The Effects of Legislated Tax Changes in Germany

Abstract

This paper studies the short run macroeconomic effects of legislated tax changes in Germany using a vector autoregression (VAR) approach. The identification of the tax shock follows the narrative approach recently proposed by Romer and Romer (2010). Results indicate a moderate, but statistically significant reduction in output as well as a strong offsetting monetary policy reaction following the announcement of the tax policy shock. In response to a one percent increase in the tax to GDP ratio, the peak output reduction is 0.67%. Distinguishing between anticipation and implementation effects suggests that tax changes affect GDP prior to actual implementation, while effects around implementation are insignificant. Our results ascribe this to an offsetting monetary policy reaction prior to actual implementation. This offers an explanation for the apparent failure of traditional VAR studies to reach coherent conclusions on tax policy effects in Germany. Moreover, these studies typically ignore anticipation effects and monetary policy reactions and hence give a misleading account of the transmission of tax policy shocks.