Congressional Budget Office

Testimony

CONGRESSIONAL BUDGET OFFICE

SECOND AND D STREETS, S.W.

WASHINGTON, D.C. 20515

Statement of 

Douglas W. Elmendorf 

Director

The Economic Outlook and 

Fiscal Policy Choices

before the 

Committee on the Budget

United States Senate

September 28, 2010

This document is embargoed until it is delivered at 

10:00 a.m. (EDT) on Tuesday, September 28, 2010. 

The contents may not be published, transmitted, or 

otherwise communicated by any print, broadcast, or 

electronic media before that time.

CBO

Chairman Conrad, Senator Gregg, and Members of the Committee, thank you for 

the invitation to testify on the outlook for the economy and the important fiscal 

policy choices facing the nation. 

Summary

This testimony reviews the Congressional Budget Office’s (CBO’s) recent analyses of 

the economic outlook and the potential impact on the economy of various fiscal pol

icy options. It also adds to those analyses by quantifying the economic impact of 

extending some or all of the 2001 and 2003 tax cuts that are scheduled to expire in 

three months.

The Economic Outlook

CBO expects—as do most private forecasters—that the economic recovery will pro

ceed at a modest pace during the next few years. In its projections released in August, 

CBO forecast that, under current laws governing federal spending and revenues, real 

(inflationadjusted) gross domestic product (GDP) would increase by 2.8 percent 

between the fourth quarter of 2009 and the fourth quarter of 2010 and by 2.0 percent 

between the fourth quarters of 2010 and 2011. With economic growth so slow, the 

unemployment rate would remain above 8 percent until 2012 and above 6 percent 

until 2014. Since CBO completed that forecast, the economic data released have been 

weaker than the agency had expected, so if CBO was redoing the forecast today, it 

would project slightly slower growth in the near term.

The pace of recovery since the recession ended in June 2009 and the growth that 

CBO projects for the next few years are anemic relative to the rate of recovery follow

ing previous deep recessions. However, the most recent recession, spurred by a finan

cial crisis, was unlike any this country has seen for a very long time, and there is rea

son to expect that the country’s recovery will also be different from past ones: 

International experience suggests that recoveries from recessions that begin with 

financial crises tend to be slower than average.1

 Following such a crisis, it takes time 

for equity and asset markets to recover, for households to replenish their resources and 

boost their spending, for financial institutions to restore their capital bases, and for 

businesses to regain the confidence required to invest in new plant and equipment. In 

addition, the scheduled increases in taxes and the waning of fiscal policy measures that 

supported the economy earlier in this recovery will hold down spending, especially in 

2011. The weak demand for goods and services resulting from those various factors is 

the primary constraint on economic recovery.

A weak economy has serious social consequences. In addition to the millions of Amer

icans who are officially unemployed, many others are underemployed or have left the 

labor force. Moreover, the unemployment rate has risen disproportionately for men, 

1. See, for example, Carmen Reinhart and Kenneth Rogoff, “The Aftermath of Financial Crises,” 

American Economic Review, vol. 99, no. 2 (May 2009), pp. 466–472.
2

CBO

for lesseducated workers, and for people living in certain states, and long

term unemployment has increased strikingly—to the point that the incidence of 

unemployment lasting longer than 26 weeks is now the highest by far in the past 

60 years. Of course, losing a job often has a significant impact on workers and their 

families, both in the short term and in the long term.

Fiscal Policy Approaches and Long-Term Budgetary Constraints

Policymakers cannot reverse all of the effects of the housing and credit boom, the sub

sequent bust and financial crisis, and the deep recession. However, in CBO’s judg

ment, there are both monetary and fiscal policy options that, if applied at a sufficient 

scale, would increase output and employment during the next few years. Those same 

fiscal policy options would, though, have longerterm economic costs. In particular, 

the cuts in taxes or increases in spending that would provide a shortterm economic 

boost would also increase federal debt. 

