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

The “monetary versus fiscal policy ” debate has not attracted much attention in recent years, and, in some ways, this is not to be regretted. It may therefore be useful to begin this discussion with a quote from Phillip

Almost twenty years ago the “fiscalist issue ” emerged as a major focus on

There is a consensus concerning business cycle facts when the facts are about real variables. For example, Backus and Kehoe (1992) note that there is a similarity among covariance structures of real time series taken from different countries and from different sample periods within a country. This consistency across data sets is no doubt one reason for the large amount of research on real business cycles. This consistency does not extend to data sets that include money and prices. Backus and Kehoe (1992) found that the cyclical properties of money and prices were unstable across historical periods and across countries. Rolnick and Weber (1997) noted that the time-series properties of prices and money are very different in economies with commodity

The science of economics has some constraints and tensions that set it apart from other sciences. One reflection of these constraints and tensions is that, more than in most other scientific disciplines, it is easy to find economists of high reputation who disagree strongly with one another on issues of wide public interest. This may suggest that economics, unlike most other scientific disciplines, does not really make progress. Its theories and results seem to come and go, always in hot dispute, rather than improving over time so as to build an increasing body of knowledge. There is some truth to this view; there are examples where disputes of earlier decades have been not so much resolved as replaced by new disputes. But though economics progresses unevenly, and not even monotonically, there are some examples of real scientific progress in economics. This essay describes one — the evolution since around 1950 of our understanding of how monetary policy is determined and what its effects are. The story described here is not a simple success story. It describes an ascent to higher ground, but the ground is still shaky. Part of the purpose of the essay is to remind readers of how views strongly held in earlier decades have since been shown to be mistaken. This should encourage continuing skepticism of consensus views and motivate critics to sharpen their efforts at looking at new data, or at old data in new ways, and generating improved theories in the light of what they see. We will be tracking two interrelated strands of intellectual effort: the methodology of modeling and inference for economic time series, and the

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.

a iarge number- of economists argued that deficit spending was required to achieve two of the stated national econonnic objectives: frill ennployment and a high r-ate of econonnic gr’owtln.’ Societywas thotnght to bemnefit fr-ornn deficit spendiing because of tine reduction in lost output arnd because tine econornw would achieve a higher n-ate of gr-owth. ‘This view of deficit spendirng Inas been dial— iernged inncr’easirngiy over- tine veal’s, A sizable nnur’n— her of economists now believe that deficit spending has little effect oin emnnplovnnemnt and output, especially in tine iorng r-un, arnd tinat it prinniam-ftv results in a i’edistr-ihution of output, eimlner witininn the pr’ivate sector- or- as a ti-arnsfer of resour’ces fr-ornn the pr-ivate to tine public sector’. ’ Support for tlnis viewpoint has produced a grownmng concern about tine potentiaHv har-rnfui effects of deficit spending arnd tine size of tine public debt The existence and magnitude of the benefits fn-onin deficit spemnding have important innplicatiotns for tine public policy debate. Pr’esumably, the decision to incur- deficits is affected by the public’s belief about whether ’ deficits provide benefits to some individuals at little or- no cost to other’s, or’ winetiner they mer-elv redistribute income. Fience, a cenitral issue inn the debate over deficit spending is wlnether-, and to what degree, it can he used to produce net benefits for society as a whoie. The purpose of tinis paper- is to examinne sornie of tine arguments amnd evidemnce on wlnether deficit spendirng yields net benefits to society.

