Does Romer & Romer mean that tax cuts are generally good for growth?
U.S. federal tax returns are due tomorrow, and the subject seems to be on the mind of bloggers. Greg Mankiw cites a recent study by Christina and David Romer, which finds a strong inverse association between exogenous tax changes and economic output:
Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.Greg cites the paper without comment, leaving readers to draw their own conclusions, and it appears that many readers have drawn conclusions that may not be warranted (and in some cases, clearly are not warranted) by the paper. The difficulty arises from taking the above finding out of context while failing to consider another important finding about the response to a tax increase:
…inflation appears to fall substantially. The point estimates show the impact reaching 2.2 percentage points after ten quarters, then spiking down to 3.1 percentage points in quarter 11 before returning to 2.2 percentage points in quarter 12.There are two things to notice about this inflation impact. First, it goes in the opposite direction from what would be expected based on a supply-side explanation of the impact of tax changes: if tax increases reduced supply, the inflation rate should rise, not fall. Second, if we take the point estimates seriously, the effect on inflation is huge. Anyone expecting a tax cut to increase growth is going to have to take into account the fact that Ben Bernanke is also likely to read this study – and we all know what Ben is likely to do when he expects inflation.
To put it bluntly, Romer & Romer’s results are quite consistent with a world in which any future tax cut (unless it is offset by a spending cut) is likely to reduce growth, once the expected monetary policy response is taken into account. Their results do not allow us to decompose the tax impact into a supply-side effect and a demand-side effect, but they are at least consistent with the complete absence of a supply-side effect, whereas they are not consistent with the absence of a demand-side effect. If there is no supply-side effect, then there is no change in the economy’s potential growth rate in the short run. Therefore there will be no change in the Fed’s target level of output. Therefore (barring a liquidity trap) the Fed will act to fully offset the short-run impact of tax changes on output. And to do so, in response to a tax cut, the Fed will have to raise interest rates, increasing financing costs for businesses and discouraging investment. Unless the marginal propensity to consume is zero or the Fed makes a mistake, the path of investment will end up lower than what it would have been in the absence of the tax cut. Therefore the capital stock will end up lower, and long-run growth will end up lower.
As I said, the results do not allow us to rule out a supply-side effect, and it’s quite possible that the supply-side effect will be enough to offset the damage to growth from the Fed’s response to the demand-side effect. But I wouldn’t be in too much of a hurry to cite this study as a reason to extend the Bush tax cuts.