This paper investigates the impact of tax changes on economic activity. We use the narrative record, such as presidential speeches and Congressional reports, to identify the size, timing, and principal motivation for all major postwar tax policy actions. This analysis allows us to separate legislated changes into those taken for reasons related to prospective economic conditions and those taken for more exogenous reasons. The behavior of output following these more exogenous changes indicates that tax increases are highly contractionary. The effects are strongly significant, highly robust, and much larger than those obtained using broader measures of tax changes. (JEL E32, E62, H20, N12) Tax changes have been a major public policy issue in recent years. The tax cuts of 2001 and 2003 were passed amid firestorms of debate about their likely effects. Some policymakers claimed that the cuts would both stimulate the economy in the short run and increase normal output in the long run. Others argued that they would raise interest rates and lower confidence and thereby reduce output in both the short run and the long run. That views of the effects of tax changes vary so radically largely reflects the fact that measuring

I undertake a quantitative investigation into the short run effects of changes in the timing of taxes for model economies in which heterogeneous households face a borrowing constraint. A combination of the distortionary effects of non-lump-sum taxation and the liquidity effects arising from the asset market structure are found to imply large real effects from tax changes. For example, a temporary proportional income tax increase in the benchmark model economy reduces aggregate consumption by around 29 cents for every additional dollar of tax revenue raised. The consumption of low wealth households who are close to the borrowing constraint is most sensitive to the current tax rate. While there are many such households, richer households account for a disproportionately large fraction of aggregate income and consumption. Thus the distortionary effects of proportional taxation are quantitatively more important at the aggregate level than the effects associated with incompleteness of asset markets.

This paper investigates the impact of changes in the level of taxation on economic activity. The paper uses the narrative record – presidential speeches, executive-branch documents, and Congressional reports – to identify the size, timing, and principal motivation for all major postwar tax policy actions. This narrative analysis allows us to separate revenue changes resulting from legislation from changes occurring for other reasons. It also allows us to further separate legislated changes into those taken for reasons related to prospective economic conditions, such as countercyclical actions and tax changes tied to changes in government spending, and those taken for more exogenous reasons, such as to reduce an inherited budget deficit or to promote long-run growth. We then examine the behavior of output following these more exogenous legislated changes. The resulting estimates indicate that tax increases are highly contractionary. The effects are strongly significant, highly robust, and much larger than those obtained using broader measures of tax changes. The large effect stems in considerable part from a powerful negative effect of tax increases on investment. We also find that legislated tax increases designed to reduce a persistent budget deficit appear to have much smaller output costs than other tax increases.

This series of guest lectures and working papers is published by the Institute of Financial Economics (IFE) at the American University of Beirut (AUB) as part of its role in making available ongoing research, at the University and outside it, related to economic issues of special concern to the developing countries. While financial, monetary and international economic issues form a major part of the institute’s work, its research interests are not confined to these areas, but extend to include other domains of relevance to the developing world in the form of general analysis or country specific studies. Except for minor editorial changes, the lectures are circulated as presented at public lectures organized by the institute, while working papers reflect ongoing research intended to be polished, developed and eventually published. Comments on the working papers, to be addressed directly to the authors, are

Liquidity constraints and partial risk-sharing are often indistinguishable. However, I illustrate using artificial data from two different model economies how band spectrum regression can be used to distinguish between lack of consumption insurance and liquidity constraints.

Technical papers in this series are preliminary and are circulated to stimulate discussion and critical comment. These papers are not subject to CBO¶s formal review and editing processes. The analysis and conclusions expressed in them are those of the author and should not be interpreted as those of the Congressional Budget Of¿ce. Any reference to this paper in other publications should be cleared with the author. Papers in this series can be obtained by sending

1997, and Hayashi, Altonji, and Kotlikoff, 1996) have found that households are not altruistically linked in a way consistent with the standard Ricardian model, as put forward by Barro (1974). We build a two-sided altruistic-linkage model in which private transfers are made in the presence of two types of shocks: an “observable ” shock that is public information (for example, public redistribution) and an “unobservable ” shock that is private information (for example, idiosyncratic wages). Parents and children observe each other’s total income but not each other’s effort level. In the second-best solution, unobservable shocks are only partially shared, whereas, for any utility function satisfying a condition derived herein, observable shocks are fully shared. The model, therefore, can generate the low degree of risk sharing found in the recent studies, but Ricardian equivalence still holds. Journal of Economic Literature Classification Number: H31. The authors would like to thank Paul Evans, Doug Hamilton, Kathleen McGarry, Ben Page, Ernesto Villanueva and participants at seminars at The Wharton School for their helpful comments. The analysis and conclusions expressed herein are those of the authors and should not be interpreted