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Romer and Romer (2007): “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks” and “Do Tax Cuts Starve the Beast? The Effect of Tax Changes on Government Spending” Loic Berger Lena Koerber UPF, May 4, 2009 Motivation • Measuring the impact of taxes on output, government spending and other macroeconomic variables is difficult: Tax changes and macroeconomic variables have often a common cause giving raise to a endogeneity problem • Romer and Romer propose new measure of fiscal shocks based on exogenous variation in taxation • Their work provides empirical evidence of the effects of fiscal policy using the dummy variable approach Data • Romer and Romer use narrative records (Economic Report of the President, Congressional records etc) to identify significant tax laws between 1947 and 2006 • Classification of tax laws into – Exogenous tax laws (not motivated by the state of the economy) intended to either • Promote long-run growth or • Reduce an inherited budget deficit – Endogenous tax laws (motivated by the state of the economy) related to either • Countercyclical policy or • Changes in government spending Data (cont.) Methodology Where Y is either output, its components, or government spending and T (measured in % of GDP) is – Any exogenous tax change in the first paper – An exogenous, long-run growth tax change in the second paper Findings (1) The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal shocks • Tax cuts are contractionary Findings (cont.) (1) The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal shocks Findings (cont.) (1) The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal shocks • • Persistency Mechanism: The negative effect of tax increases on output works primarily through investment Findings (cont.) (2) Do Tax Cuts Starve the Beast? The Effect of Tax Changes on Government Spending • The starving the beast hypothesis is rejected Findings (cont.) (2) Do Tax Cuts Starve the Beast? The Effect of Tax Changes on Government Spending • How does the government balance the budget? • Exogenous long-run tax cuts are counteracted by future tax increases