If Congress does not act soon, millions of taxpayers will see
their tax bills rise after 2010 as key provisions of the 2001 and
2003 tax acts expire. Worse still, millions more Americans will
experience a slower economy and slimmer job prospects as the
economy adjusts to the higher tax burden on labor and capital
While policymakers are getting more and more insight into how
revenues will change when the Bush tax cuts expire, they appear to
have little sense of how revenues and the economy would likely
react if the tax cuts were extended. This paper summarizes recent
research by the Center for Data Analysis on this question.
Between 2011 and 2016, extending the tax cuts would likely,
relative to the current-law baseline:
- Raise real gross domestic product (GDP) by an average of over
$75 billion annually, and by nearly $100 billion in 2012;
- Add an average of 709,000 jobs annually, and roughly 900,000 in
- Lower the unemployment rate, which means that about 270,000
unemployed workers in 2012 alone would find jobs; and
- Increase real personal income by an average of almost $200
Estimating the Economic and Fiscal
Effects of Extending the Tax Cuts
For the fourth year in a row, President George W. Bush's budget
calls for extending expiring tax provisions. The most significant
are the major provisions of two tax laws: the lower marginal tax
rates on ordinary income enacted under the 2001 Economic Growth and
Tax Relief Reconciliation Act (EGTRRA) and the preferential rates
on individual net capital gains realizations and dividend income
enacted under the 2003 jobs and Growth Tax Relief Reconciliation
Act (JGTRRA). The President's budget also proposes temporarily
raising the alternative minimum tax (AMT) exemption amount and
continuing the AMT's unrestricted use of some nonrefundable
personal tax credits. Without such an AMT fix, extending EGTRRA
and JGTRRA would spur significant growth in the number of taxpayers
subject to the AMT.
This paper summarizes an analysis of the economic and budgetary
effects of permanently extending certain key provisions of EGTRRA
and JGTRRA. The extension plan considered is similar to that
included in every budget proposed by the President since JGTRRA was
signed into law in 2003. It would extend:
- JGTRRA's preferential tax rates on individual capital gains and
- EGTRRA's lower marginal tax rates on ordinary income, and
- EGTRRA's provisions raising after-tax income.
Those provisions include the $1,000 child tax credit, repeal of
the phase out of itemized deductions and personal exemptions, and
marriage penalty relief. The extension plan reduces marriage
penalties by raising the standard deduction and widening the
15-percent tax bracket for married couples filing a joint
This analysis uses the Center for Data Analysis's
microsimulation model of the federal individual income tax and the
Global Insight (GI) short-term U.S. Macroeconomic Model to analyze the
economic and budgetary effects of the extension plan. Those effects
are measured against the Congressional Budget Office's (CBO's)
January 2006 baseline projections, which assume current-law tax
is, the CBO projects GDP, prices, individual and corporate income,
federal tax revenues, and net federal saving, among other economic
and budget variables, over the 10-year budget period assuming that
JGTRRA's preferential tax rates on capital gains and dividends
expire in 2008 and EGTRRA's lower marginal rates on
ordinary income expire in 2010. As a result, the CBO projects a
sharp increase in federal income tax revenues and some slowdown in
economic activity after 2010.
When compared to the CBO's baseline projections, this analysis
indicates that permanently extending certain provisions of EGTRRA
and JGTRRA would boost economic activity. Between 2011 and 2016,
real (inflation-adjusted) GDP would be, on average, over 0.5
percent higher. Individual incomes and the federal personal income
tax base would also expand, helping to reduce the cost of the
extension plan to the Treasury.
Macroeconomic (Dynamic) Economic
Effects of the Extension Plan
Table 1 summarizes the macroeconomic effects of the extension
plan. Between 2011 and 2016, total employment expands by an average
of over 700,000 jobs annually, and the unemployment rate drops an
average of 0.1 percentage points. That drop in the unemployment
rate occurs despite an increase in the rate of labor force
participation spurred by lower marginal tax rates on labor income.
Over the same period, real disposable income rises by an average of
nearly $200 billion annually, and personal saving climbs
sufficiently to push the personal saving rate 0.8 percentage points
above the baseline level.
