Tries to answer.
Drum summarizes better than Waldmann
Last year Christina and David Romer wrote a paper that attempted to quantify the effect of tax changes on economic growth. I read it at the time and didn’t understand it. I read it again a few minutes ago and I still don’t understand it. So my question is: Can you please explain your paper titled “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks”?
Here’s my understanding of what the paper says. Basically, the Romers looked at every tax measure enacted since 1945 and classified them into two groups. The first group they call endogenous. These are tax changes made in response to current or future economic conditions, including responses to spending changes or recessions. Since the effect of these tax changes is difficult to separate from the effects of the events being responded to, they are discarded.
The second group they call exogenous. These are tax changes designed either to reduce a deficit or to raise long-term growth. Since they aren’t motivated by current or future economic conditions, their effect on the economy is untainted by external factors.
The Romers use this second group to calculate the effect of tax changes on economic growth without confounding factors, and their conclusion is that a tax increase of 1% of GDP reduces output three years later by nearly 3%.
Then he says he doesn’t trust any methodology based on interpreting what people say — too subjective.
He also asks
Fifth, can it really be true that a 1% tax increase produces a 3% GDP reduction over the long term? European countries tend to have total tax rates that are upwards of 15% higher than ours, which should mean their GDPs are 45% lower. For the most part, however, GDP per hour worked in Europe is only modestly lower than ours.
Hmmm slipped in that “per hour worked” didn’t he. Obviously the Romers are looking for effects via aggregate demand not productivity. However, a broader analysis would make the point much more strongly. The tax burden is a higher share of GNP in rich countries than in poor countries and is not significantly correlated with slower growth (I’m always going back to Easterly and Rebello 1993 which is getting a bit long in the tooth).
However, that’s not what the Romers are talking about at all. Basically 3 years is not long run.
I am an economist and immediately perceive the paper to be a vindication of Keynes not of Laffer. I think your key question is the Europe question. The effect appears to be at a Laffable level. However, what they are really discussing is the medium term effect of budget deficits.
Europe has high taxes, but doesn’t have high budget deficits.
Now the Romer’s would not propose huge tax cuts. That is because, they assume that the long run effect of budget deficits on GNP is zero (increased demand just ends up as increased inflation) or negative (if deficits crowd out investment).
Roughly 3 years is not at all the long run.
In fact, the long run effects of deficits on growth appear to be negative (and large). This is based on comparing growth in different countries.
Now as to the methodology, the Romers are highly respected, but no one really trusts anyone to make subjective decisions in a way that doesn’t lead to bias. I think that this paper, like a similar paper on monetary policy, is likely to convince no one.