November 5, 2001 | Center for Data Analysis Report on Federal Budget
Congress and the President are debating economic stimulus legislation to ease the economic recession and to improve the incentives to work, save, and invest--the real causes of economic growth. Although Congress has shown a great degree of unity following September 11, the economic stimulus package has created strong disagreements.1 On the one side are those, led by the President, who believe that vigorous tax cuts combined with limited spending increases will do the most to lift the economy out of its current slump. On the other side are Members who believe that substantial spending increases combined with limited, targeted tax cuts will do most to remedy the economic problems worsened by the September 11 attacks.
This Report addresses the question of which approach--significant tax cuts with limited spending or significant spending with limited tax cuts--would do more to boost the economy. It evaluates each of the three leading approaches--the President's, the House's, and the Senate's--using the same economic model, against the same baseline, to determine which would produce the best economic results over the next five years.
Analysts in The Heritage Foundation's Center for Data Analysis (CDA) used the WEFA U.S. Macroeconomic Model, the Center's Individual Income Tax Model, and work by the staff of the Joint Committee on Taxation to make their projections. (See Appendix A.) Specifically, CDA economists estimated the economic effects of each plan using the same model of the U.S. economy, one that contains a two-quarter recession beginning in the third quarter of 2001 and ending during the first quarter of 2002. This analysis shows that:
President Bush's earlier tax cut plan, a 10-year measure signed into law on June 7, 2001, set the tax policy context for the current work of Washington economic policy makers. That plan's substantial change to tax law was intended, in part, to address the sluggish economy and produce stronger long-term economic growth by reducing tax burdens on labor and capital. In an early effort to boost the slowing economy, the U.S. Treasury sent nearly $40 billion in tax rebates to taxpayers this summer as the first installment of the Bush tax cut.
The terrorist attacks of September 11, however, dealt a damaging blow to these nascent efforts to encourage greater economic activity. Though estimates of how deeply terrorists harmed the U.S. economy remain highly uncertain, recent estimates indicate that the attacks in New York City resulted in direct costs of $11 billion in lost wages and $45 billion in property damage. The indirect costs may fall somewhere between $45 billion and $60 billion over the next two years, which would bring the total losses to the New York City metropolitan area to somewhere between $90 billion and $105 billion.2 Damage to the Pentagon is estimated at $1 billion, and losses to the economy of metropolitan Washington, D.C., may be greater than $360 million.3
These regional economic effects quickly spread throughout the general U.S. economy. The airline industry slashed 20 percent of its domestic flights, laid off nearly 100,000 employees, and appealed to Congress for a $15 billion emergency bailout.4 The economic shock of September 11 probably pushed the general economy into recession. On September 20, DRI-WEFA, the nation's premier economic forecasting company, lowered its forecast for 2001 from an already anemic 1.6 percent annual growth rate to 1.0 percent, including a negative growth rate for the third and fourth quarters of this year. For 2002, DRI-WEFA lowered its estimated growth rate from 2.3 percent to 1.3 percent.
Recent economic news has reinforced the pessimism that followed September 11. The Conference Board's Leading Indicators fell 0.5 percent in September, the largest one-month decline since January 1996.6 Sales of existing homes fell by a dramatic 11.7 percent in September to a slow 4.9 million annual sales rate.7 The number of Americans claiming unemployment insurance benefits rose to an 18-year high of almost 3.7 million, an increase of 1.5 million from a year ago.8 Given all of this bad news, it is little wonder that a recent survey found that 52 percent of Americans now believe that the events of September 11 are pushing the economy into recession and that 90 percent of consumers have postponed major purchases.9
On October 31, the Commerce Department's Bureau of Economic Affairs added to this widespread sense of economic crisis when it announced that, in the third quarter of 2001, the GDP shrank by 0.4 percent.10 The unemployment estimate for October underscored this clear signal of a recession: 415,000 workers lost their jobs in October, the largest one-month employment decline since May 1980.11 If the subsequent revisions to the third-quarter results support this initial signal of contraction, and if the next quarter also is negative, then the United States will have entered its first general recession since 1990.
CDA analysts evaluated three economic stimulus proposals: the President's, the legislation passed by the House of Representatives on October 24 (H.R. 3090, the Economic Security and Recovery Act of 2001), and a plan proposed by Senator Max Baucus (D-MT), chairman of the Senate's Committee on Finance.
The President's Proposal.
President Bush's economic stimulus package, sponsored in the Senate by Senator Charles Grassley (R-IA), consists of three elements: individual income tax reductions, tax policy changes that reduce capital costs, and cash relief to low- and middle-income workers. The President's plan is expected to result in a static reduction in federal revenues of $242.5 billion over the next five years.12 Specifically, the President proposes:
The House Proposal.
