The President's fiscal year (FY) 2007 budget submission to
Congress includes a number of important initiatives. Among them is
a plan to create a Dynamic Analysis Division within the Office of
Tax Analysis (OTA) in the U.S. Department of the Treasury.
Dynamic analysis gauges the impact on federal tax revenues of
the changes in output and incomes induced by changes in tax policy.
Proponents of supply-side tax cuts and fundamental tax reform
provided much of the original push for dynamic analysis. They
did so because conventional revenue estimates may take into account
the microeconomic behavioral effects of a tax policy change,  but
they exclude the effects on federal tax receipts of changes in
macroeconomic factors like labor force participation,
investment, and capital accumulation. Dynamic analysis makes
use of advances in computing technology and economic modeling to
generate dynamic revenue estimates that include these macroeconomic
The tax agenda has now shifted. In the short run, the focus will
likely be on which of the expiring provisions of the 2001 and
2003 tax acts, if any, to extend. In the longer run, devising a tax
policy that generates additional revenues without slowing
economic growth will likely be an important part of the policy
Dynamic analysis has a key role to play in this debate.
Providing one dynamic "score"--or one dynamic estimate of the
revenue effects of a tax policy change--may be difficult to
envision. The choice of macroeconomic model along with the
assumptions made about monetary policy in the short run and fiscal
policy in the long run can influence dynamic estimates, sometimes
even changing the sign of estimated gross domestic product (GDP)
and revenue effects. However, dynamic estimates can still
enhance the budgeting process by helping to identify and rank
those provisions of a tax proposal that are most likely to achieve
policymakers' stated objectives.
Both the Joint Committee on Taxation (JCT) and the Congressional
Budget Office (CBO) have been working to integrate dynamic
estimates into the budgeting process. The JCT's efforts began in
earnest with a 1997 symposium on "Modeling the Macroeconomic
Consequences of Tax Policy." In March 2003, the CBO published its first
dynamic analysis of the President's budget. Both the JCT and
the CBO have since released papers exploring the
application of macroeconomic models to the analysis of the economic
and budget effects of tax policy changes.
The Treasury Department has recently begun to produce its own
dynamic estimates. The President's Advisory Panel on Federal Tax
Reform used dynamic analysis from the Treasury Department to help
to evaluate different reform options. The FY 2007 Mid-Session
Review included for the first time dynamic estimates of the
economic effects of one of the President's tax
proposals--permanently extending some provisions of the 2001
Economic Growth and Tax Relief Reconciliation Act (EGTRRA) and the
2003 Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) that
are set to expire in 2010.
A Dynamic Analysis Division within the OTA would help to
institutionalize this work at the Treasury Department. The
U.S. House of Representatives has already approved roughly
$520,000 in funding for a nascent Dynamic Analysis Division.
However, the funding is still pending in the U.S. Senate and could
become the first casualty of the Democratic takeover of Congress in
This would be regrettable. A Dynamic Analysis Division at the
Treasury Department could do much to inform the budget debate. One
way to see this is to consider what the next steps for dynamic
analysis at the department could be, assuming the Senate approves
funding before the 109th Congress adjourns.
The Next Steps at the Treasury
The answers to four questions are important when considering the
next steps that the Treasury Department should take in developing
its dynamic analysis capabilities.
- Which macroeconomic models should the OTA use for its dynamic
- How can the OTA's dynamic estimates account for the key
macroeconomic effects of a tax policy change?
- How should the OTA estimate revenue feedbacks from a tax
- What kinds of dynamic estimates should the OTA provide?
Which macroeconomic models should the OTA use for its dynamic
analysis? The choice of which macroeconomic model to use
depends on the goal of the proposed change in tax policy and the
economic environment in which it is being considered.
Large-scale macroeconometric models are a good choice when a tax
policy change is intended to stimulate aggregate demand in the
short run. Such models impose the long-run structure of a
neoclassical growth model, but their baselines include
unemployment and short-run gaps between actual and estimated
potential GDP. Thus, they can be used to analyze how changes in
monetary and fiscal policy affect employment, personal and
corporate incomes, personal consumption and saving, residential and
business fixed investment, and other key macroeconomic
variables in the short run.
