Tax shocks have a net negative impact on the economy

Era Dabla-Norris, Frederico Lima, Macroeconomic effects of tax rate and base changes: Evidence from fiscal consolidations, European Economic Review, Volume 153, 2023, 104399, (Era Dabla-Norris is a Division Chief in the IMF's Fiscal Affairs Department. She is currently working on issues pertaining to structural reforms and productivity, income inequality, fiscal risks and spillovers, and demographics and fiscal dynamics.) (Frederico Lima is an economist in the African Department of the International Monetary Fund. ) ISSN 0014-2921, . /hcc *Dynamic effects of tax changes section and conclusion section is included

We first present our estimates for the dynamic effects of tax changes for all tax types combined. After, we differentiate between the effects of tax rate and base changes. All impulse responses show the impact of a tax increase worth one percent of GDP, and we show results for a forecast horizon of 16 quarters, together with one and two standard deviation confidence intervals. In the results that follow, we focus on exogenous shocks with a consolidation motivation, but the results are similar if we include measures with a long-run motivation as well. All tax types. The response of tax revenue and output to a narrative tax shock covering all tax types is shown in Fig. 3. The left panel shows the response of the tax-to-GDP ratio to the narrative tax shock, the first-stage of our IV estimation. The point estimates are positive throughout, with the response building up during the first year, consistent with the revenue effects projected by country authorities shown in Fig. 2. The improvement in the tax ratio remains around one for the first 12 quarters, and gradually declines after, although it does not reach zero. There are several reasons why the improvement in the tax ratio could be temporary. First, it could be due to statistical noise, noting that one remains well within the confidence interval. It could also be driven by economic agents adapting to the tax changes, including through mobility or noncompliance, although it is not clear why these behavioral changes would take years to have an impact. Lastly, it may reflect a partial unwinding of tax reforms after a few years, especially since many tax changes are enacted after elections, and governments have an incentive to relax taxes before the next election. The timing of the decline, three years after announcement, is consistent with this interpretation. The right panel of Fig. 3 shows the response of GDP to an improvement of one percent of GDP in the tax-to-GDP ratio, which is instrumented by the narrative tax shock in the second-stage of our IV estimation. Consistent with the findings elsewhere in the literature (e.g., Romer and Romer, 2010, Guajardo et al., 2014, Alesina et al., 2015), an increase in tax liabilities during fiscal consolidations results in a decline in output, with an announced increase in taxes of one percent of GDP leading to a decrease in output of 0.3 percent in the first quarter, and a peak decline of 1.1 percent two years after announcement. The impact of GDP is somewhat lower after a few years, consistent with the smaller impact on tax revenue. Tax rate and tax base changes. We next turn to the dynamic impact of tax rate versus base changes on output, the focus of our paper. To estimate the impact of tax rate changes, we continue to use Eq. (3), but now instrument the change in the tax-to-GDP ratio using the narrative shock for rate changes only. To account for discretionary changes in tax bases that may happen around the same time, we also control for lagged narrative tax base shocks. We estimate the impact of discretionary tax base shocks similarly, this time adding lagged narrative tax rate shocks as controls. As before, the estimates show responses to a 1 percent of GDP tax increase enacted either through rate or base measures. The panels on the left in Fig. 4 show the responses of GDP and tax revenue to tax rate shocks, while the panels on the right show the responses to tax base shocks. The response of GDP is shown in the top row. A tax rate shock leads to a large decline in GDP, with a decline of about 0.4 percent in the first quarter, and a peak decline of 1.7 percent after two years. The impact is persistent, and remains significant throughout the estimation horizon. In contrast, tax base shocks have a much smaller impact on GDP that is not statistically significant. Importantly, this difference is not driven by base shocks having a smaller impact on tax revenue than rate shocks, since both tax rate and base shocks lead to a significant increase in tax revenue. The following panels in Fig. 5 examine the response of different GDP components, including consumption, investment and government purchases. To ensure that these magnitudes can be directly compared, we scale the impulse responses to have the same units in percent of GDP. The first row shows the response of private-sector consumption. After a tax rate shock, consumption shows a steep decline, decreasing by 0.9 percent of GDP after eight quarters, and then recovering slightly over time. In contrast, the response of consumption after a tax base shock is more muted, with point estimates indicating a decline of 0.3 percent of GDP two years after announcement. However, this decline is not statistically significant. A similar picture emerges for private-sector investment (here defined as gross fixed capital formation), which is shown in the second row of Fig. 5. Investment decreases after a tax rate shock, declining by 0.8 percent of GDP after eight quarters, and then partially recovering. However, investment responds less to a similar size tax increased enacted only through base measures. The point estimates indicate no decline in the first two quarters, and a decline of 0.6 percent of GDP after eight quarters, although it remains not statistically significant. Finally, we examine the responses of labor market indicators to tax rate and tax base increases in Fig. 6. The top row