Federal debt held by the public is already larger relative to the size of the economy 

than it has been in more than 50 years, and it is headed higher. According to CBO’s 

baseline projections, under current law, debt held by the public would be close to 

70 percent of GDP for most of the coming decade. But other policies could result in 

substantially more debt. For example, if the 2001 and 2003 tax cuts were extended, 

the individual alternative minimum tax (or AMT) was indexed for inflation, and 

future annual appropriations remained the share of GDP that they are this year, the 

deficit in 2020 would equal about 8 percent of GDP, and debt held by the public 

would reach nearly 100 percent of GDP.2

 Such a path for federal debt is clearly 

unsustainable. Persistent deficits and continually mounting debt would crowd out 

growing amounts of private investment, require rising interest payments, restrict the 

ability of policymakers to respond to unexpected challenges, and increase the proba

bility of a sudden fiscal crisis.3

Despite that grim picture, there is no intrinsic contradiction between providing addi

tional fiscal stimulus today, while the unemployment rate is high and many factories 

and offices are underused, and imposing fiscal restraint several years from now, when 

output and employment will probably be close to their potential. What does that 

mean in practice? If taxes were cut permanently, or government spending was 

increased permanently, and no other changes were made to fiscal policy, the federal 

budget would be on an unsustainable path, and the economy would suffer. Even if 

tax cuts or spending increases were temporary, the additional debt accumulated dur

ing that temporary period would weigh on the budget and the economy over time. 

Therefore, if policymakers wanted to achieve both shortterm stimulus and longterm 

sustainability, a combination of policies would be required: changes in taxes and 

2. The baseline projections reflect an assumption that future annual appropriations will be held con

stant in real terms, yielding estimates of discretionary spending that would be low relative to GDP 

by historical standards.

3. Congressional Budget Office, Federal Debt and the Risk of a Fiscal Crisis, Issue Brief (July 27, 2010).
3

CBO

spending that would widen the deficit now but reduce it relative to current baseline 

projections after a few years. Developing such a combination would be feasible but 

not easy.

If policies that widened the deficit in the near term were enacted, observers might 

question whether, when, and how the difficult actions to narrow the deficit later 

would be carried out. The most important uncertainty facing families and businesses 

today is uncertainty about the path of the economy, but uncertainty about govern

ment policies is probably also a drag on businesses’ hiring and investing and perhaps 

on consumer spending as well. The enactment of policies that improved the budget 

outlook beyond the next few years would help to reduce that uncertainty.

CBO’s Analysis of Fiscal Policy Options 

To assist policymakers in their decisions, CBO has quantified the effects that some 

alternative fiscal policy options would have on the economy. In a January 2010 report, 

CBO estimated the effects of a diverse set of temporary policy options.4

 The agency 

reported the results in terms of the twoyear effect on the economy per dollar of total 

budgetary cost, what one might informally call the “bang for the buck.” The overall 

effects of those policies on the economy would depend also on the scale at which they 

were implemented; making a significant difference in an economy with an annual 

output of nearly $15 trillion would involve a considerable budgetary cost. 

CBO’s key conclusions from that analysis are as follows (see Figure 1):

B A temporary increase in aid to the unemployed would have a significant positive 

shortterm effect on the economy per dollar of budgetary cost. Such an increase 

would slightly raise unemployment among the affected individuals, but it would 

also raise people’s spending and thereby increase output and employment in the 

economy overall. 

B A temporary reduction in payroll taxes—especially in the share of taxes paid by 

employers—would also have a significant positive shortterm effect on the econ

omy. This approach would boost output and employment both by increasing 

demand for goods and services and by providing an incentive for additional hiring.

B A number of other temporary policy options, including the expensing of business 

investment and providing aid to states, would have smaller positive shortterm 

effects on output and employment.

4. Congressional Budget Office, Policies for Increasing Economic Growth and Employment in 2010 and 

2011 (January 2010).
4

CBO

Figure 1.

