Tax Shock 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 (see bottom of post here) 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.

Comments

[Steven Hansen]

we are faced with three bad options:
1) reduce budgets to spend within our means. this has very little impact in a smooth running economy, but it impacts big time in an economy running on vapors.
2) decrease taxes. the result is a growing debt which much be financed. literally you are borrowing money you have to pay back tomorrow to eat today. long term you must pay this back and you will remove spending during the period of payback.
3) tax to match spending to revenue. This article shows the consequences.

so we are faced with Sofia's choice. there is no good answers.

2009 Aug 02 04:11 AM

[me3tv]

For now, the government spending is an inefficient means of pumping dollars into the economy. It was supposed to be the infrastructure but that seems to have fallen by the boards. These jobs and more lax lending for homes was to pump construction jobs and feed the consumer economy. All this is slow in coming because of the inefficiency of collecting and then paying out the revenue under bureaucratic rules. A tax DECREASE would allow (would have allowed) direct investment in the economy and produce an overall tax REVENUE increase that comes with private enterprise and labor turnover of dollars at a more rapid rate. The knowledge of coming tax INCREASES locks up investment in future growth except in specific industries that "might" partake of the government's choice of investments - some of which are too economically unsound to survive without continued government subsidy. The cycle of government support will repeat and repeat - slowing the rate of real recovery as it starves the private sector of investment opportunity.

2009 Aug 02 10:30 AM

[Jimbo]

Christina Romer......Isn't she a key economic advisor for the present administration??? I'd love to hear what she has to say to the President and Vice President.

2009 Aug 02 11:56 AM

[Swiftcreek1]

Excellent article......As if we needed more proof that government is the most inefficient user of the capital resources of the private sector. The "intended" (call me a cynic) consequence of this will be to make the individual state governments more reliant on the Feds for funding and thereby more willing to agree to federal policy based on politics rather than any economic reality.

The powerblindness of Federal politicians doesn't allow them to see that they are driving our economy off a cliff, or perhaps they just don't care about the minions who vote them into office, so long as they are "protected" from what the rest of us will ultimately suffer.

me3tv above me was right. Tax reductions spur growth and lead to increased tax revenues. If that was the goal we would already be there. Tax increases, however, control behavior, and that is what the current administration is all about.....Power and Control.

If you agree with the policies of the cadre' in power in DC I'll probably get a thumbs down from you, but it won't make you any more immune to the economic realities of lost income, a lost job, a lowered standard of living, and higher costs for just about everything you use everyday.....

2009 Aug 02 01:24 PM

[perceptions_now]

As Day follows night, there were always going to be consequences, arising from this economic slowdown.

Regrettably, higher taxes, unemployment & in the fullness of time inflation, are amongst those consequences!

So, whilst higher taxes may be SHOCKING, why should they be a SHOCK?

2009 Aug 03 01:49 AM