Taxes and GDP
October 14, 2008 2:58 PM   Subscribe

How do changes to the tax rates correlate with changes to the Gross Domestic Product (GDP), and how are those changes forecasted?

Last week I read an article in the Economist magazine about the US presidential election. I don't have the article anymore, but it mentioned something about the Bush tax decrease on upper incomes having only a 0.7% effect on forecasted GDP. It also mentioned that there wasn't evidence that the Clinton tax increase made much difference either.

It would seem logical that tax rates would correlate inversely with higher GDP. However, in practice, is this really true? Does it even have an effect?

Also, how does the budget office determine how a tax change will change future GDP? Or doesn't it?
posted by brandnew to Law & Government (4 answers total)
This is the Treasury report to which that article referred.
posted by mr_roboto at 3:18 PM on October 14, 2008

Best answer: Briefly:
The Treasury Department’s dynamic analysis relies on a model that takes into account the effects of work effort, increase in savings and investment, and improved allocation of resources on the size of the economy. The overlapping generations (OLG) general equilibrium model used for this analysis (described in detail in the appendix to this report) is structured to account for the effects of changes in the effective tax rate on capital and labor income and the consequent effects on economic growth. Representative consumers and firms incorporate future prices into their current period decisions of how much to save, work, and produce. Output is generated by four production sectors, and individual level decisions of representative consumers determine the aggregate level of labor supply and savings in each year.


The model has four production sectors – owner-occupied housing, rental housing, non-corporate non-housing goods and services, and a corporate non-housing goods and services sector. The time path of investment demands in all three sectors is modeled explicitly, taking into account capital stock adjustment costs. On the consumption side, the current tax advantage of owner-occupied housing relative to other assets is taken into account in modeling the demands for the four goods. This section outlines the basic structure of the model, which combines various features from similar and well-known models constructed by Auerbach and Kotlikoff (1987), Goulder and Summers (1989), Goulder (1989), Keuschnigg (1990) and Fullerton and Rogers (1993), with the time path of investment in each production sector calculated to maximize firm value in the presence of convex (quadratic) adjustment costs, following Hayashi (1982). The full details of the model are provided in Diamond and Zodrow (2005).

Full references are listed in the report I linked to above.
posted by mr_roboto at 3:25 PM on October 14, 2008

Response by poster: Wow, that was certainly fast.
posted by brandnew at 4:41 PM on October 14, 2008

It would seem logical that tax rates would correlate inversely with higher GDP. However, in practice, is this really true? Does it even have an effect?

Yes, but deficits also correlate inversely with GDP and it turns out that this effect is slightly stronger. So reducing taxes while running deficits makes deficits worse and actually has a net effect of lowering GDP.
posted by JackFlash at 7:00 PM on October 14, 2008

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