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Empirical Evidence:
Methodological Issues
Endogeneity of tax changes
• Tax cuts potentially correlated with cycle
• Estimated of the effects of counter-cyclical
tax policy will be attenuated
– Similar attenuation from monetary nonaccommodation
• Endogeneity could have opposite sign,
e.g., tax cuts in strong economies
– State and local tax cuts typically cyclical
Empirical Approaches
Conventional econometric identification
State-level disaggregated analysis
Narrative approach
Analysis of specific episodes
Narrative Approach
Main reference for tax cuts:
Romer and Romer (AER, 2010)
Antecedents:
• Romer and Romer: monetary policy dates
• Ramey and Shapiro: military spending
dates
Narrative methodology
• Read legislative history of tax changes
• Classify tax changes
– Endogenous
• Countercyclical
• Spending driven (revenue shortfall)
– Exogenous
• Long-run growth
• Structural deficit
• Tax changes very frequent
– Every two years, on average
Narrative methodology: Issues
• Subjective judgment of motivation of policy
change
Narrative methodology: Issues
• Timing very complicated
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Proposed, often during campaigns
Formal introduction of legislation
Passage of legislation
Signing of legislation
Effective date of legislation
• Often retroactive
• Timing matters econometrically
– Rudebusch on Federal Funds shocks
– Ramey on military shocks
Narrative examples
Omnibus Budget Reconciliation Act of 1993
(Clinton tax increases)
Classification: Exogenous, Deficit-driven
Timing: Passed August 1993
• Not proposed in 1992 campaign
• Passage uncertain (one vote in House)
Narrative examples
Economic Growth and Tax Relief
Reconciliation Act of 2001 (EGTRA)
(Bush tax cuts)
Classification (mixed):
•Mainly exogenous, long-run growth
– Marginal rate cuts
•Modest endogenous component
– 2001 tax rebate
EGTRA 2001 Timing Complex
• Marginal rate cuts proposed in 2000
campaign
• Enacted in mid-2001 essential as proposed
in February 2001
• Rebate not part of original proposal
• Tax cuts to be phased in 2004 and 2006
– Made immediate in mid-2003 by 2003 tax law
• Tax cuts to sunset in 2011
– Byrd rule
Exercise: 2010 tax law
• Sunset of 2001 rate cuts in 2011
– Legislated since 2001
– Expectations about sunset varied considerably
– Obama proposal (starting in 2008 campaign)
• Make rate cuts permanent for incomes <$250K
• High income rate cuts to expire
– Republican proposal
• Make all rate cuts permanent
• Dec 2010 compromise: All rate cuts extend
for two years
2010 tax law: Classification?
• Tax cut or not?
– Tax cut relative to legislative baseline
– But little expectation that all tax cuts would
expire
– But they might have expired absent
compromise
• Romer-Romer approach:
– Only coded as change if liabilities change, i.e.,
assume current taxes (not current law) the
baseline (sunsets that actually happen coded
as changes)
2010 tax law: Classification?
• Endogenous or exogenous?
– Republican argument: long-term growth
– Obama argument: equity
– Compromise likely driven by weak economy
• Payroll tax holiday clearly endogenous
Narrative approach:
Econometric strategy
• Regress variables of interest on narrative
measures of tax change
• Various strategies for controls
– Do not matter much
– Not surprising, for exogenous tax changes
Narrative approach: Results
Large response to exogenous tax changes
• 1% of GDP tax cut increases GDP by 3%
Estimated response of GDP
to a 1% of GDP, exogenous tax increase
Source: Romer and Romer, 2010.
Narrative approach: Results
Endogenous tax changes have attenuated
effects
• Pooling endogenous/exogenous narrative
changes reduces effects
• Commonly used “cyclically adjusted
revenue” also appears endogenous
Estimated response of GDP
to a 1% of GDP, exogenous versus endogenous
tax increase
Source: Romer and Romer, 2010.
