Second-round effects of income tax reforms

Fiscal policy measures have complex economic effects. Businesses and consumers may respond by changing their behaviour and these responses can themselves have further economic effects by changing the supply, demand and prices of goods and services. Quantitative assessments of these second-round budgetary effects are those with the highest degree of uncertainty and therefore often at the centre of political and public debates. Conventional budget analysis relying on static scoring assumes that GDP remains the same when the government changes taxes or spending. Although this assumption is simple and transparent, economic theory and empirical research confirm that fiscal policy influences the path of the economy. For example, if a tax cut stimulates growth, the revenue loss will be less than its estimate, assuming unaffected GDP. The macroeconomic feedback effect may not be large enough to make tax cuts pay for themselves, but it can make tax cuts partially self-financing. This section builds on a recent paper, Barrios et al. (2017), in which the authors develop a dynamic scoring framework for analysing tax and benefit reforms in European countries.(186) The framework combines EUROMOD, a static microsimulation model, with QUEST, the European Commission’s dynamic general equilibrium model. While the microsimulation model allows for the precise translation of actual tax reform proposals into policy shocks, it cannot account for the economy-wide effects of the reforms. On the other hand, dynamic general equilibrium models can consistently capture the macroeconomic feedback effects. This section shows that accounting for the macroeconomic feedback effects is important for the comprehensive evaluation of tax reforms, including their distributional impact.