What about that tax hike?

3/10/2013 12:00:00 PM
As you may know, taxes went up on january 1st. In addition to the expiration of the Bush tax cuts on income over $400,000, there was the expiration of Obama's reduction in payroll taxes that had been in place since the stimulus act. A lot of commentators suggested that these tax hikes would stall recovery, and now that we had better than expected job gains in February, a lot of comentators are saying that the economy is doing well in spite of the tax hike.

To be sure, in normal times both theory and empirics suggest that hikes in marginal tax rates should reduce the level of GDP and employment relative to what they would otherwise have been. But these are not normal times, and almost all New Keynesian models predict that in a liquidity trap, raising the marginal tax rate on labor will actually increase the level of GDP and employment. This result is known as the "paradox of toil." I'm not aware of any empirical research confirming the theoretical prediction (how can it? liquidity traps hardly ever happen). So one interesting question is whether the economy seems to be doing well in spite of the tax hikes, or because of them.

It is too soon to tell how GDP is doing after the tax hikes. It is also too soon to tell whether February's good jobs report was real, or will be revised down. But, the fact remains that relative to where the economy was at the end of 2012, the begining of 2013 has so far exceded expectations, suggesting that the tax hike may have been stimulative afterall. The hole in this interpretation, though, is that the paradox of toil operates by way of inflation. The stimulative effect of tax hikes in the New Keynesian models works because the tax hike raises wages, which in turn raises inflation, which in turn lowers the current real interest rate, stimulating consumption. If there is no increase in inflation, then that chain is broken.

Unfortunately, we won't get consumer price data for February until the 15th. But here is what data we have through January:
The blue line is all prices, and the red line is excluding the volatile food and energy prices. The blue line here tells us very little. Inflation did rise slightly (from deflation to 0% inflation) after we got a fiscal cliff deal in december, and maybe that was in anticipation of the tax hike, or maybe that's just random noise. The red line is slightly more informative once we recognize that it is a better predictor of future prices than the blue line. We see a slight up-tick in core-CPI in December and January, suggesting that maybe, just maybe, the tax hike led to higher overall inflation in February, and that the stimulative effects of that caused the surprisingly good jobs report.

Hopefully economists will be able, years from now, discern what actually happened here. For now, however, we still cannot tell whether the paradox of toil is real, or the invention of an incomplete theory.