The Economic Growth and Tax Relief Act of 2001 (H.R. 3) recently introduced by Representative William Thomas (R-CA) would enact the federal income tax rate reductions that President George W. Bush submitted to Congress on February 8 and make the rate change retroactive. It would reduce the current five income tax rate brackets (15 percent, 28 percent, 31 percent, 36 percent, and 39.6 percent) to four lower tax brackets of 10 percent, 15 percent, 25 percent, and 33 percent.1 While most of the reductions in the tax brackets are to be implemented between 2002 and 2006, H.R. 3 would reduce the 15 percent tax bracket to 12 percent retroactive to January 1, 2001.2 H.R. 3 also would repeal the alternative minimum tax (AMT) provisions that offset the refundable child credit and earned income credit. This analysis presents the effects of H.R. 3 on the U.S. economy.
Economists generally view tax rate reduction as one of the most important steps government can take to support greater levels of economic activity. Reductions in tax rates usually mean that the labor and capital costs of goods and services fall because the tax portion of wages and interest is lower. These lower costs enable businesses to implement new production techniques, encourage customers to increase their consumption of goods, and stimulate Americans to devote more of their time to paid work rather than leisure. Economic theory predicts that the responses to lower tax rates will raise economic output and long-term economic growth.3
While H.R. 3 does not directly reduce the tax rates on capital, it significantly lowers tax rates on labor income. How will the economy respond to these lower rates, and how will this response affect the net or dynamic "cost" of this tax policy change?
To answer these questions, Heritage economists used WEFA's U.S. Macroeconomic Model to conduct a dynamic simulation of the legislation.4 Heritage economists reconstructed WEFA's December 2000 long-term model to embody the economic and budgetary assumptions published by the Congressional Budget Office (CBO) in January 2001. These are the same economic assumptions that Congress adopts when it frames and passes its annual budget resolution. This specifically adapted model then uses CBO budget assumptions to produce dynamic simulations of policy changes.
The Joint Committee on Taxation preliminarily estimated the static tax revenue reduction of H.R. 3 to be $948 billion from fiscal year (FY) 2001 to FY 2011.5 This estimate, however, is misleading because it does not recognize likely economic responses to the policy change and the expanded pool of taxable income produced by greater economic activity. Heritage's dynamic analysis, by comparison, suggests that H.R. 3 would reduce federal revenue by just $634 billion from FY 2001 to FY 2011. The difference of $314 billion over 11 years between the static and dynamic estimates results from the increased economic activity and higher employment growth that H.R. 3's tax rate reductions would help produce.
Increase economic growth. By the end of FY 2011, gross domestic product (GDP), adjusted for inflation, would be $137 billion higher than the CBO baseline forecast without the tax policy change. The rate of economic growth would increase by an average of 0.1 percentage point per year (from 3.0 percent to 3.1 percent) from FY 2001 to FY 2011.
Create more job opportunities. As Chart 1 shows, 917,000 more Americans would be working at the end of FY 2011, compared with the CBO baseline forecast. Moreover, the unemployment rate would average just 4.7 percent instead of 4.9 percent from FY 2001 to FY 2011.
Increase family income. By the end of FY 2011, real disposable personal income (or income after taxes adjusted for inflation) for a family of four would increase by $2,624.6 (See Chart 2.) In response to this increase in family budgets, consumer spending would rise by $149 billion, or $1,984 for each family of four.
Increase family savings. By the end of FY 2011, a family of four would be able to save $556 more (adjusted for inflation) than the CBO baseline forecast.7 This higher level of personal savings is reflected in a higher savings rate, which on average is 0.6 percentage point above the baseline forecast of the CBO without the tax policy change.
Increase investment. Investment (adjusted for inflation) would increase by an average of $25 billion per year from FY 2001 to FY 2011. By the end of FY 2011, the net capital stock would be $170 billion higher.
Slightly increase inflation. Stronger economic growth would raise the average rate of inflation from 2.6 percent to 2.7 percent per year between FY 2001 and FY 2011. However, average inflation would be lower than it was during the 1990s (2.9 percent) and significantly lower than the 3.4 percent rate of inflation last year.
- Modestly raise Treasury bond rates. Under H.R. 3, 10-year Treasury bond rates would increase by an average of 0.3 percentage point per year (from 5.6 percent to 5.9 percent) between FY 2001 and FY 2011.8 However, the average 10-year Treasury bond rate would be lower than it was during the 1990s (6.7 percent) and last year (6.0 percent).
Reduce federal tax revenue by $634 billion from FY 2001 to FY 2011. This reduction in federal taxes would be a substantial amount of tax relief for families, and the share of GDP taken by federal taxes would fall from 20.6 percent in FY 2001 to 19.6 percent in FY 2011.
