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Do Tax Cuts Boost the Economy?

For immediate release: September 13, 2011
Contact:  Alan Barber, (202) 293-5380 x115

WASHINGTON DC- There is a serious debate over the impact of President Obama’s stimulus. Stanford Economics Professor John Taylor, who served as Under Secretary of the Treasury for International Affairs under President Bush, recently released a draft paper that purports to show that the tax cuts that were part of this stimulus had no effect on consumption. The Center for Economic and Policy Research (CEPR) is releasing a paper today that challenges Professor Taylor’s analysis.

The paper, “Do Tax Cuts Boost the Economy?,” by CEPR economist David Rosnick and co-director Dean Baker, tests the robustness of Taylor’s findings. It also explores the possibility that there was a structural break in the relationship between consumption and disposable income after 2007 as a result of the collapse of the housing bubble and the financial crisis.

The analysis finds:

  1. Taylor’s results do not appear to be robust. Using the revised income and consumption data from the Bureau of Economic Analysis (BEA) and adding in one additional quarter of data led to substantially different coefficients for the key variables. For example, the savings rate out of disposable income was nearly cut in half as a result of these changes.

  2. The coefficient that Taylor finds for his oil price variable is implausibly large. For example, it would imply that the drop in oil prices between the third and fourth quarter of 2008 would have led to an increase in the rate of growth of consumption of more than 10 percentage points in the second quarter of 2009. This coefficient is hugely sensitive to the time period under examination.

  3. Tests for a structural break occurring in 2008 led to highly significant coefficients on variables indicative for the period after 2007. Models that include a full structural break also have highly significant coefficients for stimulus.  These coefficients imply 21 to 75 cents of increased consumption for every dollar of additional stimulus.  Models with partial breaks—allowing only for changes in the relationship between disposable income and consumption—imply that each additional dollar of tax cuts included in the stimulus increased consumption by 52 to 70 cents.

The models estimated with structural breaks are ad hoc; there are undoubtedly better ways to incorporate the impact of the collapse of the housing bubble and the financial crisis. However, these models support the idea that there was a structural break resulting from these events. And, if there was a structural break, then the data indicate that the tax cuts in the stimulus likely were effective in increasing consumption.

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