Thursday, July 16, 2009

Tax shock to the economy will create a W-shaped "recovery"

Tax increases will precipitate another shock to the economy that may be more protracted than what we have already experienced. Given the budget situation at the federal, state, and municipal levels, harsh tax increases are inevitable. We know the federal government will be raising taxes, but let's put that aside for a moment and look at the situation with state governments.

From Center on Budget and Policy Priorities (CBPP):
At least 48 states addressed or are facing shortfalls in their budgets for the upcoming year totaling $166 billion or 24 percent of state budgets. New data show a majority of states expect shortfalls in 2011 as well. Aggregate gaps through 2011 likely will exceed $350 billion.

Some states will go further into debt, but a number of them are not allowed to run deficits by law. Given the power of state employees (and their unions) over state legislators and governors, these budget shortfalls will not result in major immediate cuts. States will instead focus on tax increases (although in the long-run state employee layoffs may be inevitable.)

From CBPP - current status of state tax increases:

Given the escalating state budget crisis, tax increases will continue for some time to come. Now add the federal tax increases we all know are coming (whether it's health care emission caps) and we have what economists sometimes call an "exogenous shock" from tax increases.

A famous paper by Christina and David Romer (Berkeley - 2007) analyzes the impact of such tax shock to the system. It's a truly ugly result. Here is the impact on GDP due to a tax increase of 1% of GDP over 3 years:

This means that the tax multiplier is roughly 3: each dollar of tax increase will translate into 3 dollars reduction in GDP.

And here is how tax increases will impact unemployment:

Note that this is an extremely thorough analysis, as the authors control for all major variables that may have impacted GDP contraction. This is not simply a correlation study.

It is clear that severe tax increases have or will be taking place in the US on both state and federal level. It is also clear that tax increases have a multiplier effect on GDP contraction. There is of course a delay before the tax shock translates into GDP decline. It is entirely possible that with the temporary impact of stimulus, we may be looking at a prolonged "W" type recovery that is far more protracted than many currently estimate.

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