Estimated response of GDP
to a 1% of GDP, exogenous versus endogenous
tax increase
Source: Romer and Romer, 2010.
Narrative approach: Evaluation
• Effective for separating endogenous and
exogenous tax changes
• Very large tax cut multipliers
– Larger than plausible parameterization of
Woodford-type model treating tax cuts as
income effects
• Strong circumstantial case that
price/allocative effects are large
• Substantial lags in effects
Narrative approach to spending
shocks
Estimated Effects of Spending Shocks:
Questions
1. What happens to real wage?
–
Old debate: Keynes-Dunlop-Tarshis
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•
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Aggregate demand shocks move firms along the labor
demand curve
High aggregate demand leads to lower wages
because of diminishing MPL
Wages, however, do not appear to be countercyclical
Modern evidence from micro
•
Wages procyclical (Bils, Solon-Barsky-Parker)
Estimated Effects of Spending Shocks:
Questions
1. What happens to real wage?
–
Modern theory
•
Markup falls in booms (Rotemberg-Woodford, Macro
Annual)
– Ramey-Shapiro variant: Less clear in 2 sector model
•
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Wages procyclical (essentially 1/markup)
Use govt shocks to study exogenous movements
in demand
Estimated Effects of Spending Shocks:
Questions
2. What happens to GDP/Employment when
spending increase?
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–
Return to issues of first lecture
Key questions for fiscal policy evaluation
Estimated Effects of Spending Shocks:
Finding exogenous variation
• Narrative
– Ramey-Shapiro military build-ups
• VAR
– Blanchard-Perotti
• Instrumental variables (military)
– Hall, Barro
Ramey-Shapiro military spending dates
• Narrative approach in the tradition of Romer and
Romer
• Ramey-Shapiro Carnegie-Rochester (1998)
– Includes 2-sector model
• Ramey QJE (2011, in press)
– Updates, and comparison with VAR
– Stresses timing effects
• A military shock is news about a long sequence of spending
• VAR’s fragile with respect to timing issues
Korea (1950:3)
On June 25, 1950 the North Korean army
launched a surprise invasion of South Korea,
and on June 30, 1950 the U.S. Joint Chiefs of
Staff unilaterally directed General MacArthur
to commit ground, air, and naval forces. The
July 1, 1950 issue of Business Week
immediately predicted more money for
defense. By August 1950, Business Week was
predicting that defense spending would more
than triple by fiscal year 1952.
Vietnam (1965:1)
Despite the military coup that overthrew Diem on
November 1, 1963, Business Week was still talking
about defense cuts for the next year (November 2,
1963, p. 38; July 11, 1964, p. 86). Even the Gulf of
Tonkin incident on August 2, 1964 brought no
forecasts of increases in defense spending. However,
after the February 7, 1965 attack on the U.S. Army
barracks, Johnson ordered air strikes against military
targets in North Vietnam. The February 13, 1965,
Business Week said that this action was “a fateful
point of no return” in the war in Vietnam.
Carter-Reagan Buildup (1980:1)
The Soviet invasion of Afghanistan on December 24,
1979 led to a significant turnaround in U.S. defense
policy. The event was particularly worrisome because
some believed it was a possible precursor to actions
against Persian Gulf oil countries. The January 21,
1980 Business Week (p.78) printed an article entitled
“A New Cold War Economy” in which it forecasted a
significant and prolonged increase in defense
spending. Reagan was elected by a landslide in
November 1980 and in February 1981 he proposed
to increase defense spending substantially over the
next five years.
9/11 (2001:3)
On September 11, 2001, terrorists struck the
World Trade Center and the Pentagon. On
October 1, 2001, Business Week forecasted
that the balance between private and public
sectors would shift, and that spending
restraints were going “out the window.” To
recall the timing of key subsequent events, the
U.S. invaded Afghanistan soon after 9/11. It
invaded Iraq on March 20, 2003.
Real Defense Spending
per capita
Real Defense Spending per
capita including WWII
Total Govt Spending
per capita