Ranges of Cumulative Effects of Policy Options on 

Employment in 2010 and 2011, Assuming Enactment in 

Early 2010

Source: Congressional Budget Office, Policies to Increase Economic Growth and Employment in 

2010 and 2011 (January 2010).

Note: Estimated as years of full-time-equivalent employment (40 hours of employment per week 

for one year) with the policy option in effect minus years of full-time-equivalent employment 

without the policy option. The total budgetary cost is the amount of tax revenues or budget 

authority over the full duration of the policies’ effects unless otherwise specified.

a. Assumed spending began in March 2010, and no benefit payments would be made after July 

2011.

b. Assumed to be in effect for 2010 only.

c. Assumed to be in effect for 2010 only. Initial reductions in revenues would be nearly fully offset 

by later increases. The policy’s effects were therefore estimated per dollar of the present discounted value of the policy (discounted at businesses’ cost of debt and equity) instead of per 

dollar of total budgetary cost.

d. Assumed budget authority was provided as of April 2010, and timing of spending from new 

funding would follow historical experience.

e. Assumed to extend, through 2011, the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003 that are 

scheduled to expire at the end of 2010, and to provide relief from the individual alternative minimum tax by extending the higher exemption amounts that were in effect in 2009 (indexed for 

inflation) for 2010 and 2011.

Reducing Income Taxes in 2011

Investing in Infrastructure

Providing Aid to States for

Purposes Other

Than Infrastructure

Allowing Full or Partial

Expensing of Investment Costs

Reducing Employers' Payroll Taxes

Increasing Aid to the Unemployed

0 2 4 6 8 10 12 14 16 18 20

Years of Full-Time-Equivalent Employment per

Million Dollars of Total Budgetary Cost

a

b

c

d

d

e
5

CBO

B A temporary increase in infrastructure investment and a temporary acrossthe

board reduction in income taxes would have still smaller shortterm effects on 

output and employment per dollar of budgetary cost.5

In its January study, CBO also explained that those policy actions would lead to the 

accumulation of additional government debt that would reduce income in the longer 

term unless other policies with offsetting effects on future debt were enacted. How

ever, CBO did not quantify those future reductions in income. 

At the request of the Chairman, CBO has now estimated the shortterm and the 

longerterm effects of certain tax policy options being considered by the Congress. In 

particular, CBO studied the effects of extending the 2001 and 2003 tax cuts; extend

ing the higher exemption amounts for the AMT that were in effect in 2009 (adjusted 

for inflation) for 2010 and subsequent years; and reinstating the estate tax, which 

expired completely in 2010, for 2011 and subsequent years at the rates in effect in 

2009 and with the exemption amounts (adjusted for inflation) that applied in 

that year. CBO examined four alternative approaches to making those changes: a 

permanent change affecting all provisions (labeled a “full permanent extension”), a 

permanent change but without extending certain provisions that would apply only to 

highincome taxpayers (labeled a “partial permanent extension”), a change affecting 

all provisions but only through 2012 (“full extension through 2012”), and a change 

through 2012 but without extending certain provisions that would apply only to 

highincome taxpayers (“partial extension through 2012”).

The methodology for this analysis was quite similar to the methodology that CBO 

uses in analyzing the President’s budget each spring. CBO used several models that 

make different simplifying assumptions about people’s behavior. The models used to 

estimate the effects on the economy in 2011 and 2012 focus on the policies’ impact 

on the demand for goods and services, because CBO expects that economic growth in 

the near term will be restrained by a shortfall in demand. All else being equal, lower 

tax payments increase demand for goods and services and thereby boost economic 

activity. In contrast, the models used to estimate the effects on the economy in 2020 

and later years focus on the policies’ impact on the supply of labor and capital, 

because CBO believes that economic growth over that longer horizon will be 

restrained by supply factors. All else being equal, lower tax revenues increase budget 

deficits and thereby government borrowing, which crowds out investment, while 

lower tax rates increase people’s saving and work effort; the net effect on economic 

activity depends on the balance of those forces. Because the responsiveness of people’s

