Corporate taxes do not cause inflation

We study how monetary policy responds to permanent corporate tax reforms that are motivated by long-term objectives. Using cross-country data between 1960 and 2020, we construct a set of corporate-tax-reform shocks and show that they are exogenous to current inflation and output. Using these new corporate tax shocks, we document that central banks raise policy rates an average of 2 percentage points following a drop of 10 percentage points in the statutory corporate income tax rate. We setup a New Keynesian model with corporate taxes to assess the observed response and examine optimal monetary policy The primary objective of most central banks is to ensure price stability, and in many cases, to maintain output close to its potential. To the extent that fiscal policy has an impact on inflation and output dynamics, it matters for monetary policy. Within the various stances of fiscal policy, the corporate tax structure—through its effect on private investment—is relevant in determining the short-run fluctuations and the long-run growth potential of an economy, and in principle, should be of interest to central bankers. Do central banks respond to corporate tax reforms? Should monetary policy explicitly take into account corporate taxation? The relationship between monetary policy and corporate taxation has surprisingly received little attention in the literature due to several challenges. The first challenge is a lack of data: Corporate tax reforms happen rarely. In the US, for example, only six changes to the corporate income tax rate occurred in the last 60 years.2 Thus data limitations preclude from establishing a systematic relationship when using information from a single country. The second challenge is methodological: Diff-in-diff methodologies rely on cross-sectional heterogeneity in treatment to estimate firm-level responses to tax reforms, and therefore, by design, are unable to measure the effects on aggregate quantities and prices, which are exactly the objects monetary policy responds to.3 The third challenge is the identification of fiscal shocks in general, and corporate tax shocks in particular: Both fiscal and monetary policy could be jointly influenced by other aggregate variables, thus a simple series of corporate tax changes is not appropriate to estimate the monetary policy response. This paper proposes a new methodology that exploits cross-country data to circumvent these challenges. First, we significantly expand the number of observations by assembling a dataset with 40 countries for the last 60 years of statutory corporate tax rates. Second, following Romer and Romer (2010), we decompose changes in the statutory tax rate between tax changes motivated by long-run considerations (e.g., sustainability, efficiency, or redistribution) from tax changes motivated by short-run objectives (e.g., business cycle stabilization) using non-parametric methods that identify multiple structural breaks in time-series. The premise is that tax changes with longrun objectives generate permanent changes in the statutory corporate tax rate. In this way, we tackle the omitted-variable bias by focusing on permanent corporate tax reforms—reforms with clear long-run motives, such as growth or fairness concerns, that remain in place for long periods of time—, which ensures that the drivers of corporate tax reforms are different from the drivers of monetary policy. Through a variety of tests, we show that our new measure of corporate tax changes is exogenous to monetary policy, and in the case of the US, that our series coincides with series obtained through a narrative approach by Romer and Romer (2010). Third, we use our new shock series to estimate central bank responses to tax reforms using local projections methods (Jord`a, 2005). We find that a drop in the statutory corporate tax rate of 10 percentage points generates a 2 percentage point increase in the policy rate. Empirical results. Our main result is that, on average, central banks raise policy rates after a corporate tax reform. On average, there is a 2 percentage point (pp.) increase in the policy rate after a 10 pp. decrease in the corporate income tax rate. We also observe a lag in the Central Banks responses: On average, monetary policy rates peak two to three years after the tax reform. The shape of the response suggests that the policy response is transitory, as rates go back to their average value after 4 years. Importantly, these results control for country-level outcomes, which by definition, embed general equilibrium and aggregate effects. With new tax reform instrument to examine the relationship between tax reform, monetary policy, and other aggregates. First, we estimate our baseline specification, using local projection (LP) methods by Jord`a (2005). We then employ three other LP estimators to address concerns relating to omitted variable bias, allocation bias, and anticipatory effects. This section concludes with a discussion of the relationship between our tax reform measure and other aggregates. Quantitative results (In progress). The second part of the paper aims to understand the documented monetary policy response through the lens of a medium-scale New Keynesian model suited to conduct counterfactuals and study optimal policy. In the spirit of Justiniano, Primiceri and Tambalotti (2010), our framework will consist of a DSGE model with capital and labor inputs, wage and price rigidities, investment frictions, corporate taxes, and a Taylor-type rule followed by the monetary authority. The calibrated version of this model replicates the observed response.