticipated changes in capital and labor
income taxes are not fundamentally different. Assuming an anticipation horizon of 4 quarters, Yang
(2005) shows that in response to an anticipated cut in the labor tax rate, consumption rises during
the pre-implementation period while output, investment and hours worked contract; in response to an
anticipated cut in the capital income tax rate instead, the opposite pattern is implied. We show that
these results do not hold through in an economy with a more rigorous modeling of production and
preference structures and with reasonable degrees of adjustment costs. In the face of such aspects, the
anticipation effects of capital income and labor income tax changes are quite similar.
Secondly,inordertounderstandhowtheeconomyrespondstochangesintaxes,wederiveaHicksian
decompositionofthehoursworkedandconsumptionresponsestochangesintaxes. Wedecomposethese
responses into wealth effects, substitution effects that derive from changes in wages and interest rates,
and a “wedge”. The latter arises because of adjustment costs. The responses of hours worked and
consumption to changes in taxes are dominated by the substitution effects while the wealth effects
are very small due mainly to the fact that the wealth effects are associated with Harberger triangles
(i.e. with a change in distortionary taxes). We show that the key to understanding why hours worked
respond sluggishly to surprise changes in taxes are the opposing effects of the substitution effects due
to wages and due to changes in interest rates.
2Parker(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 remainder of this paper is structured as follows. The next section describes our estimation
approach and discusses the dynamic effects of tax shocks. Section 3 contains the description of the
DSGE model. The estimation of the structural parameters is contained in Section 4. In Section 5 we
discuss and analyze the results. Finally, Section 6 concludes and summarizes.
2 Estimation
InthissectionwepresenttheestimationresultsregardingtheimpactoftaxshocksintheUnitedStates.
A detailed analysis of the data and robustness analysis is contained in Mertens and Ravn (2009). It is
this empirical evidence that we shall later examine whether the DSGE model can account for.
2.1 Identification
We identify tax shocks using Romer and Romer’s (2007a, 2008) narrative account of federal U.S. tax
policy acts. A key advantage of the narrative approach is that it allows one to make a distinction
between anticipated and unanticipated tax shocks based on timing assumptions. Romer and Romer’s
(2007a) base their account on analyses of official government documents, presidential speeches, and
Congressional documents. They identify 49 significant legislated federal tax acts in the period 1947-
2006 and a total of 104 separate changes in tax liabilities. Some of these tax liability changes were
introduced to address concerns about the state of the economy or motivated by the need to finance of
government spending plans while other changes in tax liabilities were exogenous in nature. We focus
on the tax liability changes that Romer and Romer (2007a) classify as exogenous. This corresponds to
70 tax liability changes in total.
The tax data allows us to introduce a natural timing based distinction between unanticipated and
anticipatedtaxshocks. Foreachtaxliabilitychangewedefineanannouncementdatewhichcorresponds
to the date at which the tax legislation became law, i.e. when it was signed by the President, and an
implementation date which is the date at which, according to the legislation, the tax liability changes
were to be introduced. We define a tax liability change as anticipated if the difference between these
two dates exceeds 90 days. We use a 90 days window because it strikes a balance between robustness
of the results to the date within a quarter that a tax change became law, and the ability to measure
anticipation effects.
4
Basedonouruseofa90daywindow,38ofthetaxliabilitychangesareanticipatedand32aredefined
as surprise tax shocks.3 The median implementation lag in the data is 6 quarters. This relatively long
median anticipation lag implies that identification schemes of tax policy shocks based on the existence
of decision lags are not easily implemented, see Blanchard and Perotti (2002).
The impact of tax shocks are estimated from the following regression model:
K
X =A+Bt+C(L)X +D(L)τu+F (L)τa + G τa +e (1)
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.4 τu and τa
t t,i
arethetaxshocks. Theformerofthesecorrespondstotheunanticipatedtaxshockswhicharemeasured
astheimplieddollarchangeintax liabilitiesinpercentagesof currentpriceGDPattheimplementation
date.