The Economic Security and Recovery Act of 2001 (H.R. 3090) that passed the House on October 24 is similar to the President's current plan, but contains several important differences. The staff of the Joint Committee on Taxation estimated a static reduction in revenues of $195.4 billion over fiscal years 2002 through 2006.13 H.R. 3090 calls for:
The Senate Finance Committee Chairman's
A sharp contrast exists between two plans that are emerging in the Senate--the Republican proposals and the plan taking shape in the Senate Finance Committee.14 Under the direction of Senator Baucus, chairman of the Committee, the likely Senate plan will consist of:
Senator Baucus estimates a 10 year reduction in revenues of $56 billion.15
There may be many good political reasons for Congress to pass an economic stimulus package, but there is an overriding economic reason: The intervention should lessen the depth of the slowdown and shorten its duration. Indeed, the competing stimulus packages should be evaluated with respect to their effects on the depth and duration of the slowdown as much, or more, than with respect to any other criteria.
To determine how the three proposals compare in terms of their effect on the expected depth and duration of the current recession, CDA analysts developed projections for economic effects under each of the plans. Chart 3 shows how each plan would affect employment between the beginning of the recession (the end of the second quarter of 2001) and the time when total employment returns to the level it would likely have attained had there not been the recession of 2001 (i.e. in the first quarter of 2004). This chart shows that, while each proposal lessens the depth of job loss, only the President's plan and the House plan significantly shorten the time before employment regains the level it would have attained without a recession. In fact, Chart 3 shows that the President's plan lessens the employment trough by nearly 33 percent and shortens the length of the job slowdown by six months.
As Table 1 shows, the differences in the effects of the three plans will be even more pronounced in future years. The President's stimulus package creates more jobs, provides more income to families, and does more to expand economic activity than either the House plan or the package advanced by the Senate Finance Committee Chairman. These differences become more dramatic as the pro-growth elements of the House plan and the President's proposal take hold.
The three economic stimulus plans analyzed in this Report clearly reflect the fundamental difference in two major views of the government's role in economic planning. On the one hand, the approaches by the President and the House generally emphasize reductions in the tax rates on capital and labor to boost economic performance. By lowering tax rates and the tax burden on investment and capital assets, these supply-side plans help business owners and workers, producing more jobs and generating higher incomes--which translate, in turn, into greater investment and consumer spending.
On the other hand, Senator Baucus's demand-side approach principally relies on cash transfers to displaced workers and distressed businesses to stimulate economic activity. While this plan produces some increase in employment and income, and is better than doing nothing, it fails to achieve the level of stronger economic activity that will be attained under the other two approaches. In fact, the Senator's plan never creates the large consumer response that would be needed in order for a demand-side, expenditure-based stimulus proposal to produce the job and income responses that are generated by supply-side proposals. While all three plans transfer income to low- and moderate-income taxpayers through rebates that supplement those of this past summer, this provision plays a much more central role in the Senator's plan. The fact that this mechanism will not produce the economic benefits generated by the other plans brings into serious doubt the utility of cash payments as a tool for boosting economic activity.
William W. Beach is Director of the Center for Data Analysis at The Heritage Foundation; D. Mark Wilson is a Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation; Rea S. Hederman is Manager of Operations for, and Ralph Rector is a Research Fellow in, the Center for Data Analysis at The Heritage Foundation.
Heritage Foundation economists in the Center for Data Analysis (CDA) followed a two-step procedure in analyzing the budgetary and economic effects of the three stimulus proposals evaluated in this Report.
First, preliminary static tax revenue estimates for the economic stimulus plan were either generated by the Center's Individual Income Tax Model or obtained from the Joint Committee on Taxation (JCT).16 The CDA and JCT tax revenue estimates are based on a static methodology that generally does not account for the macroeconomic effects that would result from a reduction in tax rates.17 These effects include changes in gross domestic product (GDP), interest rates, employment, personal income, and inflation, all of which can significantly affect tax revenues. Therefore, the static estimates provide a very limited analysis of the economic and budgetary impact of any policy change. To forecast the change in federal tax revenue, spending, and the economy more accurately, a dynamic model must be used.
Static fiscal year revenue estimates for tax rate changes were computed using the CDA Individual Income Tax Micro-simulation model. This model estimates the change in tax liability for a national sample of over 100,000 tax filers. The sample contains tax return data from the Public Use Tax File that is produced by the Internal Revenue Service. In addition, the sample contains demographic and other information from the Census Bureau's Current Population Survey. Economic data from the Congressional Budget Office (CBO) August 2001 forecast were used to project the sample data forward to 2011.
Second, the static revenue changes were introduced into the WEFA U.S. Macroeconomic Model.18 The WEFA model is a dynamic model of the U.S. economy designed to estimate how the general economy is reshaped by policy reforms, such as tax law and spending changes. Heritage economists developed a revised WEFA model for Heritage work that embodies the economic and budgetary assumptions published by the Congressional Budget Office in August 2001, the recent increases in federal spending, and the latest Blue Chip forecast for economic growth following the September 11 terrorist attacks.19 This specifically adapted WEFA model produces dynamic responses from the modified CBO baseline as a result of the proposed policy changes.