General equilibrium (GE) models are a better choice when the
long-run effects of a tax policy change on labor hours, capital,
and GDP are the primary focus of analysis. GE models are
full-employment models in which prices are assumed to adjust
instantaneously to equate supply and demand. GE models used for
fiscal policy analysis typically impose the government's
intertemporal budget constraint. Thus, the government cannot
indefinitely finance higher spending or lower taxes with deficits.
Rather, in the long run, it must cut spending or raise taxes to
limit the growth rate of debt to the growth rate of GDP.
The effects of a tax policy change on labor supply and
investment can vary dramatically depending on whether the
government finances higher spending or lower taxes today with
lower spending or higher taxes tomorrow. This is because households
and firms are assumed to know the future course of fiscal policy
with perfect foresight and to make decisions about how much to
work, save, and invest accordingly.
Large-scale macroeconometric models can also be used to analyze
the effects of tax policy changes intended to boost the economy's
stock of labor and capital in the long run. However, doing so often
requires making assumptions about the response of hours worked and
investment to changes in marginal tax rates on labor and
capital income. Such assumptions are sometimes necessary because
macroeconometric models focus on the short-run effects of tax
policy changes on disposable income and consumption. Households and
firms are not assumed to know the future course of fiscal policy
and thus do not adjust work, saving, and investment in
response to the long-run effects of changes in marginal tax rates
on the returns to capital and labor and the cost of capital.
That said, analyzing marginal rate cuts in a
macroeconometric model has the advantage of allowing one to
compare the macroeconomic effects to the CBO's baseline economic
and budgetary projections over the 10-year budget period. GE models
do not afford the same opportunity because they are typically
calibrated to baselines that are consistent with full employment
and a sustainable fiscal policy.
The CBO and the JCT use several macroeconomic models when
producing dynamic estimates. In its most recent dynamic analysis of
the President's budget, the CBO used two GE models, including
an overlapping generations (OLG) model, and two macroeconometric
models, including the Macroeconomic Advisers' (MA) model. The
JCT has a set of models with similar capabilities available for
dynamic analysis, including the Tax Policy Advisers (TPA) OLG
life-cycle model and a macroeconomic growth (MEG) model. The MEG
model, like the MA model, can be used to evaluate changes in tax
policy meant to boost aggregate demand in the short run.
A new Dynamic Analysis Division should similarly maintain a
mix of models that will give it the flexibility to do dynamic
analyses of tax policy changes intended to boost aggregate demand
in the short run and the economy's stock of labor and capital
in the long run.
How can the OTA's dynamic estimates account for the key
macroeconomic effects of a tax policy change? Accounting for
the key macroeconomic effects of a tax policy change presents a
challenge. The extent to which a set of dynamic estimates
accomplishes this depends in large part on the degree of
disaggregation in the macroeconomic model being used.
The Internal Revenue Code is extremely complex, with a
progressive rate structure, different tax rates for capital gains
realizations and dividend income, an alternative minimum tax, and
myriad large and small tax credits and deductions. Most proposed
changes in U.S. tax law do not affect all taxpayers and sources of
income uniformly. Rather, they are often tailored to benefit
specific subsets of taxpayers or sectors. Thus, a proposal can
apply different tax rate changes to different sources of income. It
can also create tax incentives to reallocate income and resources
from one sector or use to another.
Microsimulation models of the federal individual and corporate
income tax capture the complexity of the U.S. tax code. They are
based on large samples of tax returns that are weighted to
match the taxpayer population. As a result, they can generate
finely disaggregated measures of the impact of a tax policy change
on federal income tax revenues and average effective marginal
income tax rates. Microsimulation models of the federal
individual income tax can also be used to estimate changes in labor
supply by type of worker and income size. Outputs from
microsimulation models are input into macroeconomic models
when simulating the macroeconomic and dynamic revenue effects
of a tax policy change.
Macroeconomic models capture little of the complexity of the
U.S. tax code. They tend to be highly stylized, often aggregating
different sources of income and tax rates into a handful of
economic and tax sectors. As a result, they implicitly assume that
most taxpayers and sources of income are treated as equivalent in
the U.S. tax code.
Taking such an approach to dynamic analysis is problematic.
Highly aggregated macroeconomic models cannot explicitly account
for the macroeconomic effects of applying different tax rates
and tax credits to different sources of income and income classes.
