The Economic and Budgetary Effects of the Katrina Emergency Tax Relief Act of 2005

Tables included in this report

Table 1: The Economic Effects of the Katrina Emergency Tax Relief Act of 2005

Introduction

Hurricane Katrina has dealt a serious blow to the Gulf Coast and New Orleans. Initial estimates from state and local authorities suggested that losses of human life could approach or even exceed levels last seen in the wake of the 1900 hurricane that destroyed Galveston, Texas. Happily, those dire predictions have not come to pass, and Katrina's death toll has thus far remained below 1,000.

But the economic costs to the region are likely to be large. The federal government has responded to Katrina and its aftermath with increased federal spending and new proposals for tax relief. The first tax relief measures considered by the U.S. House of Representatives (H.R. 3768, Katrina Emergency Tax Relief Act of 2005) and the U.S. Senate (S.1696, Hurricane Katrina Tax Relief Act of 2005) are limited to providing short-term emergency relief to persons affected by Hurricane Katrina.[1] Both measures seek to assist Katrina's victims by offering:

• Incentives to provide charitable goods and services and
• Provisions to increase temporarily disposable personal income and to assist with temporary cash flow problems.

Longer-term packages addressing the rebuilding efforts in New Orleans and along the Gulf Coast are likely to be considered later this month.[2]

An analysis of H.R. 3768 as originally passed by the House of Representatives shows that its short-run economic and budgetary effects are small but positive.[3] Relative to a baseline that takes account of Hurricane Katrina but excludes any Katrina-related tax cuts:

• U.S. real (inflation-adjusted) gross domestic product (GDP) is an average of $1.2 billion higher between 2006 and 2008;
• U.S. real personal consumption expenditures are an average of $1.6 billion higher between 2006 and 2008; and
• U.S. real disposable personal income is an average of $2.8 billion higher between 2006 and 2008.

Because the provisions of H.R. 3768 are only temporary, its economic effects are negligible over a 10-year (2006-2015) budget window. Similar results would likely be obtained from an analysis of the version of H.R. 3768 amended by the U.S. Senate on September 15.

The budgetary effects of H.R. 3768 are also small over the 10-year budget window. After accounting for the macroeconomic effects, H.R. 3768 reduces unified federal tax revenues by roughly $3 billion (not inflation-adjusted) between 2006 and 2015. It increases federal net interest payments and, therefore, the unified federal deficit by more than that $3 billion over the same period.

H.R. 3768's impact on the unified deficit would have been even smaller (in our analysis) if its provisions had been financed with spending cuts as opposed to new deficits and debt. Its positive impact on GDP, income, consumption, and other macroeconomic aggregates would likely have been much smaller or even negative if its provisions had been financed with increases in other taxes, particularly taxes affecting business owners and investors.

The Economic Costs of Hurricane Katrina

The economic costs of Hurricane Katrina to New Orleans and the Gulf Coast are likely to be large. For example, the Bureau of Labor Statistics (BLS) puts total employment in the New Orleans-Metairie-Kenner metropolitan statistical area at over 615,000 in 2004.[4] It puts the total employment in the 145,341 establishments in the 86 hardest hit counties (and parishes) in Mississippi, Alabama, and Southern Louisiana at 2.4 million, or 1.9 percent of total U.S. employment, in 2004.[5] As a result of flooding and evacuations, employment in New Orleans and most its suburbs is likely to fall sharply, at least through September.[6] Employment outside the hardest hit areas of New Orleans is likely to be less severely affected and to rebound more quickly.

Capital losses arising from Katrina are also likely to be considerable. The four hurricanes to strike Florida in 2004 and the World Trade Center attacks in 2001 resulted, respectively, in over $23 billion and $32.5 billion in privately insured damage/property losses. In comparison, recent estimates of privately insured damage due to Katrina range from $40 billion to $60 billion.[7]

Even so, the economic effects of natural disasters are not typically felt outside the affected region. Katrina is likely to be different. The damage sustained by the region's energy and port[8] infrastructure and the flooding of New Orleans is widely expected to cause ripple effects throughout the national economy, at least in the short run.

