November 9, 2001 | Center for Data Analysis Report on Federal Budget
On November 6, 2001, Senate Majority Leader Thomas Daschle (D-SD) reaffirmed his intention to introduce a two-component economic stimulus package that would combine the plans of Senators Max Baucus (D-MT) and Robert Byrd (D-WV). It now appears likely that the upcoming Senate debate on economic stimulus legislation will center around Senator Daschle's plan and a plan proposed by Senator Charles Grassley (R-IA) that is strongly supported by President Bush.
Although both plans are intended to ease the impact of the economic recession and improve the incentives to work, save, and invest (the real catalysts for economic growth), there are substantial fiscal policy differences between them. On the one side are those, led by the President and Senator Grassley, 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 those, led by Senator Daschle, who believe that substantial spending increases combined with limited, targeted tax cuts will do the most to remedy the economic problems that have been exacerbated by the September 11 attacks.
This CDA 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 both of the Senate stimulus plans, using the same economic model, against the same baseline to determine which approach would produce the best economic results over the next five years.
To address this question, 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 (JCT). Specifically, CDA economists estimated the economic effects of the Bush-Grassley and Daschle plans 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:
Although both plans transfer income to low- and moderate-income taxpayers through rebates, and although both assist the unemployed, the fact that the economic outcomes produced under the Daschle plan fall far short of those produced under the Bush-Grassley plan raises serious questions about the utility of cash payments and increased government spending as the primary tools for boosting economic activity. The better approach would be to lower tax rates and the tax burden on labor and capital to improve incentives for workers and business owners, producing more jobs and generating higher incomes, which in turn translate into higher investment and consumer spending.
SUMMARY OF PLANS
CDA analysts evaluated two economic stimulus plans for this Report: the plan proposed by Senator Charles Grassley and strongly supported by President Bush, and the plan proposed by Senator Majority Leader Thomas Daschle that would combine the plans of Senators Max Baucus and Robert Byrd.
The Bush-Grassley plan consists of five elements: individual income tax reductions, tax policy changes that reduce capital costs, cash relief to low- and middle-income workers, extending and expanding unemployment insurance, and expanding health insurance coverage. The plan is expected to result in static federal revenue reductions and spending increases totaling $248 billion over next five years.
Specifically, Senator Grassley and the President propose:
The Daschle plan consists of five elements: cash relief to low- and middle-income workers, tax policy changes that reduce capital costs, extending and expanding unemployment insurance, expanding health insurance coverage, and significantly increasing spending for infrastructure and national security projects. The key contrast between the Bush-Grassley plan and the Daschle plan centers on the amount of tax relief vs. the amount of increased spending that each provides.
Specifically, the Daschle plan would consist of:
The Daschle plan would reduce federal tax revenue and increase spending by a total of $88 billion over the next five years.
COMPARISON OF ECONOMIC EFFECTS
There may be many good political reasons for Congress to pass an economic stimulus package, but there is one overriding economic reason: The intervention should improve the incentives to work, save, and invest-the real catalysts of economic growth. Fiscal policy changes that focus on these economic incentives will lay the foundation for stronger economic growth and both reduce the depth and shorten the duration of the current slowdown. Indeed, the competing stimulus plans should be evaluated with respect to their effects on depth and duration of the recession as much as, or more than, with respect to any other criteria.
To determine how the two plans compare in terms of their effect on the expected depth and duration of the current recession, CDA analysts developed projections of the economic impact of each of the plans. Chart 3 shows how each plan will affect the change in 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., the first quarter of 2004).
Chart 3 shows that, while both proposals lessen the depth of job loss, only the Bush-Grassley plan significantly shortens the time before employment regains the level it would have attained without a recession. As the chart demonstrates, the Bush-Grassley plan reduces the employment trough by nearly 33 percent and shortens the length of the job slowdown by six months.
Both plans affect economic activity, but the Bush-Grassley plan, which contains significant tax relief and limited spending, produces uniformly better economic results than would a plan based on substantial spending increases combined with limited tax cuts. For example, in FY 2002:
Moreover, as Table 1 shows, the differences in the effects of the two plans will be even more pronounced in future years. The Bush-Grassley stimulus package creates more jobs, provides more income to families, and does a better job expanding economic activity than the Daschle plan.
These differences become more dramatic as the pro-growth elements of the Bush-Grassley plan take hold. On average, from FY 2002 to FY 2006:
The two economic stimulus plans analyzed in this Report clearly reflect the two major views of government's role in economic planning. On the one hand, the Bush-Grassley approach relies primarily on changes 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, this supply-side plan provides incentives for 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 Daschle's demand-side approach relies primarily 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 substantially increase the fundamental incentives for stronger economic activity. In fact, the Daschle plan never creates the large consumer response that would be needed for a demand-side, expenditure-based stimulus proposal to produce the job and income increases that are generated by supply-side proposals.
While both plans transfer income to low- and moderate-income taxpayers through rebates, and while both assist the unemployed, the fact that the economic outcomes produced under the Daschle plan fall far short of those produced under the Bush-Grassley plan raises serious questions about the utility of cash payments and increased government spending as the primary tools for boosting economic activity.
APPENDIX A: METHODOLOGY
Heritage Foundation economists in the Center for Data Analysis (CDA) followed a two-step procedure in analyzing the budgetary and economic effects of the two stimulus plans evaluated by this Report.
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 IRS. In addition, the sample contains demographic and other information from the U.S. Bureau of the Census 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. 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 CBO in August 2001, the recent increases in federal spending, and the latest Blue Chip forecast for economic growth following the September 11 terrorist attacks. 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 Tax
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
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.
Business Sector Price Index.
The business sector price index was reduced to reflect the lower effective tax rates on business income.
Corporate AAA Bond Rate.
The corporate AAA bond rate was reduced to reflect the lower effective tax rates on business (capital) income in the two plans.
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 two plans.
Government Grants to States.
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 two 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 two 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.
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 A. Rector is a Research Fellow in, the Center for Data Analysis.
In scoring the President's tax and displaced workers provisions, The Heritage Foundation's Center for Data Analysis used the Center's Individual Income Tax Model and analysis by the staff of the Joint Committee on Taxation. For details, see Appendix A: Methodology. "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.
The Consolidated Omnibus Budget Reconciliation Act of 1986 (Public Law 99-272).
U.S. Senate Committee on Finance, "Baucus Economic Recovery Proposal," at http://finance.senate.gov/102401leg.pdf, and Cheryl Bolen, "Byrd Details $20 Billion Spending to Put in Economic Stimulus Package," Bureau of National Affairs Daily Report for Executives, October 25, 2001, p. A36.
The JCT's estimates for changes in tax law reflect some behavioral responses, but not 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.
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.
Diana I. Gregg, "High Probability of Recession Now, Recovery Next Year, Says CEA Chairman," Bureau of National Affairs Daily Report for Executives, October 3, 2001, p. A23.