5. CBO focused on the effects of policy options during 2010 and 2011, and most of the acrossthe

board tax cut studied would not occur until halfway through that period. If CBO updated those 

estimates today and examined the impact during the 2011–2012 period, a temporary acrossthe

board reduction in income taxes would have a larger effect per dollar of budgetary cost but would 

still, by that measure, significantly trail most of the other options studied.
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CBO

work effort to changes in their after-tax compensation is uncertain, CBO produced 

estimates based on alternative assumptions about such behavioral responses.6

Notwithstanding CBO’s use of alternative models and assumptions, the actual effects 

of the policy options studied could fall above or below the estimates that CBO 

reports. With that caveat, the key findings are these:

B All four of the options for extending the expiring income tax cuts would raise output, income, and employment during the next two years, relative to what would 

occur under current law (see Figure 2). A full permanent extension or partial permanent extension would provide a larger boost to income and employment in the 

next two years than would a temporary extension, and a full extension would provide a larger boost than would the corresponding partial extension.

B But the effects of those policy options on the economy in the longer term would be 

very different from their effects during the next two years. For some of the options, 

the estimates based on different models and assumptions cover a broad range. Still, 

the estimates indicate that all four of the options would probably reduce income 

relative to what would otherwise occur in 2020 (see Figure 3, which shows the 

averages of the projected changes in GNP across the various models and assumptions). Beyond 2020, and again relative to what would occur under current law, the 

reductions in income from all four of the policy options would become larger. 

Either a full or a partial extension of the tax cuts through 2012 would reduce 

income by much less than would a full or partial permanent extension.

In sum, and as CBO has reported before, permanently or temporarily extending all or 

part of the expiring income tax cuts would boost income and employment in the next 

few years relative to what would occur under current law. However, even a temporary 

extension would add to federal debt and reduce future income if it was not accompanied by other changes in policy. A permanent extension of all of those tax cuts without future increases in taxes or reductions in federal spending would roughly double 

the projected budget deficit in 2020; a permanent extension of those cuts except for 

certain provisions that would apply only to high-income taxpayers would increase the 

budget deficit by roughly three-quarters to four-fifths as much. As a result, if policymakers then wanted to balance the budget in 2020, the required increases in taxes 

or reductions in spending would amount to a substantial share of the budget—and 

without significant changes of that sort, federal debt would be on an unsustainable 

path that would ultimately reduce income. Similarly, even temporary increases in 

government spending would add to federal debt and reduce future income, and 

6. CBO’s models incorporate different magnitudes of the responsiveness of saving to changes in the 

return on saving, but CBO did not produce explicit sensitivity analyses of the effect of variations in 

this parameter. 
7

CBO

Figure 2.

Ranges of Effects of Four Tax Policy Options on 

Real GNP in 2011 and 2012

Source: Congressional Budget Office.

Note: Estimated as gross national product adjusted for inflation (real GNP) with the policy option in 

effect relative to real GNP without the policy option.

a. This option would extend the provisions of the Economic Growth and Tax Relief Reconciliation 

Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003 that are scheduled to 

expire at the end of 2010; extend the higher exemption amounts from the individual alternative 

minimum tax that were in effect in 2009 (adjusted for inflation) for 2010 and subsequent years; 

and reinstate the estate tax—which expired completely in 2010—for 2011 and subsequent 

years at the rates in effect in 2009 and with the exemption amounts (adjusted for inflation) that 

applied in that year.

b. This option is the same as the full extension, except that certain provisions would expire that 

would otherwise have applied to married couples with income of $250,000 or more and single 

taxpayers with income of $200,000 or more. Those provisions include the lower tax rates in the 

top two income tax brackets, the lower 15 percent tax rates on capital gains and dividends, and 

the elimination of the phaseout of itemized deductions and personal exemptions.

c. This option would make the same changes as the full extension, but through 2012 rather than 

permanently.

d. This option would make the same changes as the partial extension, but through 2012 rather 

than permanently.

