The Fiscal State-Dependent Effects of Capital Income Tax Cuts

IMF Working Papers, May 29, 2020

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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.

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.
The stimulative effect of a capital income tax cut depends on the likelihood it will trigger future fiscal adjustment.
When government debt reaches a sufficiently high level, the probability of future fiscal adjustments rises, reducing the expansionary effects of capital income tax cuts.
Expected adjustments that can blunt expansionary effects include a policy reversal or a consumption tax increase.
Capital income tax cuts need not always have large revenue feedback effects.

Empirical approach: Smooth Transition VAR applied to post-WWII U.S. federal corporate income tax change data.
Theoretical approach: DSGE model with regime-switching fiscal policy to explore how expected future fiscal adjustments alter the effects of capital income tax cuts.
Mechanism identified: the conditional probability of future fiscal adjustment rises with government debt and changes the net stimulative impact of tax cuts.

The effectiveness of capital income tax cuts as a stimulus tool is state-dependent on the fiscal position (government debt level).
Policymakers should consider the probability of future fiscal adjustments when designing capital income tax policy, since higher debt can substantially reduce the intended expansionary effect.
Anticipated fiscal adjustments can take different forms (policy reversal or consumption tax increase) and both can diminish the stimulus from capital income tax cuts.
Revenue feedback from capital income tax cuts is not guaranteed to be large; expectations about fiscal consolidation matter for realized outcomes.