documents the response of the unemployment rate to a 1 percent of GDP increase in taxes. For increases adopted through rate hikes, we observe a significant increase in the unemployment rate, starting at 0.4 percent in the first year, and building up to 0.9 percent after three years. However, the impact on unemployment is considerably smaller when tax increases are adopted through base broadening. In this case, there is an increase in the unemployment rate of 0.2 in the first year after tax increases are announced, and the point estimate increases gradually to 0.5 percent over the medium-term. Moreover, these estimates remain statistically insignificant in all quarters. The bottom row shows the response of average wages per employed worker, and here again the difference between rate and base responses is noticeable. Wages decline after a rate hike is announced, and the point estimates indicate a statistically significant decline of just under 2 percentage points after two years, which appears to be persistent. However, a tax increase implemented through tax base changes is associated with a much smaller decline in wages of about 0.5 percent over the same two-year horizon. There is evidence of a continued decline in average wages over the medium-term after a base shock, but these estimates continue to be not statistically significant. 4.2. Tax multipliers The previous section describes the dynamic impact of tax shocks. Alternatively, these impacts can be translated into multipliers. Following Uhlig (2010) and Ramey and Zubairy (2018), we estimate multipliers by considering the impact of the cumulative change in tax revenue on the cumulative change in output: (4) ɛ This approach has the advantage of taking into account the total change in output and tax revenue following the announcement of a tax shock, independently of their specific paths over time. For example, this could be important if tax shocks have an immediate impact on tax revenue while having a delayed impact on growth, or vice-versa.<DATA OMITTED> Conclusion Our analysis shows that tax changes can have significant macroeconomic effects, but these effects vary with their composition. Using a new narrative dataset of tax changes during fiscal consolidations, we find that base broadening leads to smaller output and employment declines than rate increases. The estimated cumulative tax rate multiplier two years after announcement is close to 1.8, while the cumulative tax base multiplier is only 0.5 over the same horizon and not statistically significant. On average, a one percent of GDP rate hike is associated with a sustained increase in the unemployment rate of nearly 1 percentage point, while similar-size base broadening measures lead to an increase in unemployment that is only half as large. We find similar results when we separate rate and base changes within specific taxes, including personal and corporate income taxes. Our findings support the common policy advice that base broadening is less detrimental to growth, and suggest interesting possibilities for future research. First, our dataset could be extended to non-consolidation years and additional countries. This would make it possible to examine how rate and base multipliers vary by income level, the state of the business cycle, or tax system characteristics such as the initial size of the tax base and the initial tax rate (Ramey and Zubairy, 2018, Gunter et al., 2021). Future work could also examine differences in tax changes, like contrasting measures with long-run and consolidation motivations or separating by type of base broadening, and look at the long-term impact of rate hikes and base broadening on economic growth. Finally, it may be useful to explore the interaction between rate and base measures and improvements in tax administration, since the latter can have a large and immediate impact on tax compliance (Slemrod, 2019). he change in tax is instrumented with the relevant narrative tax shock, and all baseline controls are included. We focus on the multiplier at a two-year ( ) horizon, but the results are similar at shorter (4 quarter) or longer (16 quarter) horizons. In all cases, we also display the first-stage robust F-statistic, which suggests there is no weak instruments problem. Nevertheless, to ensure that our results are not affected by possible issues with instrument relevance, we conduct key hypothesis tests using Anderson and Rubin (1949) statistics, which are robust to weak instruments. The estimated tax multipliers are shown in Table 3, which contains two key findings. First, we find that the multiplier across all types of tax changes is 1.28 after two years, which is somewhat smaller than estimated in the literature. For example, Romer and Romer (2010) and Guajardo et al. (2014) also adopt a narrative approach and find two-year tax multipliers closer to 3, while Ramey (2019) surveys the recent literature and concludes that most estimates fall between 2 and 3. Instead, our lower estimate is consistent with those of Barro and Redlick (2011), who find a tax multiplier of 1.1 for the U.S. in the postwar period, and Alesina et al. (2017). The latter find a multiplier of 1.3, although they focus on tax-based consolidations (i.e., fiscal consolidations where more than half of the consolidation effort was adopted through tax changes) rather than tax changes directly. The second key finding is that tax base multipliers are significantly lower than tax rate multipliers. The impact of tax rate changes on output is large and statistically significant, reaching 1.84 after two years, while tax base changes have a much smaller impact, with a point estimate of 0.46, which is not statistically different from zero. The last column of Table 3 conducts a formal statistical test for the difference between the two multipliers, and finds it is statistically significant at 1 percent level. The Anderson-Rubin statistic, which is robust to weak instruments but may have lower power, also rejects the hypothesis that the two multipliers are equal at the 10 percent level.