Produce a positive economic "feedback" for the Treasury. Static estimates that do not account for the tax relief's influence on the economy suggest that H.R. 3 would decrease revenues to the federal Treasury by $948 billion over 11 years.9 However, a more dynamic analysis using the WEFA model suggests that because the tax relief would increase economic growth and employment, the larger tax base would generate $314 billion in tax revenue that is unaccounted for in a static analysis. In other words, when the tax relief's effect on economic performance is taken into account, the actual loss to the Treasury is just 67 percent of the purely static reduction in tax revenues over 11 years.
Increase federal net interest payments by $169 billion from FY 2001 to FY 2011. Total federal spending would rise by $218 billion because of the higher interest payments, higher outlays for the refundable earned income credit and child credit,10 and slightly higher inflation adjustments to other federal spending.
Reduce the federal surplus by $852 billion from FY 2001 to FY 2011. Even with this reduction, the total surplus would surpass $5 trillion from FY 2001 to FY 2011. Moreover, because employment and payroll tax revenue will rise, the Social Security surplus would increase by $53 billion, making more resources available over the next 11 years to reform the program.
Effectively pay off the federal debt. H.R. 3 would decrease federal debt to the lowest possible level that can be redeemed--$818 billion in FY 2011.11 (See Chart 3.) From FY 2001 to FY 2011, federal debt as a percentage of GDP would decline from 30.5 percent to just 4.7 percent.
- Accumulate over $2.3 trillion in uncommitted funds.12 Without any tax relief, the federal Treasury will likely accumulate $3.2 trillion in excess taxes and interest over the next 10 years.13 (See Chart 3.) With the substantial tax relief contemplated by H.R. 3, this amount would decline by $817 billion. The remaining funds will have to be invested with banks and the Federal Reserve or in some other private-sector asset, or they could be used to reform Social Security.
SUBSTANTIAL TAX RELIEF BY STATE
As Table 1 shows, the $948 billion in static tax relief over the next 11 years would be felt differently by each state. The two largest determinants of which states would benefit the most from H.R. 3 are population size and the amount of income taxes paid by the state. California would receive the largest share of tax relief under H.R. 3: $105 billion from FY 2001 to FY 2011, or $9.5 billion per year for the next 11 years. New York ($88.6 billion), Texas ($59 billion), Illinois ($56 billion), and Pennsylvania ($45 billion) round out the top five states.
Small states would also receive substantial tax relief. For example, taxpayers in Delaware would receive $3.8 billion in tax relief over the next 11 years, or $345 million per year. The residents of Maine ($2.8 billion), Montana ($1.8 billion), South Dakota ($1.7 billion), North Dakota ($1.6 billion), and Vermont ($1.5 billion) would receive between $136 million and $254 million in tax relief per year.
A dynamic analysis of H.R. 3 shows that it will boost economic activity, create 917,000 new jobs, and strengthen the incomes of taxpayers. The plan reduces excess tax revenue and effectively pays off the publicly held federal debt by FY 2009. Real (or inflation-adjusted) economic growth, which has recently declined sharply from its level of just six months ago, would rise an average of $77 billion per year from FY 2001 to FY 2011. On average, a family of four's after-tax budget would increase by $2,624, leading to an increase in consumption and saving. Spending on everything from health care to school clothes would rise by an average of $90 billion, and savings would increase by an average of $48 billion.
D. Mark Wilson was a Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation. William W. Beach is Director of, and Rea S. Hederman is Manager of Operations for, the Center for Data Analysis at The Heritage Foundation.
First, preliminary static tax revenue estimates for H.R. 3 were obtained from the Joint Committee on Taxation (JCT).14 The JCT tax revenue estimates are based on a static methodology that does not account for macroeconomic effects of a reduction in tax rates.15 These effects include changes in the gross domestic product (GDP), interest rates, employment, personal income, and inflation that can significantly affect tax revenues. Thus, static estimates provide a very limited analysis of the economic and budgetary impact of any policy change. To forecast the change in federal tax revenue, spending, and the economy more accurately, a dynamic model must be used.
The JCT's preliminary $958 billion static tax reduction estimate includes $10 billion in higher federal spending that results from the repeal of alternative minimum tax (AMT) provisions that offset the refundable child credit and earned income credit. Heritage economists separated the $948 billion in actual tax reductions from the $10 billion in higher federal outlays to model the proposed legislation more accurately.16
The second step was to introduce the static revenue and outlay changes into the WEFA U.S. Macroeconomic Model. The WEFA model is a dynamic model of the U.S. economy that is designed to estimate how the general economy is reshaped by policy reforms, such as tax law and spending changes. Heritage economists have developed a revised WEFA model for The Heritage Foundation that embodies the economic and budgetary assumptions published by the CBO in January 2001. This specifically adapted WEFA model produces dynamic responses from the CBO baseline as a result of proposed policy changes.