For example, Hurricane Katrina temporarily knocked out roughly 10 percent of U.S. refining capacity and 18 percent of U.S. crude oil production. The impact on energy prices was almost immediate, with the U.S. retail price of gasoline topping $3 per gallon by Labor Day.[9] Retail gas prices have since fallen, thanks to fast progress in reopening refineries and restarting pipelines, but Katrina is expected to fuel higher energy prices and consumer price index inflation through the end of 2005.[10]

Private and government forecasters also expect Katrina to dampen overall real (inflation-adjusted) economic growth. Global Insight has downgraded its forecast for real U.S. GDP growth by 0.7 percentage points (to 3.2 percent) for the second half of 2005. The Congressional Budget Office (CBO) anticipates that Katrina could reduce the growth rate of real U.S. GDP by 0.5 to 1 percentage point over the same period.[11]

Provisions of the Katrina Emergency Tax Relief Act of 2005 (H.R. 3768)

Both H.R. 3768 (as originally passed by the House of Representatives and later amended by the Senate) and S.1696 are broadly similar. To boost disposable income, both measures temporarily:

• Allow full deductibility of personal casualty losses,
• Provide a longer period of time to use insurance proceeds to replace damaged property without incurring tax,
• Extend the work opportunity tax credit to those hiring workers from affected areas,
• Exempt hurricane victims from taxes on forgiveness of debt by corporate lenders, and
• Allow penalty-free withdrawals from retirement plans to provide hurricane victims access to their saving.

In addition, H.R. 3768 gives displaced persons the option of using 2004 income to calculate the child credit tax credit and the earned income tax credit on 2005 returns.

The key provisions of H.R. 3768 as passed by the House of Representatives are as follows:[12]

Full deductibility of personal casualty losses. The most costly part of H.R. 3768 provides assistance to taxpayers who claim itemized deductions and would otherwise be subject to certain limitations on the deductibility of personal casualty losses. Under current law, taxpayers are usually allowed a deduction for losses that are not offset by insurance coverage or other forms of compensation. However, only personal casualty or theft losses that exceed $100 are included in the total loss, and the deductible amount is only that portion of the total loss that exceeds 10 percent of adjusted gross income (AGI). The proposal allows taxpayers to include individual losses less than $100 in the calculation of the total when the separate losses are attributable to Hurricane Katrina. In addition, all losses attributable to Hurricane Katrina are deducible, not just the portion that exceeds 10 percent of AGI.

Extension period for replacement of damaged property. The second most costly element of the proposal provides a longer period of time for taxpayers to replace damaged property without having the replacement increase their tax liability. Under current law, gains from the sale of property are generally calculated by subtracting a basis value from the sales price. However, special rules now allow the gain to be deferred or exempt from taxation but only if the property replacement occurs within a limited period of time. The proposal modifies these rules by increasing the replacement period to five years if the property is located in a designated area and if the replacement is associated with Hurricane Katrina.

Extension of the work opportunity tax credit. Current law provides a work opportunity tax credit (WOTC) for employers that hire individuals who are from specific target groups.[13] H.R. 3768 creates a new target group for certain individuals who lived in the Hurricane Katrina disaster area on August 28, 2005. The provision applies only when the principal place of employment is within the Katrina disaster area and is limited to work that begins during a two-year period starting on August 29, 2005.

Other provisions. H.R. 3768 relaxes some of the current-law limitations on the amount of charitable contributions that can be deducted. It also suspends the inclusion of Katrina-related debt forgiveness (such as cancellation of mortgage debt) for purposes of calculating taxable income and allows qualified taxpayers with individual retirement accounts, pensions, or other types of retirement programs to withdraw a maximum of $100,000 without paying the 10 percent penalty that would otherwise be due.[14]

Economic and Budgetary Effects of H.R. 3768

Global Insight's short-term U.S. Macroeconomic Model is used to analyze the immediate economic and budgetary impacts of H.R. 3768.[15] (See Table 1.) The results, expressed relative to a baseline that includes Hurricane Katrina but excludes any of the newly proposed tax cuts, show that:

• Real (inflation-adjusted) GDP increases by $1.9 billion in fiscal year 2007. It climbs an average of $1.2 billion between 2006 and 2008.
• Real personal consumption expenditures are $2.2 billion higher in 2007. They are an average of $1.6 billion higher between 2006 and 2008.
• Real disposable personal income is $3.8 billion higher in 2007. It is an average of $2.8 billion higher between 2006 and 2008.
• Total non-farm employment increases by a modest 16,000 jobs in 2007. It climbs an average of almost 11,000 jobs between 2006 and 2008.[16]

Because the tax relief provisions of H.R. 3768 are only temporary, any economic gains arising from them are short-lived. Thus, by 2015, real GDP, personal consumption, disposable personal income, and total non-farm employment have all roughly returned to base levels. Over the 10-year budget window (2006-2015), the average effects of H.R. 3768 on all four economic indicators are negligible. That said, any positive economic impacts derived from H.R. 3768 would likely have been much smaller or even negative (in our analysis) if its provisions had been financed with increases in other taxes, particularly taxes affecting business owners and investors.

