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Center for Data Analysis Report #03-05 on Federal Budget

April 16, 2003

The Economic and Fiscal Effects of the President's Growth Package

By , , and

Congressional efforts to fashion the fiscal year (FY) 2004 federal budget come at a time when the United States faces weaker than expected job growth, shrinking consumer con­fidence, and a heightened level of risk and uncertainty. Given these circumstances, policy­makers should carefully consider opportuni­ties to improve the U.S. economy.

Among the plans being considered is one that President George W. Bush proposed on January 7, 2003a bold tax reform proposal that would increase economic growth. The components of the Presidents Economic Growth Package include ending double taxa­tion of corporate dividends, accelerating the tax rate reductions enacted in 2001, and accel­erating other provisions of the 2001 law, such as marriage penalty relief.

This report from the Center for Data Analy­sis (CDA) at The Heritage Foundation explores the implications for the U.S. economy and fed­eral revenues of implementing the Presidents Economic Growth Package. Therefore, this report should be viewed as complementary to the recent analysis of President Bushs FY 2004 budget issued by the Congressional Budget Office (CBO).[1] Rather than analyzing the entire set of budget proposals at once, as done by the CBO, this CDA Report analyzes only the Economic Growth Package, a specific tax cut provision in the Presidents budget.

Assuming that the plan becomes effective on July 1, 2003, CDA analysts simulated its effects using the DRIWEFA U.S. Macroeconomic Model[2] and the CDAs Individual Income Tax Model. CDA economists found that imple­menting the Presidents proposal would improve the nations economic growth and employment level throughout the next 10 years while increasing the nations capital stock.

Unlike short-term and temporary stimulus plans, such as S. 414, introduced by Senator Thomas Daschle (DSD), the Presidents plan creates the conditions needed for both near- and long-term growth. Compared to the base­line forecast, CDA analysts project:

Higher gross domestic product
Gross domestic product (GDP) would increase by an average of $69 billion in inflation-adjusted dollars from FY 2004 through FY 2013, with roughly 73 percent of this increase derived from the plans dividend exclusion component. (See Figure 1.) Furthermore, the Economic Growth Package would increase GDP by $84 billion in 2004 and $81 billion in 2005, suggesting that the Presidents plan would boost the economy in the near term.

More job opportunities
The employment level would average 844,000 additional jobs from FY 2004 through FY 2013, with pro­jected increases of 997,000 in 2004 and 1,036,000 in 2005. Approximately 68 percent of the plans average job growth from FY 2004 through FY 2013 would result from ending the double taxation of dividends. (See Figure 2.) The overall increase in jobs would correspond to an average decline in the unemployment rate of no less than 0.5 percent over these 10 years.

Added disposable personal income
Dispos­able personal income (after adjusting for infla­tion) would be almost $179billion higher in FY 2004 and would increase by an average of $121 billion from FY 2004 through FY 2013. Over the same 10-year period, disposable income for a family of four is projected to increase an average of $1,653. The dividend exclusion component of the plan would account for 64 percent of the plans overall average increase in disposable personal income from FY 2004 through FY 2013. (See Figure 3.)

Higher economic growth lowering the Trea­surys static revenue effect by 57 percent[3]
Static estimates suggest the Economic Growth Package would reduce federal revenue by about $638 billion from FY 2004 through FY 2013.[4] However, the CDAs dynamic esti­mates show that the proposal would reduce federal revenue during the period by only $274 billion. (See Figure 4.) Moreover, the CDAs dynamic analysis estimates that the divi­dend component would bring about a total revenue reduction of $143 billion, far less than the static estimate of $360 billion. Unlike the conventional static method, the dynamic method employed by the CDA accounts for the effects of the plans greater economic activity.[5] Figure 4, which compares the static and dynamic projections for federal revenue, shows that the estimation method chosen can make a large difference in the projected reve­nue reduction.

The structure of this CDA Report is as follows. The first section discusses the provisions of the Economic Growth Package. The next section explains the economic results for the dividend component of the plan and is followed by a similar analysis of the entire plan. The subsequent section compares the Economic Growth Package to other types of tax proposals, and the final section sum­marizes CDA results compared to those of other analysts.

The Appendix contains a review of the eco­nomic analysis and the methods used to produce the economic simulations. In addition, the Appen­dix contains charts showing the historical trends for key economic indicators and a table listing the year-by-year data from the analysis of the Eco­nomic Growth Package.

provisions of the Presidents Economic growth package

The provisions of the Economic Growth Pack­age can be divided into the following categories: excluding corporate dividends from individual taxable income; accelerating several provisions of the Economic Growth and Tax Relief Reconcilia­tion Act of 2001 (EGTRRA); increasing small busi­ness expensing; and increasing the exemption for the alternative minimum tax (AMT).[6]

Excluding Corporate Dividends from Individual Taxable Income

Under the Economic Growth Package, divi­dends paid to individuals would be excludable from taxable income provided they were paid out of after-tax corporate income. Each year, corpora­tions would report the amount of excludable divi­dends to their shareholders. Additionally, corporations would report the amount of exclud­able retained earnings to their shareholders. This amount could be used by individuals to adjust their basis when selling shares of stock, an adjust­ment that would reduce their capital gains tax lia­bility.