The WEFA model contains a number of variables that are used to simulate proposed policy changes. The following sections briefly describe how the Heritage analysts introduced the static revenue and outlay estimates into the WEFA model to estimate the dynamic economic and budget results.
The WEFA model contains a variable that measures the total amount of all federal taxes on individual income as a percentage of the nominal personal income tax base. Heritage economists adjusted this average effective tax rate downward for each of the forecast years to reflect the static tax revenue decrease estimates.
The WEFA model contains a number of federal transfer variables for programs such as Social Security and unemployment insurance. Heritage economists adjusted the variable for other federal transfer payments for each of the forecast years to reflect the static outlay increase estimates.
Small adjustments were made in the model's exogenous labor force participation rate and in the number of hours worked to account for the dynamic effects of decreasing marginal income tax rates.
The business sector price index was reduced to reflect the lower tax rates on business income that would be reported on personal income tax forms. These adjustments are based on previous research conducted by Heritage economists.
The model assumes that the Federal Reserve Board will react to this policy change as it has historically. This assumption was embodied in the Heritage model simulation by including the stochastic equation in the WEFA model for monetary reserves.
How H.R. 3, The Economic Growth and Tax Relief Act of 2001, Would Affect Selected Economic Indicators
Click on tables to enlarge.
3. For more on how the U.S. economy has responded to rate reductions in the past 50 years, see William W. Beach, Daniel J. Mitchell, Ph.D., and D. Mark Wilson, "How Faulty Official Figures Greatly Overstate the Cost of the Bush Tax Plan," Heritage Foundation Backgrounder No. 1416, March 6, 2001.
4. The Center for Data Analysis at The Heritage Foundation used the Mark 11 U.S. Macro Model of WEFA, Inc., formerly Wharton Econometric Forecasting Associates, to conduct this analysis. The model was developed in the late 1960s by Nobel Prize-winning economist Lawrence Klein and several of his colleagues at the Wharton Business School of the University of Pennsylvania. It is widely used by Fortune 500 companies, prominent federal agencies, and economic forecasting departments. The methodologies, assumptions, conclusions, and opinions herein are entirely the work of Heritage Foundation analysts. They have not been endorsed by, and do not necessarily reflect the views of, the owners of the model.
5. Joint Committee on Taxation, "Estimated Revenue Effects of the Economic Growth and Tax Relief Act," prepared for Representative William Thomas, February 28, 2001. The JCT billion tax reduction estimate is actually $958.2 billion, which includes $947.7 billion in tax reductions and $10.5 billion in higher federal spending that results from repeal of the AMT provisions that offset the refundable child credit and earned income credit.
8. Because of lower unemployment, an increase in the demand for money, and the Federal Reserve Board's assumed reaction to higher levels of economic activity, the plan also would increase short-term interest rates.
10. See footnote 5. The Earned Income Credit (EIC) program is the second largest federal welfare-spending program for low-income families after Medicaid. In 1997, it provided $23.9 billion in direct welfare payments to 13.2 million families with incomes below $25,000. It is often referred to as a tax credit only because the program is administered through the federal income tax system and a small portion of it is used to offset the federal income tax liability of some families. However, the refundable portion of the EIC (80.2 percent) is considered to be a welfare-spending program. To the extent that the EIC is mistakenly viewed as an offset to payroll taxes, it would more than completely offset federal income and payroll taxes for the group of families with incomes of $16,500 or less.
11. This amount reflects publicly held debt. Net federal debt equals publicly held debt less uncommitted funds. Both the CBO and the Office of Management and Budget estimate that regardless of the size of the surpluses over the next 10 years, some debt will remain outstanding and incur interest costs. The CBO estimates that in FY 2011, $818 billion in publicly held federal debt cannot be paid because it consists of long-term bonds and savings bonds that will not be available for redemption.
12. "Uncommitted funds" is the term the CBO uses to describe the surplus tax revenue that accumulates because it cannot be used to redeem federal debt (see footnote 11). The CBO assumes that this cash will be invested, possibly in the private market, and earn a rate of return equal to the average rate projected for Treasury bills and notes.
13. Peter B. Sperry, "Growing Surplus, Shrinking Debt: The Compelling Case for Tax Cuts Now," Heritage Foundation Backgrounder No. 1408, February 7, 2001.
15. While the JCT's estimates for changes in tax law reflect some behavioral responses, they do not reflect possible changes in macroeconomic variables. For example, while the JCT would take into account how tax changes increase the amount of itemized deductions or shift compensation from taxable to tax-exempt or tax-deferred forms, it does not take into account how tax changes would affect work effort and saving, which could affect gross domestic product.