Marginal income tax rates and the U.K. economy: three essays

Abstract

This dissertation investigates the role of fiscal policy on economic activity by analyzing the response of major macroeconomic variables to innovations to the average marginal income tax rate (AMTR) measures in the U.K. by employing vector autoregressive (VAR) models. We identify these innovations by making certain assumptions about fiscal policy and then analyze the dynamic behavior of output, the interest rate, the exchange rate, and the trade balance in response to an increase in AMTR by studying the impulse response functions (IRFs) derived from the VAR and structural VAR (SVAR) approaches. The first essay focuses upon the calculation of the AMTR in the U.K. by using the methodologies of Seater (1982, 1985) and Barro and Sahasakul (1983, 1986). The second essay uses a VAR model to estimate the dynamic effects of fiscal policy shocks on macroeconomic variables in the U.K. We find that in response to an increase in AMTR, output falls, the trade balance improves, and the exchange rate depreciates. The results are quite robust to changing the ordering of the Choleski decomposition and using a different lag length. The third essay employs a SVAR model that imposes long run restrictions, and estimates the dynamic effects of fiscal policy shocks on macroeconomic variables in the U.K. Our findings indicate that a positive innovation to AMTR, which results in a permanent increase in the AMTR, reduces output, raises the interest rate, and depreciates the exchange rate. These results are robust with respect to different lag lengths and different orderings of fiscal policy variables. The empirical findings from the SVAR model are similar to those from the earlier benchmark model. The point estimates of impulse response functions for the SVAR models lie within the confidence intervals for the previous benchmark model, which implies that there are no significant differences between the benchmark and the SVAR models.