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by cactus

A Further Critique of Romer and Romer

Let's take another look at the main Romer and Romer findings, namely that under some circumstances, tax cuts are good for economic growth. In the past I noted I have a few problems with it, but I thought I'd let the Romers work speak for itself as much as possible when making this critique.

Let's start with the most recent version of the best-known paper in this series. The best explanation in the paper itself for what its about comes from the conclusion:

This paper investigates the causes and consequences of changes in the level of taxation in the postwar United States. We find that despite the complexity of the legislative process, most significant tax changes have a dominant motivation that fits fairly clearly into one of four categories: counteracting other influences on the economy, paying for increases in government spending (or lowering taxes in response to reductions in spending), addressing an inherited budget deficit, and promoting long-run growth. The last two motivations are essentially unrelated to other factors influencing output, and so policy actions taken because of them can be used to estimate the effects of tax changes on output.

Our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of 1% of GDP lowers real GDP by almost 3%. Our many robustness checks for the most part point to a slightly smaller decline, but one that is still typically over 2.5%. We also find that the output effects of tax changes are much more closely tied to the actual changes in taxes than to news about future changes, and that investment falls sharply in response to exogenous tax increases.

We also examine the behavior of output following changes in other measures of taxes. The estimated output effects obtained using broader measures of tax changes, such as the change in cyclically adjusted revenues or all legislated tax changes, are substantially smaller than those obtained using our measure of exogenous tax changes. Thus, failing to account for the reasons for tax changes can lead to substantially biased estimates of the macroeconomic effects of fiscal actions.

Paragraph 1 tells you they separate out tax changes intended to pay for inherited budget deficits or to promote long term growth (exogenous tax changes, or changes that are not driven by events) from tax changes intended to deal with business cycles and/or increased government spending (endogenous tax changes, or changes that are driven by events). Because the latter group is tied into other ups and downs in the economy, if you want to figure out the "true" effect of tax cuts and tax hikes, you should focus on exogenous tax hikes. Paragraph 2 tells you that their exogenous tax changes do ineed show that tax increases will hurt the economy. Paragraph 3 admits that you only get the paragraph 2 results if you do separate out exogenous and endogenous tax changes.

As I've stated many, many times before in this blog, one should always check the data. Always. Check. The. Data.

More after the fold. Written by cactus

So where does their data come from? Well, it comes from a narrative they compiled, the most recent version of which is here. The abstract of the narrative record tells us:

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 postwar tax policy actions.

Long story short – they identified all tax changes they considered major, including their timing, size and motivation. While this isn't the focus of my criticism, I have two problems with this sentence. One is that huge changes in regulation and enforcement can come about through what are apparently minor changes in the law. The transfer pricing regulations, for instance, as I vaguely recall from my days at a (then) Big 6 Accounting firm, come from 2 sentences of law. Then there's the issue of the "size" issue on which they expand:

Thus, in almost every case we construct our main measure of size using information from our narrative sources concerning policymakers' estimates of the expected revenue effects.

The most straightforward estimates to use are statements about the expected revenue effects of a tax change at the time it was scheduled to go into effect. Such estimates are often provided in the Economic Reports, especially in the 1960s and 1970s. For this reason, we place particular emphasis on revenue figures from this source. When such statements are not available, we construct our revenue estimates from other contemporaneous descriptions of the expected effects of the tax change on the path of revenues. For example, many tax changes go into effect on January 1 of some year. In these cases, we often use the estimated impact of the change in its first calendar year. When neither straightforward statements of the expected revenue effects nor estimates of the effects in the first calendar year are available, we generally use estimates for the first full fiscal year the law was scheduled to be in effect. The Conference report on the final version of a tax bill is often a particularly rich source of such calendar-year and fiscal-year revenue estimates.

Anyway, long story short, if St. Ronnie and the Chicago Boys said something was gonna be a tax cut of size X, by golly, that piece of legislation was a tax hike of size X, nevermind what actually happened.

