Which model is used to evaluate the effects of macroeconomic policy such as tax cuts?
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journal article Show The American Economic Review Vol. 100, No. 3 (JUNE 2010) , pp. 763-801 (39 pages) Published By: American Economic Association https://www.jstor.org/stable/27871230 Read and download Log in through your school or library Alternate access options For independent researchers Subscribe to JPASS Unlimited reading + 10 downloads Purchase article $10.00 - Download now and later Monthly Plan
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Abstract 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 post-war 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 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. Journal Information The American Economic Review is a general-interest economics journal. Established in 1911, the AER is among the nation's oldest and most respected scholarly journals in the economics profession and is celebrating over 100 years of publishing. The journal publishes 11 issues containing articles on a broad range of topics. Publisher Information Once composed primarily of college and university professors in economics, the American Economic Association (AEA) now attracts 20,000+ members from academe, business, government, and consulting groups within diverse disciplines from multi-cultural backgrounds. All are professionals or graduate-level students dedicated to economics research and teaching. Rights & Usage This item is part of a JSTOR Collection. Federal Budget and Economy Q. How do taxes affect the economy in the long run? A. Primarily through the supply side. High marginal tax rates can discourage work, saving, investment, and innovation, while specific tax preferences can affect the allocation of economic resources. But tax cuts can also slow long-run economic growth by increasing deficits. The long-run effects of tax policies thus depend not only on their incentive effects but also their deficit effects. Economic activity reflects a balance between what people, businesses, and governments want to buy and what they want to sell. In the short run, demand factors loom large. In the long run, though, supply plays the primary role in determining economic potential. Our productive capacity depends on the size and skills of the workforce; the amount and quality of machines, buildings, vehicles, computers, and other physical capital that workers use; and the stock of knowledge and ideas. TAX INCENTIVESBy influencing incentives, taxes can affect both supply and demand factors. Reducing marginal tax rates on wages and salaries, for example, can induce people to work more. Expanding the earned income tax credit can bring more low-skilled workers into the labor force. Lower marginal tax rates on the returns to assets (such as interest, dividends, and capital gains) can encourage saving. Reducing marginal tax rates on business income can cause some companies to invest domestically rather than abroad. Tax breaks for research can encourage the creation of new ideas that spill over to help the broader economy. And so on. Note, however, that tax reductions can also have negative supply effects. If a cut increases workers’ after-tax income, some may choose to work less and take more leisure. This “income effect” pushes against the “substitution effect,” in which lower tax rates at the margin increase the financial reward of working. Tax provisions can also distort how investment capital is deployed. Our current tax system, for example, favors housing over other types of investment. That differential likely induces overinvestment in housing and reduces economic output and social welfare. Budget effectsTax cuts can also slow long-run economic growth by increasing budget deficits. When the economy is operating near potential, government borrowing is financed by diverting some capital that would have gone into private investment or by borrowing from foreign investors. Government borrowing thus either crowds out private investment, reducing future productive capacity relative to what it could have been, or reduces how much of the future income from that investment goes to US residents. Either way, deficits can reduce future well-being. The long-run effects of tax policies thus depend not only on their incentive effects but also on their budgetary effects. If Congress reduces marginal tax rates on individual incomes, for example, the long-run effects could be either positive or negative depending on whether the resulting impacts on saving and investment outweigh the potential drag from increased deficits. Putting it togetherThat leaves open questions on how large incentive and deficit effects are, and how to model them for policy analysis. The Congressional Budget Office and the Joint Committee on Taxation each use multiple models that differ in assumptions about how forward-looking people are, how the United States connects to the global economy, how government borrowing affects private investment, and how businesses and individuals respond to tax changes. Models used in other government agencies, in think tanks, and in academia vary even more. The one area of consensus is that the most pro-growth policies are those that improve incentives to work, save, invest, and innovate without driving up long-run deficits. The Urban-Brookings Tax Policy Center (TPC) has developed its own economic model to analyze the long-run economic effects of tax proposals. In TPC’s model, simple reduced-form equations based on empirical analysis determine the impact of tax policy on labor supply, saving, and investment. TPC used this model to estimate the long-run economic and revenue effects of the Tax Cuts and Jobs Act. Updated May 2020Further Reading Congressional Budget Office. 2014. “How CBO Analyzes the Effects of Changes in Federal Fiscal Policies on the Economy.” Washington, DC: Congressional Budget Office. Edelberg, Wendy. 2016. “Dynamic Analysis at CBO.” Washington, DC: Congressional Budget Office. Gale, William, and Andrew Samwick. 2014. “Effects of Income Tax Changes in Economic Growth.” Washington, DC: Urban-Brookings Tax Policy Center. Joint Committee on Taxation. 2015. “Macroeconomic Analysis at the Joint Committee on Taxation and the Mechanics of Its Implementation.” Report JCX-3-15. Washington, DC: Joint Committee on Taxation. Page, Benjamin R., and Kent Smetters, 2016. “Dynamic Analysis of Tax Plans: An Update.” Washington, DC: Urban-Brookings Tax Policy Center. Page, Benjamin R., Joseph Rosenberg, James R. Nunns, Jeffrey Rohaly, and Daniel Berger. 2017. “Macroeconomic Analysis of the Tax Cuts and Jobs Act.” Washington DC: Urban-Brookings Tax Policy Center. What effects will a tax cut theoretically have on the macro economy?Supply-side tax cuts are aimed to stimulate capital formation. If successful, the cuts will shift both aggregate demand and aggregate supply because the price level for a supply of goods will be reduced, which often leads to an increase in demand for those goods.
How do you calculate tax in macroeconomics?This equation can be expanded to represent taxes by the equation Y = C(Y - T) + I + G + NX. In this case, C(Y - T) captures the idea that consumption spending is based on both income and taxes. Disposable income is the amount of money that can be spent on consumption after taxes are removed from total income.
What happens in the Keynesian model when the tax rate increases?In the Keynesian cross, the tax increase shifts the planned expenditure function down by MPC x ∆T. The amount by which Y falls is given by the product of the tax multiplier and the increase in taxes: ∆Y = [-MPC/(1-MPC)]∆T.
What is tax multiplier in macroeconomics?The tax multiplier measures how gross domestic product (GDP) is impacted by changes in taxation. GDP is defined as the total value of goods and services produced in a country over a given time frame. The tax multiplier is negative in value because as taxes decrease, demand for goods and services increases.
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