Dividends not taxed at the corporate level would not qualify as excludable. For example, if a corporation distributed $100 in dividends but paid no federal income taxes on those funds, shareholders would not be able to exclude any of the $100 from their personal income taxes. How­ever, since firms would be required to calculate the amount of excludable dividends, individual share­holders would only have to report dividends as directed by the firms.

Acceleration of EGTRRA Provisions

Four of the Economic Growth Packages compo­nents accelerate the phase-in of provisions con­tained in the Economic Growth and Tax Relief Reconciliation Act of 2001. These components are marriage penalty relief, expanding the 10 percent tax bracket, reducing marginal tax rates, and increasing the child tax credit. These provisions are currently scheduled to phase in throughout the next seven years.

Under the Presidents proposal, the standard deduction for married couples would be increased to double the amount of the standard deduction for single filers in 2003. Also in 2003, the width of the 15 percent bracket for married couples would be increased to twice the width for single filers. These marriage penalty relief provisions would otherwise phase in over the period 2005 to 2009.

The 10 percent bracket would be fully expanded in 2003 rather than 2008. In addition, the bracket would be indexed for inflation begin­ning in 2008. The endpoint for the 10 percent bracket would be increased from $12,000 of tax­able income to $14,000 for married couples and from $6,000 to $7,000 for single taxpayers.

The reduction in income tax rates scheduled for 2004 and 2006 would take effect in 2003. Under current law, the rates above the 15 percent bracket are 27, 30, 35, and 38.6 percent. The new rates would be 25, 28, 33, and 35 percent, respectively.

In addition, under current law, an increase in the child tax credit is set to phase in between 2005 and 2010. Under the proposal, the amount of the child tax credit would be increased from $600 to $1,000 in 2003. Additionally, this increased credit would be paid in advance (beginning in July 2003) based on the information in the taxpayers 2002 tax return. These provisions would combine to lower federal income taxes for a broad range of taxpayers.

Increased Small Business Expensing and AMT Exemption

Two additional provisions are included in the Economic Growth Package. The first is a provision that would increase the maximum amount of investment in qualified new equipment that could be immediately expensed by small businesses (Section 179 Expensing). This amount would be increased from $25,000 to $75,000 beginning in 2003. The amount of investment eligible for this immediate deduction would begin to phase out for investments above $325,000 (up from $200,000). The new dollar amounts would be indexed for inflation beginning in 2004.

The amount of the alternative minimum tax exemption would also be increased by $8,000 for married taxpayers and by $4,000 for unmarried taxpayers in 2003 through 2005. Without this provision, some taxpayers whose regular income tax would be reduced by other provisions in the plan would see their AMT liability increase.

Economic and fiscal Effects of the Economic Growth Package

Although it contains various types of changes in tax law, the Presidents proposal is designed to cre­ate economic growth primarily through the divi­dend exclusion and reductions in individuals marginal tax rates. Economists hold a variety of views on how changes in tax policy affect individ­ual behavior and, therefore, the economy. These views can be categorized into those that focus on increasing aggregate demand and those that focus on increasing aggregate supply.

Aggregate demand measures the total amount of goods and services that households, firms, and governments are willing to buy at given aggregate price levels. Aggregate supply measures the total amount of goods and services that households, firms, and governments are willing to produce at given aggregate price levels.

Policies aimed at increasing aggregate demand are designed to move the economy closer to full employment, given the current level of capacity. Policies aimed at bolstering aggregate supply increase employment levels by raising the long-run productive capacity of the economy. The tax reductions in the Economic Growth Package are consistent with the view that strengthening sup­ply-side incentives is the best way to bolster the economy.

A recent report by the CBO classifies demand-side effects as cyclical changes caused by the business cycle. These changes occur during a busi­ness cycle and are associated with increases in the unemployment rate during a recession and decreases during an economic boom. Supply-side changes are seen as those that increase the capacity of the economy.[7]

For example, the Presidents proposal would allow individuals to keep more of the next dollar they earn by lowering marginal income tax rates. This benefit, in turn, would provide an added incentive for individuals to work more, whether through longer hours or joining the labor force. Similarly, lowering the tax on firms cost of capital, achieved by ending the double taxation of divi­dends, would strengthen incentives to invest.[8] In addition, the proposal has an important demand-side component, as it increases taxpayers purchas­ing power through changes in the personal income tax code.

Stronger incentives would, in turn, lead to increased purchases of business equipment, machinery, and structures. An increase in the capacity of plant and equipment and its quality commonly is associated with an expansion of the labor force, and this effect can be seen in the results of the CDA analysis.

In practice, care must be taken to distinguish supply-side policies from supply-side effects. For example in its modeling, the CBO attributed the decrease in the unemployment rate following enactment of the Presidents budget to demand-side effects. Assuming that demand-side effects (classified as cyclical effects) reduced the unem­ployment rate leads naturally to the conclusion that they also caused much of the new economic growth and the increased tax revenues.

Supply-side tax policies, however, are designed to create jobs and economic growth now and in the future. Yet, as the CBO report shows, much of the short-run effects of the supply-side policies are sometimes classified as cyclical rather than supply-side. The CBO method does not allow analysts or policymakers an opportunity to compare the effects of different types of policies. In contrast, by separating the dividend proposal from the other components of the Economic Growth Package, the CDA analysis can be used to study the effects of the different types of proposals.

