Economic Tax Policy 7.docx

One aspect of the macroeconomic policy debate resonates especially with the public finance community: the balance between relying on income and substitution effects in countercyclical policy. Tax cuts, delivered as a rebate check or as reduced employer withholding, "work" as a countercyclical tool primarily to the extent that households increase spending in response to higher after-tax incomes. The permanent income hypothesis suggests that tax changes perceived to be temporary will have little effect on spending (and the Ricardian view suggests they will have none at all), but much recent evidence suggests that this is not true. Other tax measures rely on inducing businesses and individuals to move forward investment and consumption, respectively, that they otherwise would do later, by reducing the relative price for some window of time. In the United States, the primary example of such an investment incentive is temporary "bonus" depreciation, used both in the 2001 recession and again in 2008; the United Kingdom doubled the main capital allowance rate from 20 to 40 percent for tax year 2009-10. (13) In the United States, a tax credit of up to $8,000 became available for qualified first-time home buyers purchasing a principal residence on or after January 1, 2009, but before December 1, 2009. This discussion resonates because of the importance of intertemporal substitution in assessing the welfare consequences of estimated behavioral elasticities. Consider the behavioral response to the anticipated increases in the income tax rate for high-income families beginning in 1993. The large decline from 1992 to 1993 in reported taxable income on high-income tax returns suggested a substantial elasticity of taxable income, which in turn implies a high welfare cost per dollar of revenue collected. But closer analysis shows that much of the response was the result of moving into 1992 taxable income that would otherwise have been reported in 1993 and thereafter. This suggests that the behavioral response to a permanent change in tax rates is much smaller than otherwise, but that the short-term intertemporal response to anticipated tax rate changes can be substantial. (14) On the surface this bodes well for the effectiveness of countercyclical policies that work by changing intertemporal relative prices, but an important caveat applies. Keynesian multipliers do not apply to taxable income reports, but rather to consumer purchases and business investment. (15) The 1992-1993 shift was largely the former. This discussion naturally leads to the question of whether a consumption tax system would have differing counterrecession properties than an income tax system. One aspect of this is the cyclicality of revenues, and here the evidence from state tax systems indicates that sales tax revenues have been less pro-cyclical than income tax revenues, although the depth of the recent fall in retail sales suggests that this question should be re-visited. Another issue is whether consumption tax systems naturally allow more flexibility for enacting changes in the intertemporal relative price of consumption. Note that, as part of its counter-cyclical policy, the United Kingdom reduced its standard VAT rate from 17.5 to 15 percent for December 2008 and all of 2009.16 This type of policy will be more effective the larger the intertemporal elasticity of substitution, and is more credible than the implicit promise to restore the tax rate to its pre-crisis level once the crisis is over. Note, though, that Blundell (2009) has cautioned that the amount of intertemporal substitution might be lower in a recession plagued by uncertainty about the future. Although in the absence of uncertainty the intertemporal substitution effect should be especially large for durable purchases, uncertainty increases the option value of waiting to make irreversible investments.