They also cannot explicitly account for the macroeconomic effects
of changes in the tax code, which create incentives to
reallocate income and resources to tax-favored sectors of the
economy. Accounting for these macroeconomic effects would
require a macroeconomic model that is sufficiently disaggregated to
take as inputs more disparate microsimulation-model estimates of
the revenue, marginal rate, and labor supply effects of tax policy
The JCT disaggregates income--and thus tax rates and
revenues--in its macroeconomic models. For example, the MEG model
includes tax rates for wages and salaries, interest income, rental
income, dividend income, capital gains, proprietors' income, other
individual income, and corporate income. In contrast, in its GE
models, the CBO does much less to disaggregate changes in tax
rates. In general, tax policy changes are summarized using average
effective marginal tax rates on labor and capital income. The JCT
has found that its dynamic estimates of the economic and budget
effects of tax policy changes are sensitive to the degree of
disaggregation included in the macroeconomic model.
In its Mid-Session Review dynamic analysis of the
President's tax proposals, the OTA takes an approach similar to
that of the JCT. The OTA inputs into the TPA model estimated
changes in marginal tax rates on capital gains, dividend income,
wage and salary income, interest income, and business income. A new
Dynamic Analysis Division should continue to disaggregate tax rates
and sources of income in its macroeconomic models.
How should the OTA estimate revenue feedbacks from a tax
policy change? Revenue feedbacks are the additional
tax revenues that will be collected relative to a baseline
forecast. They are the result of the macroeconomic effects of a tax
policy change on federal receipts. Policy analysts can use such
information to gauge the extent to which a tax policy change is
likely to improve the government's finances by generating higher
levels of economic activity, higher incomes, and additional
Disaggregation also has a role to play when estimating
revenue feedbacks. Revenue feedbacks can be calculated as simply
the difference between a dynamic revenue estimate from a
macroeconomic model and a conventional revenue estimate from a
microsimulation model. Alternatively, they can be calculated by
simulating the macroeconomic effects of a change in tax policy and
then updating the microsimulation model to reflect changes in the
forecast levels of incomes and prices.
Calculating revenue estimates using an updated microsimulation
model is potentially important because the microsimulation model
includes a high degree of disaggregation. Thus, the
microsimulation model estimates the change in income tax
payable on a tax return basis. In contrast, a
macroeconomic model can at best estimate a change in aggregate
tax revenues by income source.
In The Heritage Foundation's Center for Data Analysis, we
estimate revenue feedbacks from major changes in the federal
individual income tax using a microsimulation model.
Specifically, we iterate between a microsimulation model of the
federal individual income tax and a macroeconomic model of the
U.S. economy, in our case the Global Insight (GI) model. We update
individual and business incomes in the microsimulation model using
outputs from the GI model. We then use revenue and marginal rates
estimates from the updated microsimulation model to adjust
forecasts from the macroeconomic model so that they better reflect
the effects of the tax proposal. We continue in this way until
differences between the estimated changes in federal individual
income tax revenues in the microsimulation model and federal
personal income tax revenues in the GI model are minimal or can be
accounted for by definitional and other differences in the federal
income tax bases used.
Estimates of revenue feedbacks can be sensitive to how they are
calculated. An analysis of permanently extending some of the 2001
and 2003 tax acts' expiring provisions put revenue feedbacks at
$296.3 billion over 10 years, based on a comparison of the dynamic
revenue estimate from the macroeconomic model and the conventional
revenue estimate from the microsimulation model. A comparison of
the dynamic revenue estimate obtained by iterating between the
macroeconomic and microsimulation models and the conventional
revenue estimate put revenue feedbacks at $295.5 billion--a
difference of less than $1 billion over 10 years.
This difference was more substantial in a dynamic analysis of a
flat-tax plan that broadened the personal and corporate income tax
bases. A comparison of the dynamic revenue
estimate from the macroeconomic model and the conventional
revenue estimate put revenue feedbacks at $968.2 billion over
10 years. A comparison of the dynamic revenue estimate obtained by
iterating between the macroeconomic and microsimulation models and
the conventional revenue estimate put revenue feedbacks at $768.1
billion. Thus, accounting for disaggregation by taking
estimates of the change in federal individual income taxes from the
microsimulation model reduced revenue feedbacks by about $200
What kinds of dynamic estimates should the OTA provide?
