The macroeconomic effects of income and consumption tax changes

Do consumption and income tax changes affect the economy differently? We answer this question by estimating structural VARs, where we proxy the latent tax shocks with a newly constructed narrative account of income and consumption tax liability changes in the United Kingdom. We find that income tax shocks have large short run effects on GDP, private consumption and investment. The implied income tax present-value multiplier is around 2.7. The effects of consumption tax cuts are modest and not statistically different from zero on GDP and investment and only marginally expansionary on private consumption. These results indicate that i) it is crucial to distinguish between direct and indirect taxation when studying the transmission mechanism of fiscal policy, and ii) consistent with conventional public finance theories, consumption taxes are less distortive than income taxes.