Macroeconomic Effects of Ending Double Taxation of Dividends

The importance of the supply-side approach can be observed by comparing the projected effects of eliminating the double taxation of divi­dends to the projected effects of the entire plan.[9] In virtually all key economic categories, CDAs pro­jections show that eliminating the double taxation of dividends is the most beneficial component of the Economic Growth Package. Unless otherwise noted, all amounts discussed below are adjusted for inflation, and all fiscal year differences are compared to a baseline forecast.

Specifically, the analysis projects that eliminat­ing the double taxation of dividends would:

Increase GDP
GDP would increase by an inflation-adjusted average of $51 billion from FY 2004 through FY 2013. This figure repre­sents roughly 73 percent of the Economic Growth Packages projected additional GDP. (See Figure 1.)

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Create more job opportunities
The dividend provision accounts for 577,000 (68 percent) of the plans projected total job growth of 844,000. (See Figure 2.) This increase in jobs would correspond to an average decline in the unemployment rate of 0.4 percent per year over these 10 fiscal years.

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Increase disposable personal income
Dis­posable personal income would increase by an inflation-adjusted average of more than $77 billion from FY 2004 through FY 2013, repre­senting 64 percent of the plans projected aver­age increase. For a family of four, the increase in disposable income resulting from the divi­dend component would average at least $1,054. (See Figure 3.)

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Provide additional investment
The dividend component of the Presidents plan would con­tribute an average of almost $53 billion in additional non-residential investment between FY 2004 and FY 2013. (See Figure 5.) This average shows that the dividend element accounts for approximately 90 percent of the plans projected investment increase. By FY 2013, the plans dividend component would account for about 95 percent ($327 billion) of the increase to the nations capital stock.

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Economists have long argued that the double taxation of dividends reduces the after-tax return on capital in the nations economy and thus dis­courages corporate investmentincluding pur­chases of new business equipment and machinery.[10] This reduced corporate investment weakens economic growth. Recognizing that elim­inating the double taxation would produce greater corporate investment and economic growth, sev­eral nationsincluding Australia, France, Italy, Canada, Germany, Japan, and the United King­domhave abolished or reduced their double tax­ation of corporate dividends.[11]

Under current law, corporations pay dividends to their shareholders out of after-tax profits. This dividend income, despite being taxed at the corpo­rate level, is taxed again as personal income on shareholders individual income tax returns. This added layer of taxation can have several deleteri­ous effects.

The clearest economic effect of this tax is that it raises the cost of capital, making it more expensive for firms to invest. By eliminating this duplicate layer of taxation, the Presidents plan would lower the cost of capital. Reducing the cost of capital (the price of investment) allows corporate managers to invest more, even in the face of increased risk.

For any given set of investment projects, a firms cost of capital can be thought of as a hurdle rate. A capital project that is not expected to return at least the cost of capital will not be undertaken because it does not clear the hurdle. After lowering the cost of capital, projects which previously failed to clear the hurdle rate would then do so.[12] As firms invest in more capital projects, they hire additional workers and the economy expands.

Macroeconomic Effects of the Entire Economic Growth Package

Table 2 in the Appendix contains a year-by-year reporting of key economic results from the CDAs dynamic analysis of the Economic Growth Pack­age. Unless otherwise noted, all amounts dis­cussed below are adjusted for inflation and represent fiscal year differences compared to a baseline forecast. These results suggest that imple­menting the plan would:

Increase GDP
GDP would increase by an average of at least $69 billion from FY 2004 through FY 2013. (See Figure 1.) GDP is pro­jected to be $84 billion higher in 2004 and $81 billion higher in 2005.

Create more job opportunities
The Presi­dents plan is projected to add an average of approximately 844,000 jobs from FY 2004 through FY 2013. (See Figure 2.) Furthermore, the plan is projected to increase employment by 997,000 jobs in 2004 and 1,036,000 jobs in 2005. Over this same 10-year period, the Economic Growth Packages increase in jobs would correspond to an average decline of 0.5 percent in the unemployment rate.

Increase disposable personal income
Dis­posable personal income is projected to increase by an average of $121 billion from FY 2004 through FY 2013, with a projected increase of $179 billion in 2004. For a family of four, disposable income is projected to increase by an average of $1,653 over the 10 years. (See Figure 3.)

Add to investment
Non-residential invest­ment is projected to increase an average of $57 billion from FY 2004 through FY 2013. (See Figure 5.) By FY 2013, net physical capital stock would be almost $17 trillion, roughly 2 percent above baseline projections. For this same 10-year period, the Economic Growth Package is projected to lower the user cost of capital by an average of 4.0 percent compared to the baseline forecast.

Fiscal Effects of the Entire Economic Growth Package

The economic analysis in this report is based initially on conventional, or static, estimates of the fiscal effects of the proposed tax law changes. This method assumes that federal tax policy does not affect economic growth and has been used by the Joint Committee on Taxation (JCT) and the Con­gressional Budget Office. Because the static approach does account for some of the ways tax­payers alter their tax reporting and filing in response to changes in tax law, it provides an excellent starting point for performing dynamic analysis.