Permanently extending JGTRRA's preferential rates on capital
gains and dividend income permanently reduces the cost of capital
to business. Real, non-residential fixed investment responds
positively, climbing an average of nearly $9 billion annually
between 2011 and 2016. The economy's stock of productive capital is
bolstered as a result, and real potential GDP expands in every
quarter between 2009 and 2016. Reflecting that increase in the
economy's productive potential, real GDP exceeds the CBO's January
2006 baseline projections by $60.2 billion by 2016.
Making the tax cuts permanent avoids the disincentive effects on
working, saving, and investing that would arise from higher taxes
after 2010. The CDA simulation shows that the greatest positive
effects of permanent extension come from lowering marginal tax
rates on capital gains, dividend income, and ordinary income. Permanently
extending the $1,000 child tax credit, repeal of the phase out of
itemized deductions and personal exemptions, and marriage penalty
relief also has some effect on economic activity. However, they
tend to do so by increasing after-tax incomes.
In general, tax relief measures that reduce marginal tax rates
on capital and labor income will produce bigger gains in GDP than
measures that only tinker with the size of after-tax income. This
is because cuts in marginal tax rates both increase the after-tax
wage rate and lower the cost of capital. They therefore tend to
encourage individuals to work more and businesses to invest.
Increases in labor supply, saving, and the domestic capital stock
New or bigger personal deductions and tax credits typically do
not have the same incentive effects. They do little to spur
employment or new business investment. And they boost after-tax
incomes, not after-tax wage rates. Thus, individuals can increase
or even maintain the same level of after-tax income by working the
same or fewer hours.
Two additional factors mitigate the economic benefits of the
extension plan. First, in the simulations, rising output and
falling rates of unemployment prompt the Federal Reserve to
increase the federal funds rate despite little change in the rate
of CPI inflation. Yields on Treasury notes and bills and on
corporate and other debt rise as a result, increasing the cost of
capital to business. Second, the ever-expanding reach of the AMT
nearly halves the size of the tax reduction under the extension
plan, reducing gains in personal disposable income, personal
consumption, and saving. It also boosts the average effective
marginal tax rate on ordinary income, in some cases offsetting
incentives for supplying more labor.
Dynamic Budgetary Effects of the
Extending EGTRRA's and JGTRRA's expiring provisions has a
positive effect on U.S. GDP, incomes, and employment over the
10-year budget period. It also generates substantial revenue
feedbacks ($295.5 billion). Ignoring the macroeconomic effects of
the extension plan on individual, non-corporate business, and
corporate incomes puts federal tax revenues $991.9 billion below
the CBO's projected baseline levels over 10 years. Taking the
dynamic effects of the extensions into account reduces the
estimated revenue loss to the Treasury to $696.4 billion over 10
2009 and 2010, dynamic revenue feedbacks do not exceed about $9
billion. But they more than treble in size in each of the final 6
years, reaching $56 billion in 2016.
The estimated change in federal income tax revenues would be
significantly higher if not for the AMT. The extension plan does
not include a permanent increase in the AMT exemption amount or
indexation of the AMT brackets to inflation. Without these, an ever
larger number of middle-to-upper-income taxpayers will fall prey to
With no change in current law, EGTRRA's lower marginal rates on
ordinary income and JGTRRA's preferential rates on individual net
capital gains realizations and dividend income will expire at the
end of 2010. Extending these provisions would boost U.S. GDP,
employment, incomes, and federal tax collections over the 10-year
budget period. However, the President's fiscal year 2008 budget
includes only a one-year extension of AMT relief for individuals.
The AMT's expanding reach partially offsets simulated economic
gains from the extension plan.
L. Foertsch, Ph.D., is a Senior Policy Analyst and Ralph A.
Rector, Ph.D., is a Senior Research Fellow and Project Manager
in the Center for Data Analysis at The Heritage Foundation.
 The analysis
and conclusions presented here are discussed in greater detail in a
November 2006 Center for Data Analysis Report. See Tracy L.
Foertsch and Ralph A. Rector, "A Dynamic Analysis of the 2001 and
2003 Bush Tax Cuts: Applying Alternative Techniques 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/cda06-10.cfm.
That Report is an expanded version of a methodological paper
prepared for the 2006 Federal Forecasters Conference, held in
Washington, D.C., on September 28, 2006.
additional details, see U.S. Department of the Treasury, General
Explanations of the Administration' s Fiscal Year 2008 Revenue
Proposals, February 2007, at .
