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Macroeconomic Policy, Midterm 2 (Nov 18) – Revisiting the Tax Cut & Jobs Act

Summary:
How would you answer Question 2? [20 minutes] Consider expansionary fiscal policy in 2017-2018, in the form of the Tax Cuts and Jobs Act. The tax cut increased the federal debt by about .5 trillion over ten years. Chart 1. Chart 2. 2.1 Do you expect the fiscal multipliers to have been relatively large or small for the tax cut at the time of passage? Why? Use equations or graphs to explain. 2.2 If the intent of fiscal policy is to stabilize the economy around Yn, and to stabilize the country’s finances, did the tax cut passed at the end of 2017 make sense? Here’s my answers: [20 minutes] Consider expansionary fiscal policy in 2017-2018, in the form of the Tax Cuts and Jobs Act. The tax cut increased the federal debt by about .5 trillion over ten years. Chart 1. Chart 2. 2.1

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How would you answer Question 2?

  1. [20 minutes] Consider expansionary fiscal policy in 2017-2018, in the form of the Tax Cuts and Jobs Act. The tax cut increased the federal debt by about $1.5 trillion over ten years.

Macroeconomic Policy, Midterm 2 (Nov 18) – Revisiting the Tax Cut & Jobs Act

Chart 1.

Macroeconomic Policy, Midterm 2 (Nov 18) – Revisiting the Tax Cut & Jobs Act

Chart 2.

2.1 Do you expect the fiscal multipliers to have been relatively large or small for the tax cut at the time of passage? Why? Use equations or graphs to explain.

2.2 If the intent of fiscal policy is to stabilize the economy around Yn, and to stabilize the country’s finances, did the tax cut passed at the end of 2017 make sense?

Here’s my answers:

  1. [20 minutes] Consider expansionary fiscal policy in 2017-2018, in the form of the Tax Cuts and Jobs Act. The tax cut increased the federal debt by about $1.5 trillion over ten years.

Chart 1.

Macroeconomic Policy, Midterm 2 (Nov 18) – Revisiting the Tax Cut & Jobs Act

Chart 2.

2.1 Do you expect the fiscal multipliers to have been relatively large or small for the tax cut at the time of passage? Why? Use equations or graphs to explain.

The output gap was essentially zero in the last quarter of 2017. The evidence by Auerbach and Gorodnichenko is that multipliers are fairly small when output is high relative to potential GDP (Yn) or increasing, and larger when output is low relative to potential GDP (Yn) or decreasing. This can be explained by the aggregate supply curve being kinked so that it is steeper Y > Yn, and flatter Y < Yn. This is shown in Figure 1 below (yFE is same as Yn)

Macroeconomic Policy, Midterm 2 (Nov 18) &ndash; Revisiting the Tax Cut & Jobs Act

Figure 1.

An alternative explanation is Fed monetary policy tends to tighten when output rises above Yn, and tends to loosen when output falls below Yn. Suppose the IS curve is shifting due to changes in taxes; the LM curve shifts mean that the change in income is smaller above Yn, than below Yn.

Macroeconomic Policy, Midterm 2 (Nov 18) &ndash; Revisiting the Tax Cut & Jobs Act

Figure 2.

2.2 If the intent of fiscal policy is to stabilize the economy around Yn, and to stabilize the country’s finances, did the tax cut passed at the end of 2017 make sense?

Output was at full employment levels at 2017Q4, so a tax cut at that time did not make sense, as it pushed output *away* from potential GDP. Moreover, at full employment, you want the cyclically adjusted budget balance at about zero. It was already at -3% of GDP then, and the tax cut just made the cyclically adjusted budget balance even worse.
Menzie Chinn
He is Professor of Public Affairs and Economics at the University of Wisconsin, Madison

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