For example, a static estimate might include the effects of taxpayers' shifting compensation from taxable to tax-exempt (or tax-deferred) forms in response to certain tax law changes. However, it does not take into account the way investors and workers alter their consumption, investment, sav­ing, and work effort in response to changes in tax policy.[13] Such changes in taxpayers' behavior could affect important macroeconomic variables, including employment, personal income, and GDP.

Therefore, the CDA extends the static approach by also using a dynamic model to analyze the effects of tax policy proposals. For example, if a tax rate reduction were to strengthen national eco­nomic growth, the resulting larger tax base could actually increase tax collections, which could par­tially offset the federal revenue reduction caused by the lower rate. The CDA's more complete approach accounts for the interactions between these economic and fiscal effects.

The CDA analysis shows that there can be a substantial difference between dynamic and static estimates of the budgetary effects for plans such as the Economic Growth Package. Specifically, the CDA forecasts that:

Higher economic growth lowers the Trea­sury's static revenue effect by 57 percent
Static estimates suggest that the Economic Growth Package would reduce federal revenue by about $638 billion from FY 2004 through FY 2013.[14] However, a more realistic estimate is that the proposal would reduce federal reve­nue during the period by a total of $274 bil­lion. (See Figure 4.) The difference between these static and dynamic estimates arises because the improved economic growth caused by the President's plan is projected to increase the number of workers and the overall level of income. These increases result in an expanded tax base and higher tax collections than would be predicted using a static approach. (See Table2c.)

A federal surplus will be maintained within the 10-year budget window
On-budget, the federal government is projected to move from deficit to surplus within the 10-year budget window. By 2013, the federal on-budget sur­plus is projected to be more than $337 billion. Off-budget, the federal government is pro­jected to maintain a surplus throughout the 10-year budget window. (See Table 2c.)

The Possibility of "Crowding Out"

The "crowding out theory" of budget deficits suggests that higher government debt will lead to higher interest rates and reduced economic growth. According to this theory, government budget deficits shrink the supply of credit in pri­vate markets. This reduction in supply, in turn, leads to higher prices--interest rates--in private credit markets.

Nonetheless, historical evidence suggests that "crowding out" effects are rather negligible as long as fiscal policies do not produce large economic imbalances, such as extremely high debt-to-GDP ratios. The projected average debt-to-GDP ratio in the CDA analysis is not high by historical stan­dards,[15] suggesting that the benefits of implement­ing the Economic Growth Package should far outweigh any corresponding negative crowding out effects. Furthermore, the projections indicate that the plan's long-term economic growth would achieve an on-budget federal surplus within the 10-year budget window and maintain an off-bud­get surplus throughout the 10-year window.[16]

COMPARISON WITH OTHER PLANS

Some legislators have called for tax cuts lasting two years or less and tax rebates in order to increase consumption and move the economy out of a slow-growth phase.[17] However, such calls for temporary tax cuts and rebates ignore the bulk of economic theory on lifetime consumption and the recent experience with tax rebates. Both have indi­cated that rebates and other temporary tax reduc­tions are generally not consumed as if they were ordinary income. Instead, they are used to reduce debt or increase saving--an effect precisely the opposite of the one intended.[18]

The Economic Growth Package, however, would more likely be perceived as providing long-term reductions in marginal tax rates. These long-term reductions, consequently, are more likely to be viewed by economic agents as a permanent increase in income. Taxpayers benefiting from long-run, rather than temporary, tax relief are likely to spend their increased disposable income at the same rate as they do the rest of their per­sonal income. More important, lowering marginal tax rates provides individuals with a higher after-tax return on working and saving by allowing them to keep more of the next dollar they earn.

CDA analysts used the DRI-WEFA model to examine the difference between temporary and long-term tax reductions. The model was used to estimate the effects of Senator Thomas Daschle's proposal (S. 414), which employs one-year, tar­geted tax cuts to boost economic growth.[19] This analysis suggests that the Daschle plan would cre­ate fewer jobs and less GDP than the President's proposal, particularly in the long run. For exam­ple, the CDA projects that the Daschle plan would add 545,000 jobs by the end of calendar year 2003, far less than the 844,000 jobs projected for the Bush plan in calendar year 2003.[20] The 10-year averages for growth in jobs and GDP under the two plans exhibit an even greater disparity.

For instance, for calendar years 2004 through 2013, the Daschle plan is projected to bring about an average increase of 22,100 jobs. On the other hand, the President's Economic Growth Package is estimated to add an average of 787,000 jobs for calendar years 2004 through 2013. Over the same 10-year period, the Bush plan is projected to pro­vide an average of $69 billion in additional GDP, while the Daschle plan adds only an estimated $3.4 billion to GDP.

COMPARISON WITH OTHER FORECASTS

Simulations of the President's proposal have been performed by several other groups, including the Business Roundtable (BRT),[21] Decision Eco­nomics (DE), Global Insight (GI), and Macroeco­nomic Advisers (MA). This section compares the CDA forecast to the forecasts of these other groups.[22] Table 1 summarizes these comparisons.

