I recently wrote about the failed 1990 budget deal. My big complaint was that President George H.W. Bush compounded the mistake of higher taxes by also allowing a big increase in the burden of government spending.
However, I didn’t blame the agreement for that year’s recession for the simple reason that the downturn began in July and the tax hike was signed in November (that would make me like Paul Krugman, who wanted people to think that Estonia’s 2008 recession was caused by spending cuts in 2009).
But maybe I’m not being sufficiently critical. After all, Bush announced he would abandon his no-tax pledge in June, and that was then followed by months of tax-hike negotiations. Isn’t it reasonable to think all that talk would have a negative effect, especially on investors and business owners?
The answer may be yes, at least in part. There’s a very interesting new study by Sandra García-Uribe at Spain’s central bank. She examines how the anticipation of tax changes affects economic performance.
Prior to the approval of laws, there is often widespread information about the progress of bills. This information may be valuable for the forecasts that agents make about the economic environment in the future. …This paper provides a way to account for
the economic responses to anticipation of tax shocks… In this paper I introduce a new measure of mass media anticipations of tax bill approvals by exploiting the content of news in the US television during the period 1968-2007. …this is the first paper that exploits a dynamic factor model to account for fiscal policy effects on economic activity. The factor specification considers the dynamics of the factor and the potential effects of tax changes and their anticipation on it.
She’s definitely correct about there being a process for tax legislation, so people (“agents” in economic jargon) have ample warning.
The study includes data on how tax increases harm growth once they are adopted.
Figure 3 presents the implementation effects of exogenous tax liability changes on economic activity, in the period 1948 to 2007…The figure shows the cumulative effects in terms of an increase in tax liabilities of a one percent of QGDP together with the one-standard-error bands. The maximum effects are achieved 29 months after implementation of the tax changes when monthly economic activity growth drops by 99.56%. …the maximum implementation effect of a 1% of QGDP increase of tax liabilities is a reduction of monthly economic activity growth of 0,28%. …For the period that we dispose of television data, 1968 to 2007, immediate implementation effects are -6.6% for monthly economic activity growth. Two months after implementation the effects are -10.7%. Maximum effects are a -69.1% and happen 25 months after implementation.
Here’s a chart showing the negative impact of tax increases.
But does the discussion of tax changes also impact the economy?
According to the research, the answer is yes.
Anticipating tax increases reduces economic activity by 1,36% while anticipating tax cuts stimulates it by 3,04%. …Conditional on the media release of information about a potential tax approval, it is likely that people is aware of what is the net tax liability change associated to the potential approval since media also makes reference to terms like ”increase”, ”rise” or ”cut”. There are 20 episode approvals in the sample and learning how to predict the sign joint to the approval based on 10 approvals per sign resulted in something unfeasible. I construct an indicator variable that captures the mention of ”increase” or ”rise” within the tax news to approximate the possibility of a tax rise approval. …In columns (3) and (4) I control for this indicator and its interaction with media anticipation of tax approvals …A 10% probability of tax approvals conditional on the tax news at t not mentioning tax increases significantly stimulates current monthly economic activity growth by 3.04%. In the case of the media mentioning tax increases the effect is a reduction of monthly economic activity growth by 1.36%.
For economic junkies, here’s the relevant table from the study.
By the way, none of this changes my view that monetary policy is always the first place to look when assigning blame for economic downturns and volatility.
Simply stated, taxation is just one of many factors that determine economic performance. But the fact that it’s not the only thing that matters doesn’t change the fact that it’s a very bad idea to increase the tax burden.
