U.S. Tax Cuts Boost Economy—but for How Long?
Did the U.S. tax cuts boost economic activity in 2018?
The answer is yes, at least according to the recent empirical literature on the macroeconomic effects of taxes. The consensus estimate across models is that the tax cuts raised real gross domestic product (GDP) growth in 2018 by 1 percentage point.
The same models on average predict an impact of 0.5 percentage points in 2019 but little further effect in 2020.
Data indicate that real GDP expanded 3 percentage points last year. This number exceeds most professional forecasts in 2017 and is well above official estimates of the trend growth rate of about 2 percent. In late 2017, federal lawmakers enacted a comprehensive tax overhaul with economic growth as one of its major goals.
The new tax law substantially cut tax rates for individuals and pass-through businesses until 2025, and permanently lowered the tax rate for corporations from 35 percent to 21 percent. How can we know whether these tax cuts indeed lifted economic growth and what their longer-term effect will be?
Taxes and Economic Activity
Most economists would agree that reducing taxes on labor and capital income is likely to increase economic activity. However, views on the magnitude, duration and even the broad underlying mechanisms vary widely. The simple reason is that measuring the effects of tax changes on the national economy is not easy.
Any economywide evidence is necessarily nonexperimental, and observations of higher or lower growth following any particular tax law change are not directly informative. There are always other confounding cyclical factors. Averaging growth performances after multiple tax changes helps control for the other factors but is insufficient.
Tax cuts are frequently used for stimulus in recessions. Tax hikes often accompany spending increases that are independently expansionary. Lawmakers’ tendency to cut tax rates when GDP growth is low and raise them when it is high based on factors other than growth can very easily create the impression that tax rates and economic activity are unrelated.
Looking at Recent Estimates
A renaissance in fiscal research after the global financial crisis of a decade ago has led to new and better ways of obtaining estimates of the macroeconomic impact of federal tax changes. Table 1 shows estimates of the 2017 tax cuts’ growth impact, derived from statistical models published in top academic journals.
Table 1: Impact of 2017 Tax Cuts on Real GDP Growth
|Academic paper/model (percentage points)||2018||2019||2020||Cumul.
|Blanchard and Perotti (2002)||0.91||0.30||-0.18||1.02|
|Romer and Romer (2010)||1.31||0.81||0.56||2.68|
|Favero and Giavazzi (2012)||1.20||-0.11||-0.30||0.80|
|Mertens and Ravn (2012)||1.28||1.14||-1.06||1.36|
|Mertens and Ravn (2013)||1.92||-0.22||-0.20||1.50|
|Mertens and Ravn (2014)||1.53||-0.08||-0.35||1.10|
|Caldara and Kamps (2017)||0.84||0.06||-0.15||0.76|
|Mertens and Montiel Olea (2018)|
|Marginal rate model||1.04||0.81||0.11||1.96|
|Marginal/average rate model||1.05||0.88||-0.01||1.93|
|Top 1%/bottom 99% taxpayer model||0.43||0.84||1.16||2.43|
|SOURCES: Updated author calculations based on Dallas Fed Working Paper 1803.|
While there are some important differences, all models involve 1) a form of averaging across past experiences involving U.S. tax law changes, and 2) a careful strategy to remove the biases induced by variation in taxes that are policy responses to other events. (For more details, see Dallas Fed Working Paper no. 1803.)
All models listed in the table predict that the 2017 tax cuts will generate higher levels of economic activity over the course of 2018–20. The average estimated cumulative increase in the level of real (inflation adjusted) GDP in the first three years is approximately 1.6 percentage points. There is substantial variation in the timing of the effects across models, but on average, the growth impact in 2018 is around 1 percentage point.
The consensus model forecast is for further GDP growth of 0.6 percentage points in 2019 and little additional effect on growth in 2020. The impacts of the 2017 tax cuts on GDP growth will likely diminish over time.
Assumptions Affect Longer-Term Estimates
Some models see negative effects—GDP levels returning to the pre-tax-cut trend—as early as 2019. Others anticipate substantial positive effects on the growth rate also in 2020 and even afterward. The wider range beyond the first year reflects that forecasting further into the future always becomes harder.
Another reason is that federal tax rates historically tend to revert to long-run average levels. In each model, the trajectory of future tax rates is part of the estimation. Some models project that future tax rates will revert sooner than others, and these tend to predict more transitory growth effects as well. The growth effects in later years are inevitably more uncertain and will depend materially on whether legislation reverses or extends the cuts.
There is no way of knowing for sure that the 2017 tax law is the reason growth in 2018 surprised to the upside. What we can do is verify the predictions made by models. The predictions of the immediate growth impact of the tax cuts, based on macro-empirical approaches developed since the financial crisis, are larger than those made by most models but are more consistent with the strong growth performance in 2018. Perhaps fiscal research has indeed come out of the dark ages.
About the Author
The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.