K
Thevector τa denotestheanticipatedtaxshocksthatarepartoftheinformationsetatdatet.
t,i
i=0
h i
Specifically, τa measuresthepre-announcedtaxchangeswhich areknownatdatet andwhicharetobe
t,i
implemented at date t+i. This is thesum of tax liabilitychangesannounced today or in the past which
have the same implementation date.5 The regression model then implies that the current realization
of X depends on lags of current and past changes in taxes through the terms D(L)τu and F (L)τa ,
t t t,0
and on currently known but yet not implemented changes in taxes through the terms K G τa . This
i=1 i t,i
latter terms therefore corresponds directly to “news” shocks. P
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
3Alternatively,Lustig,SleetandYeltekin(2007)useinformationon“abnormal”returntomeasureexpectedgovernment
defense spending changes.
4The 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
5In order to measure these we assume that pre-announced tax shocks enters agents’ information sets at the earliest M
quarters before their implementation. We set this maximum lag equal to 3 years.
5
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.1 in the appendix.
The VAR above assumes that the tax shocks have persistent but non-permanent effects on the
vector of observables (under the condition that the lag-polynomial C(L) does not contain unit roots).
We also checked the results when allowing for permanent effects of the tax shocks using a VAR in first
differences. The results are very similar to those that we derive with the VAR in equation (??) and are
therefore not reported.
2.2 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 1 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
percent rise above trend.
6
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 1 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. The peak drop in investment is highly statistically significant. 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 almost the entire pre-implementation period. Hours worked
also drop significantly below trend throughout the announcement period peaking at 1.9 percent below
trend 4 quarters before the 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
7
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.6
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.
Mertens and Ravn (2009) demonstrate that the results above are extremely robust. The results do
6Moreover, 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.
8
not hinge on particular tax acts. In particular, the anticipation effects and the effects of implemented
tax changes are roughly the same when we remove the Kennedy tax act, the Reagan tax acts or the
Bushtaxacts. Nordotheresultsdependcruciallyonthefactthatwedonotcontrolforotherstructural
shocks. When we control for either government spending shocks or for monetary policy shocks, we find
much the same impact of the tax changes on the vector of observables. Importantly, Mertens and Ravn
(2009a) also show that there are little if any signs that the unanticipated tax shocks have any impact
on the economy before their implementation. In other words, the results do support the timing based
distinction that we make between anticipated and unanticipated tax shocks.
The analysis above assumes pre-announced tax changes can impact on X from a maximum 6
t
quarters before their implementation. Figure 2 illustrates the impact of an anticipated tax liability
cut when we vary K, the maximum anticipation horizon, between 4 and 10 quarters. Regardless of
the value of K, the pre-implementation period is characterized by a recession and once the tax cut is
implemented, the economy goes into a boom. However, the depth of the pre-implementation downturn
and the size of the post-implementation expansion are sensitive to K. In particular, the longer the
assumed maximum anticipation horizon, the deeper isthe pre-implementation downturn and the milder
is the post-implementation expansion. In Section 4 we will examine whether these results are consistent
with economic theory. The sensitivity of the anticipation effects to the assumed length of the maximum
anticipation horizon reconciles our findings with those of Blanchard and Perotti (2002) who find little
evidenceofanticipationeffectsbutallowonlyforaonequarteranticipationhorizon. Ourresultsindicate
that for longer, and empirically relevant, anticipation horizons, there are significant pre-implementation
effects of pre-announced tax liability changes.
3 Theory
We examine whether a dynamic stochastic general equilibrium model can account for the empirical
results derived above. We extend earlier DSGE models of distortionary taxation, see e.g. Baxter and
King(1993),Braun(1994),McGrattan(1994)orHouseandShapiro(2006),byintroducingfeaturessuch
as habit formation, adjustment costs, consumer durables, and variable capacity utilization. Burnside,
Eichenbaum and Fisher (2004) also stress the importance of habit formation and adjustment costs for
9