Macroeconomic Effects of Discretionary Tax Changes in Canada: Evidence From a New Narrative Measure of Tax Shocks

Abstract

In this paper we study the macroeconomic effects of changes in federal taxes for the Canadian economy for the time period 1961:1 - 2014:4. We employ the narrative methodology of Romer and Romer (2010) and Cloyne (2013) to identify exogenous changes in federal taxes. In particular, we study, in detail, all the budget documents for the Canadian economy and document all legislated tax changes and the motivations behind them. We then isolate those tax changes that were not motivated by contemporaneous movements in the economy and classify them as exogenous tax changes. Our main empirical result shows that an exogenous tax cut of 1 percent of GDP leads to a significant but short-run increase in output. Our analysis of disaggregated measures exogenous tax changes shows that 1) tax hikes associated with deficit consolidation have the biggest (contractionary) effects on output, 2) changes in personal income taxes have larger effects than changes in other types of taxes, 3) anticipated tax changes have strong expansionary announcement effects, 4) tax increases tend to have bigger (contractionary) effects on output than the (expansionary) effects of tax decreases, and 5) the effectiveness of tax policy has drastically decreased over time.