In general, the results of the simulations agree that the President's Economic Growth Package would bolster economic and employment growth in the early years. However, the CDA and BRT simulations find sustained improvement, while the GI and MA simulations find that the plan's benefit would decline after the initial years. The two fore­casts finding sustained improvement take account of both the demand-side and supply-side effects of the plan, while the two finding declining improve­ment take account principally of the plan's demand-side effects.

Aggregate Demand vs. Aggregate Supply

The BRT appears to have focused on both short-term demand and long-term supply-side incen­tives.[23] For instance, John J. Castellani notes that "The dividend component of this package is the key driver of economic growth, as it will consis­tently and continually pump fuel into the econ­omy over the long-run."[24] In fact, BRT's forecasted levels of GDP and employment remain well above baseline in both the short and long terms, with larger increases in the first two years. The CDA, the only other group that focused on both demand and supply-side incentives throughout the 10-year budget window, forecasted trends similar to those projected by BRT.

In contrast, GI and MA both appear to have focused more on demand-side consequences rather than supply-side incentives. For example, GI states that "In our model, the policy works its magic mainly through stimulating consumption, although it also gives investment in equipment and software a modest short-term boost."[25] Simi­larly, MA states that "Initially the plan would stim­ulate aggregate demand significantly by raising disposable income, boosting equity values, and reducing the cost of capital. However, the tax cut also reduces national saving directly while offering little new, permanent incentive for either private saving or labor supply."[26]

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Comparisons of Economic Effects[27]

The average inflation-adjusted additional GDP forecasted for FY 2003 through FY 2007 by the CDA and GI is $61.0 billion and $65.5 billion, respectively. (See Table 1.) However, the annual average additional GDP projected by GI and the CDA for the later years exhibits a larger difference. From 2008 through 2012, the CDA and GI project higher average GDP of $66.3 billion and $39.2 bil­lion, respectively, above baseline.

MA reported GDP growth rates for select years from 2003 through 2017 but did not report the actual level of GDP forecasted for all years.[28] While MA forecasts GDP growth rates below base­line for several years, there is no way to determine, based on the reported information, whether the actual level of GDP is above or below baseline. The CDA's forecasted GDP growth rates, for instance, are below baseline by 0.2 percentage point in 2006 and 0.1 percentage point in 2007, while its projected level of real GDP is above baseline by $68 billion in 2006 and $61 billion in 2007.

Another key economic variable to compare is the level of employment. The average numbers of additional jobs forecasted for calendar years 2003 through 2007 by the CDA and GI are 763,000 and 708,000, respectively. Yet the averages projected for the years 2008 through 2012 by the CDA and GI are 200,800 and 354,000, respectively. As a result, GI's forecasted average job growth for 2003 through 2012 is lower than the CDA's estimate: 531,000 versus 774,000.

BRT, the only other group to mention strong supply-side effects explicitly in its analysis, projects employment growth similar to that fore­casted by the CDA for the long term. For calendar years 2008 through 2012, BRT forecasts an aver­age of 700,000 additional jobs, almost twice as high as GI's calendar years 2008 through 2012 estimate. The unemployment rate reported by MA also suggests that they focused more heavily on demand-side consequences, reporting an unem­ployment rate below baseline through 2007 but above baseline from 2008 through 2017.[29]

Comparisons of Fiscal Effects

Both GI and the CDA project a similar dynamic federal revenue reduction in the earlier years of the 10-year budget window. For example, from FY 2003 through FY 2007, the CDA and GI forecast a dynamic federal revenue reduction of $241 billion and $219 billion, respectively. However, from FY 2008 through FY 2012, the CDA and GI project a federal revenue reduction of $53 billion and $170 billion, respectively. Similar patterns also exist in the estimated effects on the federal surplus.

For FY 2003 through FY 2007, the CDA and GI project reductions in the federal surplus of $332 billion and $310 billion, respectively. From FY 2008 through FY 2012, however, the CDA and GI estimate reductions in the federal surplus of $239 billion and $430 billion, respectively. Further­more, from calendars years 2003 through 2007, BRT and MA forecast dynamic federal surplus reductions of $262 billion and $311 billion, respectively.

Federal Reserve Reaction

The CDA assumed that the President's proposal would not significantly interfere with the Federal Reserve's goal of maintaining price stability in a growing economy.[30] GI, however, modeled a non-accommodating Federal Reserve response, mean­ing that the Fed raised interest rates soon after the implementation of the plan and continued to do so in several of the following years.[31]

Also, in the short run, MA held the nominal money supply to baseline, allowing "changes in fiscal stimulus to be reflected in GDP."[32] In the long run, however, MA modeled a rise in interest rates as a pro-cyclical response to higher economic growth. Consequently, both GI and MA projected that the Federal Reserve would raise interest rates in response to higher economic growth, thus sti­fling employment and GDP.