The WEFA model contains a number of variables that are used to simulate proposed policy changes. The following sections describe how the CDA static estimates were introduced into the WEFA model to estimate the dynamic economic and budget results.
Average Effective Personal Income
The WEFA model contains a variable that measures the total amount of all federal taxes on individual income as a percentage of the nominal personal income tax base. Heritage economists adjusted this average effective tax rate downward for each of the forecast years to reflect the static revenue decrease estimates.
Average Effective Corporate Tax
The WEFA model contains a variable that measures the total amount of federal corporate tax revenue as a percentage of nominal corporate profits. Heritage economists adjusted this average effective tax rate downward for each of the forecast years to reflect the static revenue decrease estimates.
Labor Force Participation and
Average Weekly Hours.
Small adjustments were made in the model's exogenous labor force participation rate and in the number of hours worked to account for the dynamic effects of accelerating the marginal income tax rate reductions.
The WEFA model contains variables that measure the amount of federal transfers to persons. Heritage economists increased these amounts to reflect the tax rebates, unemployment insurance benefits, and any other transfers to persons in the three plans.
Government Grants to
The WEFA model contains variables that measure the amount of federal grants to states. Heritage economists increased these amounts to reflect any increased spending on medical insurance and other state grants in the three plans.
The WEFA model contains variables that measure the amount of federal defense and non-defense spending. Heritage economists increased these amounts to reflect any increased spending in the three plans.
The model assumes that the Federal Reserve Board will react to this policy change as it has historically. This assumption was embodied in the Heritage model simulation by including the stochastic equation in the WEFA model for monetary reserves.
1. See H.R. 2926, The Air Transportation and Security Act, which provided financial support for the airline industry; and S. 1447, The Aviation Security Act, which dealt extensively with anti-terrorism issues.
12. Scoring of the President's tax and displaced workers provisions was made by the Center for Data Analysis, which used the Center's Individual Income Tax Model and analysis by the staff of the Joint Committee on Taxation. See Appendix A: Methodology for details. "Static" revenue reductions do not take into account the behavioral response of taxpayers to tax policy change. Such responses usually result in revenue changes that are significantly different from the estimates developed using accounting or static methods.
13. Joint Committee on Taxation, "Estimated Budget Effects of a Modified Chairman's Amendment in the Nature of a Substitute to the Revenue Provisions Contained in H.R. 3090, the `Economic Security and Recovery Act of 2001,' Scheduled for Markup by the Committee on Ways and Means on October 12, 2001," JCX-70--01, October 12, 2001.
14. As of this writing, the Senate Finance Committee had several economic stimulus plans before it. Indeed, the Senate may debate legislation other than the proposal by Senator Baucus. However, the Senator's proposal closely resembles legislation presented by the Democrat leadership in the House during debate over H.R. 3090. CDA analysts decided to publish the Center's analysis of the Senator's package now, rather than wait for any changes he or others would make to it. If those changes are extensive, the Center will revise its analysis and make the results available upon request.
15. CDA analysts assumed a $16 billion, 10-year expenditure on unemployment insurance. U.S. Senate Committee on Finance, "Baucus Economic Recovery Proposal," http://finance.senate.gov/102401leg.pdf. See also "Statement by Senator Max Baucus on October 23, 2001," Bureau of National Affairs, Daily Report for Executives, October 24, 2001, p. L-1.
16. Joint Committee on Taxation, "Estimated Budget Effects of a Modified Chairman's Amendment in the Nature of a Substitute to the Revenue Provisions Contained in H.R. 3090," JCX-70-01, October 12, 2001.
17. While the JCT's estimates for changes in tax law reflect some behavioral responses, they do not reflect possible changes in macroeconomic variables. For example, while the JCT would take into account how tax changes increase the amount of itemized deductions or shift compensation from taxable to tax-exempt or tax-deferred forms, its estimates do not take into account how tax changes affect work effort and saving that could affect gross domestic product.
18. The Heritage Foundation's Center for Data Analysis used the Mark 11 U.S. Macro Model of WEFA, Inc., formerly Wharton Econometric Forecasting Associates, to conduct this analysis. The model was developed in the late 1960s by Nobel Prize-winning economist Lawrence Klein and several of his colleagues at the Wharton Business School of the University of Pennsylvania. It is widely used by Fortune 500 companies, prominent federal agencies, and economic forecasting departments. The methodologies, assumptions, conclusions, and opinions herein are entirely the work of Heritage Foundation analysts. They have not been endorsed by, and do not necessarily reflect the views of, the owners of the model.