The fiscal state-dependent effects of capital income tax cuts

• Published in: Journal of economic dynamics & control Vol. 117; p. 103860
• Main Authors: Fotiou, Alexandra, Shen, Wenyi, Yang, Shu-Chun S.
• Format: Journal Article
• Language: English
• Published: Elsevier B.V 01.08.2020
• Subjects: Capital income tax effects; Dynamic scoring; Fiscal policy effects; Nonlinear DSGE model; Regime-switching model; Tax multiplier; E62; Regime-switching model; E63; H30; Tax multiplier; Capital income tax effects; Nonlinear DSGE model; H24; Dynamic scoring; Fiscal policy effects
• ISSN: 0165-1889; 1879-1743
• DOI: 10.1016/j.jedc.2020.103860

Using the post-WWII data of U.S. federal corporate income tax changes, within a Smooth Transition VAR, this paper finds that the output effect of capital income tax cuts is government debt-dependent: it is less expansionary when debt is high than when it is low. To explore the mechanisms that can drive this fiscal state-dependent tax effect, the paper uses a DSGE model with regime-switching fiscal policy and finds that a capital income tax cut is stimulative to the extent that it is unlikely to result in a future fiscal adjustment. As government debt increases to a sufficiently high level, the probability of future fiscal adjustments starts rising, and the expansionary effects of a capital income tax cut can diminish substantially, whether the expected adjustments are through a policy reversal or a consumption tax increase. Also, a capital income tax cut need not always have large revenue feedback effects as suggested in the literature.