Dividend Payout Ratio

The CDA and BRT followed U.S. Department of the Treasury estimates, increasing the dividend payout rate by 2 percentage points above the base­line in 2004 and 4 percentage points above base­line from 2005 through 2013.[33] GI, on the other hand, did not assume "any increase in dividend payout above what the model wants to give."[34]

Conclusion

Due mainly to its elimination of the double tax on corporate dividends, the President's Economic Growth Package is projected to increase the num­ber of workers and the overall level of income in the United States throughout the next 10 years. Relative to the baseline forecast, from 2004 through 2013, the CDA forecasts that GDP would average an additional $69 billion, employment would average an added 844,000 jobs, and dis­posable income would average an additional $121 billion. Consequently, this higher economic growth would result in an expanded tax base, sug­gesting that the true federal revenue reduction would be only about $274 billion--far less than the U.S. Treasury's static estimate of $638 billion.

William W. Beach is Director of, and Ralph A. Rector, Ph.D., is Research Fellow and Alfredo Goyburu and Norbert J. Michel are Policy Analysts in, the Cen­ter for Data Analysis at The Heritage Foundation.



[1]See Congressional Budget Office, An Analysis of the President's Budgetary Proposals for Fiscal Year 2004, March 2003, at www.cbo.gov.

[2]CDA used the DRI-WEFA Mark 11 U.S. Macroeconomic Model, owned by Global Insight, to conduct this analysis. The model was developed by Nobel prize-winning economist Lawrence Klein and several col­leagues at the University of Pennsylvania's Wharton School of Business. The methodologies, assumptions, conclusions, and opinions in this report 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.

[3]Unless otherwise noted, to maintain comparability with published CBO long-term projections, projections of changes in federal spending and revenue are not adjusted for inflation in this paper.

[4] Budget of the United States Government, Fiscal Year 2004: Analytical Perspectives (Washington, D.C.: U.S. Government Printing Office, 2003), pp. 81, 83.

[5]The differences between static and dynamic analysis are discussed in greater detail in subsequent sections of this report.

[6]CDA analysts modeled the President's Economic Growth Package as described in Budget of the United States Govern­ment, Fiscal Year 2004: Analytical Perspectives, pp. 66-68. As described in this document, the Economic Growth Pack­age does not include a provision for personal reemployment accounts. The CBO analysis, however, does include a provision for personal reemployment accounts in the Economic Growth Package. See Congressional Budget Office, An Analysis of the President's Budgetary Proposals for Fiscal Year 2004, p. 46.

[7]See Congressional Budget Office, An Analysis of the President's Budgetary Proposals for Fiscal Year 2004, p. 46.

[8]The terms "cost of capital" and "return to capital" are closely related. For example, the return on capital that a firm has to provide to an investor is the cost of employing that capital. Lowering the tax on this capital thus results in added incentives to invest and, therefore, purchase the capital.

[9]The term "double taxation" refers only to the federal taxation of dividends. When state and local taxes are considered, there are more than two layers of taxation on dividend income. However, the President's proposal eliminates only the personal federal layer of this taxation.

[10]For academic studies on the economic effects of federal double taxation of dividends, see James M. Poterba, "Tax Pol­icy and Corporate Saving," Brookings Papers on Economic Activity No. 2, 1987, pp. 455-515; Peter Birch Sorensen, "Changing Views of the Corporate Income Tax," National Tax Journal, Vol. 48, Issue 2 (June 1995), pp. 279-294; James M. Poterba and Lawrence H. Summers, "The Economic Effects of Dividend Taxation," National Bureau of Economic Research Working Paper No. 1353, 1984; and James M. Poterba and Lawrence H. Summers, "New Evidence That Taxes Affect the Valuation of Dividends," The Journal of Finance, Vol. 39, Issue 5 (December 1984), pp. 1397-1415.

[11]Deborah Thomas and Keith Sellers, "Eliminate the Double Tax on Dividends," Journal of Accountancy, November 1994; Ervin L. Black, Joseph Legoria, and Keith F. Sellers, "Capital Investment Effects of Dividend Imputation," The Journal of the American Taxation Association, Vol. 22, Issue 2 (2000), pp. 40-59.

[12]For more information on hurdle rates, see Norbert J. Michel, "Everyone Profits from Hurdling Dividends," Heritage Foundation Web Memo No. 248, April 3, 2003, at www.heritage.org.

[13]For a discussion of the shortcomings of static analysis of the effects of tax policy changes, see Daniel J. Mitchell, "The Correct Way to Measure the Revenue Impact of Changes in Tax Rates," Heritage Foundation Backgrounder No. 1544, May 3, 2002, at www.heritage.org/Research/Taxes/BG1544.cfm. See also "The Argument for Reality-Based Scoring," Her­itage Foundation Web Memo No. 92, March 29, 2002, at www.heritage.org/Research/Taxes/WM92.cfm, and Daniel R. Burton, "Reforming the Federal Tax Policy Process," Cato Institute Policy Analysis No. 463, December 17, 2002, at www.cato.org/pubs/pas/pa-463es.html.

[14]This amount is slightly different from the CBO definition of the Economic Growth Package, which includes a provi­sion for personal reemployment accounts. Based on this definition, the CBO states that the Treasury's static federal rev­enue reduction for the plan is $642 billion. See Table 11, footnote D, in An Analysis of the President's Budgetary Proposals for Fiscal Year 2004, p. 46, at www.cbo.gov.

[15]See Figure 15.

[16]For a discussion of the plan's fiscal effects on national saving, see the Appendix.