Partial Extension, Through 2012

Full Extension, Through 2012

Partial Extension, Permanent

Full Extension, Permanent

0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0

Percent of Real GNP

2011

2012

a

b

c

d
8

CBO

Figure 3.

Effects of Four Tax Policy Options on Real GNP in 2020

Source: Congressional Budget Office.

Note: Estimated as gross national product adjusted for inflation (real GNP) with the policy option in 

effect minus real GNP without the policy option. Based on the average of four estimates of 

effects from a life-cycle model, which accounts for additional policy changes needed to put 

fiscal policy on a sustainable path in the long run, and two estimates of effects from a “textbook” growth model, without additional policy changes. Averages are reported to the nearest tenth. Weak and strong labor responses correspond to the responsiveness of hours 

worked to changes in the effective marginal tax rate on labor income. For a description of 

the tax policy options, see the notes to Figure 2.

permanent large increases in spending that were not accompanied by other spending 

reductions or tax increases would put federal debt on an unsustainable path. Com

pared with the options examined here for extending the expiring tax cuts, various 

other options for temporarily reducing taxes or increasing government spending 

would provide a bigger boost to the economy per dollar of cost to the federal 

government.

The Economic Outlook

Growth in the nation’s output since mid2009 has been anemic in comparison with 

that of previous recoveries from deep recessions, and the unemployment rate has 

remained quite high, standing at 9.6 percent in August. That weak performance 

reflects several factors that are likely to remain in place over the next few years. The 

considerable number of vacant houses and underused factories and offices will be a 

continuing drag on residential construction and business investment. In addition, 

although conditions in financial markets have improved markedly from what they 

were in the depths of the recent crisis, households’ wealth remains below prerecession 

Partial Extension, Through 2012

Full Extension, Through 2012

Partial Extension, Permanent

Full Extension, Permanent

-2.0 -1.8 -1.6 -1.4 -1.2 -1.0 -0.8 -0.6 -0.4 -0.2 0

Percent of Real GNP

Weak Labor Response

Strong Labor Response
9

CBO

levels, and some potential borrowers still are having trouble obtaining credit because 

lending standards have tightened; both factors are likely to restrain consumer spend

ing in the near term, as will slow growth in employment and labor income. Moreover, 

under current law (which, in preparing its baseline projections, CBO assumes will 

remain in place), another factor will slow the recovery: Fiscal policy will provide much 

less support to economic activity in 2011 and 2012 than it has in the past few years. 

In particular, the scheduled expiration of the tax cuts enacted in 2001 and 2003, 

along with the waning of the effects of additional government spending and tax cuts 

enacted in last year’s stimulus legislation, will produce slower economic growth next 

year than would otherwise occur.

As a result of those factors, CBO projects that the economic recovery will continue at 

a modest pace during the next few years.7

 Slow growth in output will generate slow 

growth in the demand for labor. The unemployment rate is likely to remain high for a 

prolonged period, which will have serious economic and social consequences.

CBO’s Baseline Economic Forecast

Given the assumptions about fiscal policy that underlie the baseline, CBO projects 

that real GDP will increase by 2.8 percent between the fourth quarters of 2009 and 

2010 and by 2.0 percent between the fourth quarters of 2010 and 2011. After 2011, 

the projected growth of real GDP picks up, averaging 4.1 percent annually from 

2012 through 2014; at that pace, GDP will reach its estimated potential level by the 

end of 2014.

The modest growth in output projected for the next two years points to sluggish 

growth in employment during the remainder of this year and next. Consequently, the 

unemployment rate in CBO’s projections declines slowly, falling to 9.3 percent at the 

end of 2010 and 8.8 percent at the end of 2011. After 2011, growth in employment 

rises along with growth in output, and the unemployment rate declines more rapidly, 

reaching 5.1 percent at the end of 2014.