See also U.S. Department of the Treasury, General Explanations
of the Administration' s Fiscal Year 2007 Revenue Proposals,
February 2006, at
extension plan analyzed is also similar to one considered by the
Treasury Department' s Office of Tax Analysis (OTA) in a July 2006
dynamic analysis of the President' s fiscal year (FY) 2007 tax
relief proposals. 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 .
The OTA analysis does not include permanent repeal of the estate
tax. For comparison purposes, this analysis also excludes permanent
repeal. However, permanently repealing the estate tax would provide
a further boost to the economy. See Alfredo Goyburu, "The Economic and Fiscal
Effects of Repealing Federal Estate, Gift, and Generation-Skipping
Taxes," Center for Data Analysis Report No. CDA02-08,
November 15, 2002, at www.heritage.org/Research/Taxes/CDA02-08.cfm.
additional information on EGTRRA' s expiring provisions, see Joint
Committee on Taxation, "Summary of Provisions Contained in the
Conference Agreement for H.R. 1836, The Economic Growth and Tax
Relief Reconciliation Act of 2001," JCX-50-01, May 26, 2001, at
 The Global
Insight model is used by private-sector and government economists
to estimate how changes in the economy and public policy are likely
to impact major economic indicators. The methodologies,
assumptions, conclusions, and opinions presented here are entirely
the work of analysts at The Heritage Foundation' s Center for Data
Analysis. They have not been endorsed by, and do not necessarily
reflect the views of, the owners of the Global Insight model.
 CBO' s
baseline projections also embody the rules and conventions
governing a current-services federal budget. Thus, the CBO projects
GDP, prices, individual and corporate income, net federal saving,
and other variables over the 10-year period assuming the
continuation of current levels of federal spending. For additional
details on the CBO' s January 2006 baseline projections, see
Congressional Budget Office, "The Budget and Economic Outlook:
Fiscal Years 2007 to 2016," January 2006, at .
For a discussion of the CBO' s current-law federal budget baseline,
see Christopher Williams, "What Is a Current-Law Economic
Baseline?" Economic and Budget Issue Brief, June 2, 2005, at
 This is
because the Tax Increase Prevention and Reconciliation Act (TIPRA)
of 2005 was not current law at the time the CBO prepared its
January 2006 baseline projections. For additional details on
TIPRA' s provisions, see Joint Committee on Taxation, "Estimated
Revenue Effects of the Conference Agreement for the 'Tax Increase
Prevention and Reconciliation Act of 2005,' " JCX-18-06, May 9,
2006, at . Here, "current law"
refers to current law as defined by CBO in January 2006.
additional details on how this analysis simulates the responses of
labor and investment to permanent extension of EGTRRA' s lower
marginal rates on ordinary income and JGTRRA' s preferential rates
on capital gains and dividend income, see Tracy L. Foertsch and
Ralph A. Rector, "A Dynamic Analysis of the 2001 and 2003 Bush Tax
Cuts: Applying Alternative Techniques for Calibrating Macroeconomic
and Microsimulation Models."
analysis models refundable credits as a change in federal transfer
payments to persons and, thus, a change in federal outlays.
analysis uses an econometrically-estimated reaction function in the
GI model that adjusts the effective interest rate on federal funds
in response to changes in the unemployment rate and the rate of
inflation in the CPI.
additional details on the impact of AMT on average marginal tax
rates and labor supply, see Joint Committee on Taxation, "Present
Law and Background Relating to the Individual Alternative Minimum
Tax," JCX-37-05, May 20, 2005, at .
estimated changes in federal individual income tax revenues exclude
net refundable credits. The dynamic revenue feedback is calculated
as the difference between -$696.4 billion and -$991.9 billion.
example, in 2006, Treasury estimated that with permanent extension
of EGTRRA and JGTRRA and no additional AMT relief, the number of
individual AMT taxpayers would jump from 5.5 million in 2006 to
almost 26 million in 2007 and over 56 million in 2016. See U.S.
Department of the Treasury, Office of Tax Policy, "Tax Relief
Kit-The Toll of Two Taxes: The Regular Income Tax and the AMT,"
2006, at .