[17]For example, both Democratic leaders in the U.S. Congress have proposed one-time tax rebates as important elements of their own economic growth plans. Democratic House leader Nancy Pelosi (D-CA) proposed a refundable tax rebate of $300 per adult in a family, up to $600 per family. See Office of the House Democratic Leader, "House Democratic Economic Stimulus Plan," January 6, 2003, at www.house.gov/budget_democrats/analyses/econ_stimulus/ house_dem_stimulus_plan.pdf (March 23, 2003). On February 14, 2003, Senator Thomas Daschle (D-SD) introduced a tax rebate of $300 per adult in a family and $300 for every child, up to $1,200 per family. See Library of Congress, "S‑414, Economic Recovery Act of 2003," February 14, 2003, at thomas.loc.gov.

[18]National Bureau of Economic Research economists Matthew D. Shapiro and Joel Slemrod analyzed data on the Uni­versity of Michigan Survey of Consumers to study the consumption effects of the tax rebate component of the 2001 EGTRRA tax cut. They found that only 22 percent of responding households were planning to spend the rebate. In addition, Shapiro and Slemrod found that the likelihood of spending varied only slightly across income levels and actually increased with income level. It was also slightly higher among households owning stock than among non-stockholding households. This finding is consistent with the holdings of modern economic consumption theory, which maintains that most people do not base their consumption decisions on their current level of income, but instead on their current estimate of their lifetime level of income. Thus, people receiving a windfall, such as a tempo­rary personal income tax reduction, are likely to save a significant share of that windfall and increase consumption slowly afterward. Conversely, people suffering a temporary reduction in income or wealth, such as a temporary per­sonal income tax increase, tend to reduce consumption slowly and decrease savings in order to maintain their previ­ous level of consumption. See Robert P. O'Quinn, "The Effects of the Duration of Federal Tax Reductions: Examining the Empirical Evidence," Joint Economic Committee, February 2002, p. 2, at www.house.gov/jec/tax.htm. For more on the shortcomings of tax rebates as a form of economic stimulus, see Norbert Michel, "Fact v. Fiction: Tax Rebates," Heritage Foundation Web Memo No. 192, January 27, 2003, at www.heritage.org/Research/Taxes/wm192.cfm.

[19]See William W. Beach, "A Side-by-Side Comparison of President Bush's and Senator Daschle's Plans to Boost Economic Growth," Heritage Foundation Web Memo No. 231, March 20, 2003, at www.heritage.org/research/taxes/wm231.cfm.

[20]Calendar year results were used for comparison purposes only and are slightly different from the fiscal year results shown in Table 1.

[21]This simulation was performed for the Business Roundtable by PricewaterhouseCoopers using the Inforum model at the University of Maryland.

[22]As of this writing, CDA analysts do not have sufficient information to evaluate Decision Economics' forecast.

[23]Business Roundtable, "BRT Study on Economic Jobs and Growth Plan," January 21, 2003, at www.brt.org/pdf/PWC20030130/PWCMarylandStudy.pdf (March 15, 2003).

[24]Ibid., p. 2.

[25]Patrick Newport, "Bush Plan Boosts Short-term U.S. Growth, But Adds to Deficits," Global Insight, February 28, 2003.

[26]Macroeconomic Advisers, A Preliminary Analysis of the President's Jobs and Growth Proposals, Special Analysis, January 10, 2003, p. 2.

[27]Unless otherwise noted, years in this section are federal fiscal years.

[28]MA also reported a decline in potential GDP for 2017, a measure that could be mistaken for actual GDP. Potential GDP, however, is different from actual GDP in that it is a theoretical measure of the level of real output that an economy could produce.

[29]Macroeconomic Advisers, A Preliminary Analysis, chart on p. 7.

[30]This assumption required CDA analysts to adjust downward, compared to the baseline, a model variable controlling the Federal Funds Rate (see the Appendix for details); a downward adjustment corresponds to a more accommodating monetary policy than is built into the model.

[31]For a simulation of the Democrat plan, however, GI modeled an accommodating Federal Reserve that held interest rates to baseline. See Newport, "Bush Plan Boosts Short-term U.S. Growth," p. 3.

[32]Macroeconomic Advisers, A Preliminary Analysis, p. 6.

[33]Business Roundtable, "BRT Study on Economic Jobs and Growth Plan."

[34]Newport, "Bush Plan Boosts Short-term U.S. Growth." To examine the effects of increasing the payout rate, CDA analysts performed a sensitivity analysis in which the dividend payout rate was held to baseline. The results from this alternative simulation were not materially different from those reported in the paper. For details, see the Appendix.

[35]The Center for Data Analysis at The Heritage Foundation used the DRI-WEFA Mark 11 U.S. Macroeconomic Model, owned by Global Insight, to conduct this analysis. The model was developed by Nobel Prize-winning economist Lawrence Klein and several colleagues at the University of Pennsylvania's Wharton School of Business. The methodologies, assumptions, conclusions, and opinions in this report 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.

[36]Congressional Budget Office, "The Budget and Economic Outlook: An Update," August 2002, at www.cbo.gov/show-doc.cfm?index=3755&sequence=0 (March 15, 2003).