Tax proposals can include individual provisions that affect
the economy in different ways. Dynamic analysis should help
policymakers identify the macroeconomic and dynamic revenue effects
of a proposal's key provisions.
Such an approach to dynamic analysis is not the norm. The JCT
has typically analyzed proposed changes in current tax law only in
aggregate. The CBO lumps all proposed changes in taxes and
spending into a single package in its annual dynamic analysis of
the President's budget.
However, for the FY 2007 Mid-Session Review, the OTA
decomposed the President's proposal to extend permanently some of
EGTRRA's and JGTRRA's expiring provisions into three separate
components. The OTA first did a dynamic analysis of only a
permanent extension of JGTRRA's preferential rates on capital
gains and dividend income. It then layered onto that a dynamic
analysis of an extension of EGTRRA's lower marginal rates on
ordinary income. Finally, the OTA performed a dynamic analysis of a
package that included not just EGTRRA's and JGTRRA's lower rates on
capital gains, dividend income, and ordinary income, but also
EGTRRA's provisions primarily affecting after-tax income.
Treasury could build on this approach. A new Dynamic Analysis
Division could evaluate and rank individual provisions of proposed
changes in current tax law by their effects on key economic
indicators like GDP, labor, capital, investment, and
consumption. The choice of economic indicator could vary with the
objective of either the individual provision or the proposal
in aggregate--e.g., a short-run aggregate-demand stimulus or a
long-run increase in labor and capital. The ranking of the
provision could vary with assumptions made about monetary and
A new Dynamic Analysis Division could also rank individual
provisions on the basis of their revenue effects. The OTA's
dynamic analysis for the FY 2007 Mid-Session Review focused
only on the macroeconomic effects of the President's tax
proposals. However, the CBO and the JCT already regularly translate
the macroeconomic effects of tax proposals into revenue
feedbacks. Treasury could use estimates of economic outcomes
from its macroeconomic models to produce similar measures of
the dynamic budget effects of key provisions of proposed
changes in tax policy.
A Dynamic Analysis Division in the OTA could build on and expand
work already underway at the CBO and the JCT. It could enhance both
the budget process and our understanding of the interactions of
taxes and the macroeconomy by:
- Maintaining the mix of macroeconomic models needed to
analyze a variety of proposed changes in tax policy (e.g., tax
policy changes meant to stimulate consumption or investment in the
short run and tax policy changes meant to increase the supply of
labor or capital in the long run);
- Exploring the extent to which disaggregation influences
estimates of the macroeconomic and dynamic revenue effects of a tax
policy change; and
- Reporting the macroeconomic and dynamic revenue effects
of the important provisions of proposed changes in tax policy.
However, the Treasury Department is unlikely to undertake this
work without congressional approval of funding for a Dynamic
Analysis Division. With not many days remaining before this
Congress adjourns, time is running out.
Tracy L. Foertsch, Ph.D.,
is a Senior Policy Analyst in the Center for Data Analysis at
The Heritage Foundation.
Thus, conventional revenue estimates may
include shifts between business sectors and entity forms and in the
timing of transactions and income recognition.
Joint Committee on Taxation, U.S. Congress, Joint Committee on
Taxation Tax Modeling Project and 1997 Tax Symposium Papers,
JCS-21-97, November 20, 1997, at www.house.gov/jct/s-21-97.pdf (December 1,
Congressional Budget Office, An Analysis of the President's
Budgetary Proposals for Fiscal Year 2004, March 2003, at www.cbo.gov/ftpdocs/41xx/doc4129/03-31-AnalysisPresidentBudget-Final.pdf
(December 1, 2006). Prior to March 2003, the CBO's annual analysis
of the President's budget did not include a chapter on the
macroeconomic effects of the President's budget proposals.
