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 non-accommodation

•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– 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

• 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

• 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?

– 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