[37]The same rate of growth used to extrapolate the dividend forecast was used to extrapolate the final year of the overall plan because the majority of the other provisions would have expired by 2013.

[38]Budget of the United States Government, Fiscal Year 2004: Analytical Perspectives, pp. 81, 83.

[39]The resulting estimates are similar to those used in Macroeconomic Advisers' year-by-year estimate of the static revenue effects of the plan. See Macroeconomic Advisers, A Preliminary Analysis.

[40]Kevin A. Hassett, "Evaluation of Proposals for Economic Growth and Job Creation: Incentives for Investment," testimony before the Senate Finance Committee, February 12, 2003, at www.aei.org/news/newsID.15964/news_detail.asp.

[41]R. Glenn Hubbard, "Testimony of R. Glenn Hubbard, Chairman, Council of Economic Advisers, Before the Budget Committee, United States Senate," February 4, 2003, at www.senate.gov/%7Ebudget/democratic/testimony/2003/hubbard_hrng020403.pdf.

[42]The observed (dynamic) change in the user cost of capital was not quite 5.5 percent because the reduction in federal revenue and the increased economic activity associated with ending double taxation of corporate dividends would exert upward pressure on the user cost of capital. The CDA simulation of the dividend component alone found that the user cost of capital averaged 5.3 percent lower under the plan than under current law during 2004-2013. The CDA simulation of the Economic Growth Package found that the user cost of capital averaged 4.0 percent lower during 2004-2013.

[43]Business Round Table, "BRT Study on Economic Jobs and Growth Plan."

[44]Many economists believe that equity values would rise as a result of ending the double taxation of dividend income and that this rise in stock market values would increase the amount of consumption because of wealth effects.

[45]CDA analysts performed tests of the DRI-WEFA model and found that even when accounting for crowding out, the response within the model of non-residential fixed investment to changes in the user cost of capital was weaker than is supported by recent literature. For literature citation, see footnote 47.

[46]These elasticities are consistent with those found in 1992 by Jason Cummins and Kevin Hassett. Cummins and Hassett's findings indicate that the effective elasticities were lower because a portion of the increase in investment caused by the reduction in the user cost of capital was assumed to be crowded out by increases in net publicly held debt. On elasticities, see Jason Cummins and Kevin Hassett, "The Effects of Taxation on Investment: New Evidence from Firm Level Panel Data," National Tax Journal, Vol. 45, No. 3 (September 1992), pp. 243-251, at ntj.tax.org/wwtax/ntjrec.nsf/4F54FD9041AEC3118525686C00686DFA/$FILE/v45n3243.pdf (March 17, 2003). On crowding out, see footnote 47.

[47]In other words, the elasticity of non-residential fixed investment with respect to the user cost of capital was applied to investment net of crowding out. The rule of thumb that every dollar increase in net publicly held debt displaces 60 cents of private investment is reported in the 2003 Economic Report of the President. This rule of thumb is distinct from the crowding out effect on interest rates. Even using this rule of thumb, the effect of crowding out on interest rates can be negligible. See Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 2003), p. 56.

[48]The simulation found that the dividend plan alone would increase the net physical capital stock by 2.0 percent in FY 2013. From FY 2004 through FY 2013, the user cost of capital would fall by an average of 5.3 percent and GDP would rise by an average of 0.44 percent. This relationship among changes in the capital stock, the use cost of capital, and GDP is consistent with recent empirical analysis. See Robert S. Chirinko, Steven M. Fazzari, and Andrew P. Meyer, "That Elusive Elasticity: A Long-Panel Approach to Estimating the Price Sensitivity of Business Capital," Emery University Department of Economics Working Paper 02-02, January 2002, at userwww.service.emery.edu/%7Ecozden/chirinko_02_02_cover.html.

[49]See Congressional Budget Office, "Labor Supply and Taxes," January 1996, p. 11, at www.cbo.gov/ftp-doc.cfm?index=3372&type=1 (March 15, 2003).

[50]See William G. Gale and Peter R. Orszag, "The Economic Effects of Long-Term Fiscal Discipline," Urban-Brookings Tax Policy Center, Discussion Paper, December 17, 2002, at www.brook.edu/views/papers/gale/20021217.htm (March 24, 2003); William G. Gale and Samara R. Potter, "An Economic Evaluation of the Economic Growth and Tax Relief Reconciliation Act of 2001," Brookings Institution, March 2002, at www.brook.edu/views/articles/gale/200203.htm (March 24, 2002); and Alan J. Auerbach, "The Bush Tax Cut and National Saving," National Bureau of Economic Research Working Paper No. 9012, December 2002, at emlab.berkeley.edu/users/auerbach/bushtaxcut.pdf (March 24, 2003).

[51]The CDA analysis includes changes in the state and local government component of national saving. In contrast, Gale and Potter note that "We ignore any induced effects [of the tax cut] on savings by state and local government." Auerbach states that a simplifying assumption used in his analysis was "the omission of the state and local fiscal sector." See Gale and Potter, "An Economic Evaluation of the Economic Growth and Tax Relief Reconciliation Act of 2001," and Auerbach, "The Bush Tax Cut and National Saving."

[52]Comparisons of the August 2002 and January 2003 baselines are based on a geometric mean average of the annual growth rates.

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