example, see Joint Committee on Taxation, U.S. Congress,
Macroeconomic Analysis of Various Proposals to Provide $500
Billion in Tax Relief, JCX-4-05, March 1, 2005, at www.house.gov/jct/x-4-05.pdf (July 31,
2006), and Exploring Issues in the Development of
Macroeconomic Models for Use in Tax Policy Analysis, JCX-19-06,
June 16, 2006, at www.house.gov/jct/x-19-06.pdf (December 1,
2006). See also Rosanne Altschuler, Nicholas Bull, John Diamond,
Tim Dowd, and Pamela Moomau, "The Role of Dynamic Scoring in the
Federal Budget Process: Closing the Gap Between Theory and
Practice," American Economic Review, Vol. 95, No. 2 (May
2005), pp. 432-436, and Joint Committee on Taxation, U.S. Congress,
Overview of Work of the Staff of the Joint Committee on Taxation
to Model the Macroeconomic Effects of Proposed Tax Legislation to
Comply with House Rule XIII.3.(h)(2), JCX-105-03, December 22,
2003, at www.house.gov/jct/x-105-03.pdf (December 1,
example, see Congressional Budget Office, "How CBO Analyzed the
Macroeconomic Effects of the President's Budget," July 2003, at
(May 16, 2006), and Robert Dennis et al.,
"Macroeconomic Analysis of a 10-Percent Cut in Income Tax
Rates," Congressional Budget Office Technical Paper 2004-07,
May 2004, at www.cbo.gov/ftpdocs/54xx/doc5485/2004-07.pdf
(July 31, 2006).
President's Advisory Panel on Federal Tax Reform, Simple, Fair,
and Pro-Growth: Proposals to Fix America's Tax System, November
2005, pp. 224-225, at www.taxreformpanel.gov/final-report
(December 1, 2006).
Office of Management and Budget, Mid-Session Review, Budget of
the United States Government, Fiscal Year 2007
(Washington, D.C.: U.S. Government Printing Office, 2006),pp.
3-4, at www.whitehouse.gov/omb/budget/fy2007/pdf/07msr.pdf
(December 1, 2006). In July 2006, the OTA released a separate
report giving a detailed description of the dynamic analysis
included in the fiscal year 2007 Mid-Session Review. See
U.S. Department of the Treasury, Office of Tax Analysis, "A Dynamic
Analysis of Permanent Extension of the President's Tax Relief,"
July 25, 2006, at www.treasury.gov/press/releases/reports/treasurydynamicanalysisreporjjuly2520
06.pdf (December 1, 2006).
Treasury Department used only the TPA model in its recent dynamic
analysis of extending EGTRRA's and JGTRRA's expiring provisions.
However, it has used the MA model to estimate the economic effects
of tax relief passed in 2001, 2002, and 2003.
See also Altschuler et al., "The Role
of Dynamic Scoring in the Federal Budget Process."
For additional details, see Tracy L. Foertsch
and Ralph A. Rector, "Calibrating Macroeconomic and Microsimulation
Models to CBO's Baseline Projections," The IRS Research
Bulletin: Recent Research on Tax Administration and Compliance,
Publication 1500, forthcoming 2007. A more detailed working-paper
version is available upon request.
See Tracy L. Foertsch and Ralph A. Rector, "A
Dynamic Analysis of Permanently Extending EGTRRA and JGTRRA: An
Application of a Coordinated Calibration of Macroeconomic and
Microsimulation Models," The 15th Federal Forecasters
Conference--2006: Papers and Proceedings, forthcoming
2007. For a longer working-paper version of this publication, see
Tracy L. Foertsch and Ralph A. Rector, "A Dynamic Analysis of the
2001 and 2003 Bush Tax Cuts: Applying an Alternative Technique for
Calibrating Macroeconomic and Microsimulation Models," Heritage
Foundation Center for Data Analysis Report No. CDA06-10,
November 22, 2006, at www.heritage.org/Research/Taxes/upload/CDA_06-10.pdf
(November 27, 2006).
See Tracy L. Foertsch and Ralph A. Rector,
"Economic and Budget Effects of a Two-Period Revenue Neutral Flat
Tax," unpublished working paper, August 2006.
Two separate tax models were actually used in
this analysis: a microsimulation model of the federal individual
income tax and a corporate income tax calculator. Just a little
under $110 billion separated the dynamic estimate of corporate
income tax revenues obtained from the macroeconomic model and the
income-adjusted estimate of corporate income tax revenues obtained
by iterating between the macroeconomic model and the corporate tax
calculator. A little over $200 billion separated the dynamic
estimate of personal income tax revenues obtained from the
macroeconomic model and the income-adjusted estimate of individual
income tax revenues obtained by iterating between the macroeconomic
and microsimulation models.