outstanding role in the development of monetary policy analysis. I did not know him personally, but I have been very strongly influenced by economists who knew and admired him greatly—Karl Brunner, Milton Friedman, and Allan Meltzer come to mind immediately. My work has also been influenced by writings coming from the research department of the Federal Reserve Bank of St. Louis, which he directed, and by the availability of monetary data series developed there. For this lecture I originally had planned a title of “The Evolution of Monetary Policy Analysis, 1973-1998. ” As it happens, I have decided to place more emphasis on today’s situation and less on its evolution. But, a few words about history may be appropriate. I had chosen 1973 as the starting point for a review because there was a sharp break in both academic analysis and in real-world monetary institutions during the period around 1971-73. Regarding institutions, of course, I am referring to the breakdown of the Bretton Woods exchange-rate system, which was catalyzed by the U.S. government’s decision in August 1971 not to supply gold to other nations ’ central banks at $35 per ounce. This abandonment of the system’s nominal anchor naturally led other nations to be unwilling to continue to peg their currency values to the (overvalued) U.S. dollar, so the par-value arrangements disintegrated. New par values were painfully established during the December 1971 meeting at the Smithsonian Institution, but after a new crisis, the system crumbled in

is always a pleasure to return to St. Louis and to Washington University and to see so many friends and former colleagues. But it is a special pleasure to be here for this occasion, the Homer Jones Lecture. Homer Jones was still active at the Federal Reserve Bank of St. Louis when I arrived at Washington University in 1969, and his wife, Alice, was a faculty member in the economics department. I had the pleasure of getting to know both. Homer was special in many ways. He was, of course, a leader in building the research department of the Federal Reserve Bank of St. Louis and in orienting it toward a monetarist perspective. But there was also the remarkable contrast of his strong convictions and his gentle manner. It was a combination to both admire and emulate. I admit I may have been more successful in emulating the strong convictions than the gentle manner. But that only makes me admire Homer even more. I can remember vividly my first visit to St. Louis and Washington University in early 1969. I was a graduate student at MIT visiting the university in search of an appointment as an assistant professor of economics. I was picked up at the airport and delivered to my hotel, in advance of my seminar at the university the following day. When I walked into my hotel room, a small sign on a desk immediately caught my attention. It read: “Money matters. ” My first reaction was awe at the reach of the St. Louis Fed. They take this monetarism bit pretty seriously, I thought. It turned out in fact to be an ad for a local commercial bank, not for the St. Louis Fed. But the story about this incident provided a humorous opening to my seminar the next day. I was nervous, so getting the seminar off to a good start with an amusing story helped. It gave me momentum. And look where I ended up. So when I considered topics for the Homer Jones Lecture, I thought of monetarism and the role of money. My mind quickly took me back to that incident, and I took as my title, “Does Money Matter?” What I had in mind was an assessment of monetarism’s role in shaping current thinking about

thuat shar-p thuctuationus mu tlue shuort—ruru growth rate of Ml since 1979 have reduced GNP gn’owth, raised iruter’est rates atud geruerated expectations of luighet- fufur’e inufiatioru. Miltoru Friedman, fri one, has coruchuded that variable nuloruev gn-owth ~ liv producing these conditions — was n’esponsilile for the shiorter anud nuuor-e abrupt cycles mu r’eah income exper-ieruced river that period,i Based on shightI~’difien-erut anualyses, Bomlroff’, and Mascar’o atud Meltzer also have conuchuded that var-iahhe nuonev gr-ovvth has tended to hower tlue level of output.- F’inuallv, a recerut conference sponsor-ed by ‘flue (:ato Institute was devoted entirely to thueadvense effects of variabhe money gr-ownh anud methods liv which ruuoruev growth could be nuade nuuore stable.’ Econuonuic tlueorv nruuphies nluat variable nuroney gro%vth could lower- the level of GNP by n-educing its short—runu gr-owtlu n-ate, if thuis variahihitywer-e associated with certain changes in nuoney deruuanud and velocity. ‘Fhis an-tide r-eviews the theoretical case for- such a liruk anud provides empir-ical evidence on the existence of this rehationship. flue r’esults suppoi-t tlue notioru fiuat variable money gn-owtiu — by increasing moruey dernand and n-educing vehocity — luas had significant ruegative effects oru hotlu the level anud tlue gr-owthu rate of nonuinal GNP in recent year’s. Michael T. Belongia is an economist at the Federal Reserve Bank of