We've heard a lot about government spending and tax cut multipliers in the press and blogosphere. In a new NBER working paper (ungated version here) Eric Leeper and his co-authors address a fundamental issue in measuring the effects of tax cuts. They call it "fiscal foresight".
Here's the abstract:
"Fiscal foresight—the phenomenon that legislative and implementation lags ensure
that private agents receive clear signals about the tax rates they face in the future—is
intrinsic to the tax policy process. This paper develops an analytical framework to study
the econometric implications of fiscal foresight. Simple theoretical examples show that foresight produces equilibrium time series with nonfundamental representations, which misalign the agents’ and the econometrician’s information sets. Economically meaningful shocks to taxes, therefore, cannot generally be extracted from statistical innovations in conventional ways. Econometric analyses that fail to align agents’ and the econometrician’s information sets can produce distorted inferences about the effects of tax policies. The paper documents the sensitivity of econometric inferences of tax effects to details about how tax information flows into the economy. We show that alternative assumptions about the information flows that give rise to fiscal foresight can reconcile the diverse empirical findings in the literature on anticipated tax changes."
And here's a punch line:
"We couch the quantitative assessment in terms of tax multipliers and show that conventional econometric methods, such as identified VARs, can produce wildly inaccurate inferences: multipliers can be estimated to be positive, negative, or zero and they can be five or more times too large over various forecast horizons."
Oh my. People, that is not good. The paper though IS very good and well worth reading.