The Tea Party Is Right AND Correct On Tax Policy

Posted on May 22, 2012 by


Well now, this is interesting. A new economic study from Cornell University shows that the history of expected AND unexpected tax shocks has a demonstrable drag effect on our economy.

Who would have guessed? Oh that’s right, the Tea Party. We have been telling legislators for three years that they should make the Bush Tax Cuts permanent, but the Left has been crying out that it would be irresponsible, as if responsible management of revenue ever mattered to them.

The paper is titled, Empirical Evidence on the Aggregate Effects of Anticipated and Unanticipated U.S. Tax Policy Shocks. The study has some very interesting conclusions:

We provide empirical evidence on the dynamics effects of tax liability changes in the United States. We distinguish between surprise and anticipated tax changes using a timing-convention. We document that pre-announced but not yet implemented tax cuts give rise to contractions in output, investment and hours worked while real wages increase. In contrast, there are no significant anticipation effects on aggregate consumption.

They also show that the opposite, tax cuts, produces the exact opposite effect:

Implemented tax cuts, regardless of their timing, have expansionary and persistent effects on output, consumption, investment, hours worked and real wages. Results are shown to be very robust. We argue that tax shocks are empirically important impulses to the U.S. business cycle and that anticipation effects have been important during several business cycle episodes.

So, will this answer the Hayek vs Keynes, supply side vs demand side argument once and for all? We’ll let the authors’ conclusion speak for itself:

Our results appear consistent with strong supply side effects of tax changes. The strong decline in investment and the drop in hours worked in response to a pre-announced tax cut is consistent with the idea that future lower taxes motivate firms to delay purchases of capital goods and gives rise to intertemporal substitution of labor supply. Indeed, Mertens and Ravn (2011) show that a DSGE model can account quite precisely for the dynamics of output, investment, and hours worked that follow after unanticipated and anticipated changes in taxes…

We will delve into this paper in more depth in a subsequent blog post.

h/t Ben Domenech, The Transom

Posted in: Big Government, Taxes