Monday, August 23, 2010

Time Horizons And Reactions To Tax Changes

Arpit Gupta:
why do the negative impact of taxes appear much larger at the national level than the firm level?

A clever resolution is suggested by a set of papers by Raj Chetty, an economist at Harvard. Chetty points out that the micro estimates rely on instantaneous adjustment to higher tax rates, and typically focus on short durations after law changes. However, a variety of factors may combine to make the behavior responses to tax cuts a more long-run effect. People face costs in switching jobs or entering the job force. They may simply be unaware of tax changes or lazy. Any of these plausible frictions are compatible with large long-term effects of tax cuts that are difficult to capture in micro data.

This distinction is important, because policymakers are generally interested in the economy-wide and durable impacts of tax increases, rather than their short-term impacts. Macro estimates, which use economy-wide data, may be better suited to answer this question.

FLG is ever more convinced that his time horizons theory really does have a lot of explanatory power.

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