Output, Employment, and Price Effects of U.S. Narrative Tax Changes: A Factor-Augmented Vector Autoregression Approach

Abstract: This paper examines the short- and long-run effects of U.S. federal personal income and corporate income tax cuts on a wide array of economic policy variables in a data-rich environment. Using a panel of U.S. macroeconomic data set, made up of 132 quarterly macroeconomic series for 1959-2018, the study estimates factor-augmented vector autoregression (FAVARs) models where an extended narrative tax changes dataset combined with unobserved factors. The narrative approach classifies if tax changes are exogenous or endogenous. This paper identifies narrative tax shocks in the vector autoregression model using the sign restrictions with Uhlig's (2005) penalty function. Empirical findings show a significant expansionary effect of tax cuts on the macroeconomic variables. Cuts in personal and corporate income taxes cause a rise in output, investment, employment, and consumption; however, cuts in personal taxes appear to be a more effective fiscal policy tool than the cut in corporate income taxes. Real GDP, employment, investment, and industrial production increase significantly and reach their maximum response values two years after personal income tax cuts. The effects of corporate tax cuts have relatively smaller effects on output and consumption but show immediate and higher effects on fixed investment and price levels.