Such results are not entirely unexpected. Tax incentives broadly stimulate economic activity through one of two channels. Tax cuts aimed at permanently lowering the cost of capital can encourage new investment. In the long run, the resulting increase in the economy's stock of productive capital raises productivity and the rate of economic growth. Long-run gains in incomes and employment are a natural result. Tax cuts aimed at only temporarily raising disposable personal income boost consumption and output in the short run. However, they do little to spur new business spending on capital goods or to boost long-term hiring or improve the economy's long-run rate of potential growth.

The positive economic effects of H.R. 3768 are also limited in part by its provisions to extend the replacement period for damaged property. Joint Committee on Taxation (JCT) estimates of the revenue effects of H.R. 3768 put revenue losses from this provision at $1.9 billion over fiscal years 2006 through 2008.[17] However, the JCT estimates revenue gains from the same provision in every year from 2009. In aggregate, H.R. 3768 raises taxes in every year after 2010. As a result, disposable personal income and personal consumption are slightly below base levels in the later years.

The budgetary effects of H.R. 3768 are small. Between 2006 and 2015, H.R. 3768 reduces unified federal tax revenues by just under $5.3 billion (not inflation-adjusted) as estimated by the JCT and by roughly $3 billion (not inflation-adjusted) on a fully dynamic basis.[18] The simulations assume that provisions in H.R. 3768 are financed not with spending cuts, but rather with new deficits and debt. As a result, federal net interest payments rise, and the unified federal deficit increases by a total of almost $8.5 billion over the 10-year budget window. H.R. 3768's impact on the unified deficit would likely have been smaller if its provisions had been financed at least in part with spending cuts.

Methodology Appendix

Global Insight's September 2005 U.S. Macroeconomic Model was used to analyze the economic and budgetary effects of H.R. 3768.[19] Analysts in the Heritage Foundation's Center for Data Analysis (CDA) typically use a version of the Global Insight model that has been calibrated to the most recent CBO baseline economic and budgetary assumptions and forecasts. However, for this analysis, CDA's CBO-like baseline model could not be updated to reflect the effects of Katrina in the time available. As a result, Global Insight's September model, which takes Katrina into account, was used.

Unlike a CBO-like baseline model and forecast, Global Insight's baseline model and forecast do not embody current-law assumptions about changes in tax policy and government spending.[20] For example, a current-law baseline forecast would assume the expiration by 2010 of all components of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 and the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003. It would also exclude any new legislation increasing federal spending, even when such legislation is likely to be enacted. In contrast, Global Insight's September 2005 baseline forecast assumes that not all components of EGTRRA and JGTRRA expire as currently scheduled. It also explicitly includes $100 billion in new federal spending for the Federal Emergency Management Agency and for the rebuilding of infrastructure in New Orleans and along the Gulf Coast.

A two-step procedure was followed in analyzing the economic and budgetary effects of H.R. 3768. First, estimates of the changes in tax revenues stemming from H.R. 3768's general tax relief provisions were taken from JCT estimates.[21] Average effective federal personal income tax rates in the Global Insight model were then adjusted to target JCT estimates of aggregate revenue losses and gains between 2006 and 2015. Second, the implied changes in average effective personal income tax rates were introduced into the Global Insight model. CDA analysts assumed that the tax cuts implied by H.R. 3768's general provisions were not offset by cuts in federal spending.

In addition, CDA analysts assumed that the Federal Reserve Board would follow historical patterns of behavior when reacting to a change federal spending and taxes. This assumption was implemented in the Global Insight model using an econometrically estimated reaction function that determines the effective interest rate on federal funds.

Tracy L. Foertsch, Ph.D., is a Senior Policy Analyst and Ralph A. Rector, Ph.D., is a Research Fellow and Project Manager in the Center for Data Analysis at The Heritage Foundation.