Inflation in the prices of consumer goods and services is projected to be about 1 per

cent in 2010 and 2011, when measured on a fourthquartertofourthquarter basis 

using the price index for personal consumption expenditures. In CBO’s projections, 

inflation picks up moderately thereafter but remains below 2 percent from 2012 

through 2014. Interest rates also remain very low through the end of 2011 and then 

rise gradually as the recovery continues. 

Economic forecasts are subject to a considerable degree of uncertainty, and many fac

tors could lead to economic performance that is substantially different from CBO’s 

projections. In fact, new information has already become available since the agency 

completed its forecast in early July. The latest data indicate that the growth in spend

ing by households and businesses has been weaker than anticipated in CBO’s forecast, 

7. See Congressional Budget Office, The Budget and Economic Outlook: An Update (August 2010).
10

CBO

suggesting that growth in the near term is likely to be a bit slower than the agency 

anticipated.

Conditions in Some Key Sectors

The tepid nature of the recovery owes importantly to conditions in several key sectors 

of the economy—housing, international trade, and financial markets. 

Housing. The housing sector, which was at the center of the problems that triggered 

the recession, remains weak. Home builders began construction on residential hous

ing at an annual rate of 600,000 units during the first eight months of this year. That 

figure is more than the number of housing starts in 2009 (which was about 550,000 

units, the lowest since at least 1958) but still well below the estimated 1.5 million 

units that would be necessary to keep up with the growth of the population and the 

replacement of obsolete units. Those low rates of housing starts primarily reflect the 

unusually high number of vacancies among existing housing units—by CBO’s esti

mate, about 2.6 million more than would normally be expected. Low levels of con

struction over the past two years have failed to diminish that number because the 

recession and a sharp rise in mortgage foreclosures have reduced the number of people 

able to maintain independent households.

CBO expects housing starts to pick up this year and to continue to grow next year. 

However, because so many vacant units exist and the construction of multifamily 

housing has been inhibited by the difficulty of obtaining credit for commercial real 

estate, housing starts will probably not return to levels consistent with population 

growth and the demand for replacement units until late 2012.

House prices are also unlikely to start rising significantly until the inventory of unsold 

homes shrinks considerably. Those prices have been falling since 2007, and although 

the recent data show some evidence that prices are stabilizing, CBO forecasts that the 

national average price of a house will drop by an additional 7 percent between the 

middle of 2010 and the fall of 2011. 

International Trade. Net exports (that is, the difference between exports and imports) 

declined sharply in the first half of this year. Although exports rose faster than in the 

past few years, imports grew even more. CBO expects that net exports will continue 

to be a drag on the growth of real GDP in the coming year. The average pace of eco

nomic recovery among the United States’ trading partners is expected to be slow, 

dampening demand for U.S. exports. Net exports are also likely to decline in the near 

term because of the increase in foreign demand for U.S. financial assets stemming 

from the fiscal crisis in some European countries.

Financial Markets. Conditions in financial markets improved last year and early this 

year as the effects of the financial crisis diminished and the economy strengthened, 

although problems persist in some sectors. Financial conditions deteriorated a bit dur

ing the second quarter of 2010, apparently reflecting concerns about the strength and 

durability of the economic recovery in the United States and about the debt burden of 
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CBO

some European governments and its threat for the health of some financial institu

tions in Europe. Even though some degree of stability appears to have returned, those 

concerns have continued to weigh on global financial markets. Nevertheless, corpora

tions’ cost of raising funds remains quite favorable relative to longterm historical 

averages. Most small businesses report that, although they are concerned about the 

availability of credit, their larger concern is about whether they will have adequate 

sales. Although banks’ willingness to lend to consumers has improved, the demand for 

loans is still weak.

