The Effects of Tax Shocks on Output: Not So Large, But Not Small Either
In a seminal contribution, Romer and Romer (2010) (RR henceforth) estimate GDP tax multipliers of up to -3 after 3 years. These results have been criticized as implausibly large. For instance, Favero and Giavazzi (2010) (FG henceforth) argue RR's specification cannot be interpreted as a proper (truncated) moving average representation of the output process. They show that when the system is estimated in its VAR form, or its correct truncated MA representation, a unit realization of the RR shock has much smaller effects on GDP than in RR, typically about - .5 percentage points of GDP. I argue that on theoretical grounds the discretionary component of taxation should be allowed to have different effects than the automatic response of tax revenues to macroeconomic variables; existing approaches, including FG's, that do not allow for this difference, exhibit impulse responses that are biased towards 0. I show that the correct impulse responses to a RR tax shock are about half-way between the large effects estimated by RR and the much smaller effects estimated by FG: typically, a one percentage point of GDP increase in taxes leads to a decline in GDP by about 1.5 percentage points after 3 years. I also create two new datasets of tax shocks, one based on receipts and the other on liabilities; in these datasets, I distinguish between different types of taxes (personal, corporate, indirect, and social security) and their subcomponents.
I thank Roger Gordon and a referee for very helpful suggestions; Carlo Favero for several discussions that helped clarify the issues, and for pointing out a crucial mistake in an earlier version of the paper; Yuriy Gorodnichenko, who discussed an earlier version at the NBER-IGIER TAPES conference held in Varenna, Italy in June 2010; and Morten Ravn for very useful comments. Elia Pietro Boe provided excellent research assistance. This paper was produced as part of the project Growth and Sustainability Policies for Europe (GRASP), a Collaborative Project funded by the European Commission's Seventh Research Framework Programme, contract number 244725. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.
The Effects of Tax Shocks on Output: Not So Large, But Not Small Either, Roberto Perotti. in Fiscal Policy (Trans-Atlantic Public Economics Seminar, TAPES), Gordon and Perotti. 2012
Roberto Perotti, 2012. "The Effects of Tax Shocks on Output: Not So Large, But Not Small Either," American Economic Journal: Economic Policy, vol 4(2), pages 214-237.