But like I said, I digress. I have bigger fish to fry than that. While the skillet is warming up, let's look at two tax actions that I know a bit about, and which (according to the Romers) were about the same size: the Tax Equity and Fiscal Responsibility Act of 1982 and the Taxpayer Relief Act of 1997 and Balanced Budget Act of 1997.

Let's begin with the former, which was classified as "Exogenous; Deficit-driven" and which the Romers assign a Present Value of $24.85 billion in 1982Q3. We're told by the Romers:

The motivation for this tax increase was deficit reduction and increased fairness. The fiscal action was clearly not taken because policymakers felt the economy was overheating.

They add some quotes from St. Ronnie, including this one:

Not only must those deficits be reduced, they must show a decline over the next 3 years

They also include this one:

The most essential thing is to send a message to the money market that we, Democrats and Republicans alike, can agree on reducing the deficit and continuing to hold down inflation

Here's a third one:

I support it [TEFRA] because it will, when combined with our cuts in government spending, reduce interest rates and put more Americans back to work again

The Romers then add write this:

Because the tax increase was taken to reduce the deficit and improve fairness, not to achieve a return to normal economic growth, we classify it as exogenous. Since concern over the deficit appears to have been the primary motivation, we classify it as a deficit-driven tax change.

On to the second tax action, the Taxpayer Relief Act of 1997 and Balanced Budget Act of 1997. This one had a couple of components – a small exogenous piece with a $1.93 present value in 1997Q3, tacked onto a negative 20.3 billion "Endogenous; Spending-driven" tax (1997Q3 Present Value) tax cut.

They're a bit stingier with the Clinton quotes than with the Reagan quotes, but they do give us Clinton's explanation for the tax cut:

We must balance the budget to keep interest rates down and investment up and jobs coming in.

Reads an awful like the Reagan quotes, doesn't it? Especially the third Reagan quote, right? I mean, there's the balancing the budget bit, the keeping interest rates down bit, and the jobs bit. The two quotes the Romers give us could easily have come from the same speech.

What do the Romers tell us about this tax event? This:

Even though the Congressional motivations were partly philosophical, the tax reduction occurred in the context of a balanced budget agreement between the president and Congressional leaders that called for spending reductions. Thus the tax cut was inextricably linked with spending cuts. We therefore classify it as an endogenous, spending-driven action.

OK. Let's review. These tax changes are associated with two Presidents, both of whom claimed to be concerned about deficits. We know this because one had already cut the deficit all four years he had already been in office, and the other had been talking about the size of the debt (remember how far he told us a stack of dollar bills would go and back?) for at least a decade. Both Presidents reluctantly accept changes to the tax code that doesn't quite fit their philosophy – Reagan swallowed a tax hike (he would accept quite a few more, all of which were dwarfed by the big cut in 81 that created the problem) and Clinton took a tax cut – in exchange for less spending from Congress. Both were very clear about their motivation – it's balancing the budget.

And yet, one of these is classified as endogenous by the Romers, and the other is classified as exogenous. (Frankly, I could almost understand if the Reagan hike was considered endogenous and the Clinton hike exogenous. The budget deficit to which Reagan was reacting occurred had dropped during the Carter years from 4.2% to 2.7% of GDP, and had gone back to 4% in 82 and would hit 6% in 83, so to some extent, the urgency of action was a reaction to events overtaking his mighty tax cut of 81. On the other hand, the Clinton tax cut occurred because the Congress truly believed it would increase long run growth. The Romer's classification of these two evnts is not just inconsistent, it makes no sense.) I might add that reading the paper, I had a few issues with the classification of other points as well, but I think these two points illustrate why I think the results of the paper cannot be taken seriously. So… the Romers develop a data set based on observations they deem important, they further prune the data set in a manner that is at times inconsistent and seemingly arbitrary, and from there, they manage to show that tax cuts are good for the economy. Forgive me if I don't believe it. After all, if true, their results, should be easy to show. Or maybe not.
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by cactus

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