Despite the general improvement in financial markets, some markets have yet to 

recover fully—especially the banking sector and the markets for assetbacked securi

ties. Before the crisis, those securities, which are backed by loans on real estate or 

other assets, provided a significant amount of funding for loans to consumers and 

other borrowers. With markets for such securities still troubled, some potential bor

rowers are having difficulty obtaining loans for which they would qualify under nor

mal conditions. 

The Effect of Current-Law Fiscal Policies on CBO’s Baseline Economic Forecast

Through both higher federal spending and lower tax receipts, the federal budget has 

provided substantial support to economic activity during the downturn. Under cur

rent laws regarding taxes and spending, that support will diminish very rapidly over 

the next few years: In its baseline, CBO projects that between fiscal years 2010 and 

2012, the federal budget deficit will decline by about $675 billion (or from 9.1 per

cent to 4.2 percent of GDP). That reduction would be the sharpest twoyear decline 

in the deficit relative to GDP since shortly after World War II. 

Several factors contribute to the coming reduction in fiscal stimulus, including the 

expiration of numerous tax and spending provisions of current law and the diminish

ing effects of the automatic responses of federal tax revenues and spending to cyclical 

changes in the economy—the socalled automatic fiscal stabilizers. The temporary 

relief from the individual alternative minimum tax that was enacted most recently in 

the American Recovery and Reinvestment Act of 2009 (ARRA) expired at the end of 

last year. Without the relief from the AMT, tax rates and liabilities for 2010 are 

already higher for some people than they were last year. But CBO estimates that 

almost all of the economic effects of those increases will occur in 2011, when nearly 

all of the additional taxes will be paid. In addition, tax reductions enacted in the Eco

nomic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs 

and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) are scheduled to expire 

at the end of this year. Altogether, the expiration of all of those tax provisions will 

deliver a significant dose of fiscal restraint in 2011: They will reduce disposable per

sonal income by $250 billion relative to what it would otherwise be (thereby reducing 

people’s spending, albeit by a smaller proportion) and increase marginal tax rates for 

some workers (thereby reducing their aftertax wages and modestly dampening the 

supply of labor). 
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Moreover, by CBO’s estimate, the increase in economic activity caused by the spend

ing increases and other tax reductions enacted in ARRA peaked in the middle of 

2010. That impact is diminishing now and will continue to do so next year. As the 

economy strengthens and output starts to move closer to its potential level, federal fis

cal stimulus will also decline as the automatic stabilizers provide less support. That is, 

as output increases, tax payments to the government will begin to rise, and transfer 

payments to households (such as unemployment insurance) will decline. 

Labor Markets

The recession and the recovery that has followed have been marked by extremely weak 

demand for labor. Payroll employment fell by 7.3 million during the recession and by 

an additional 1.1 million during the second half of 2009, after the recession ended. 

The cumulative decline of 8.4 million jobs was the largest drop in employment in 

percentage terms—6.1 percent—since World War II. Although the labor market has 

turned up, employment gains totaled only 656,000 in the first eight months of the 

year (excluding temporary jobs associated with the decennial census, most of which 

have now ended). In contrast, if the recession had not occurred, employment would 

have increased during the past few years, so even with this year’s increase, employment 

now stands roughly 10 million below the level it would have reached.

The dramatic loss of jobs pushed the unemployment rate to more than 10 percent. 

The unemployment rate has fallen slightly from its peak but remains high, at 9.6 per

cent (see Figure 4). Data from the Job Openings and Labor Turnover Survey (JOLTS) 

indicate that through July, there were about five unemployed workers per job open

ing, down from slightly over six in late 2009 but still much higher than the peak fol

lowing the previous recession. The unemployment rate would be even higher had 

there not been a considerable falloff in the rate of participation in the labor force—the 

percentage of people age 16 or older who are working or seeking work—as the lack of 

available jobs caused some people to cease looking for a job. The labor force participa

tion rate remains well below its prerecession level. 

A few other measures suggest a modest improvement in labor market conditions thus 

far in 2010. According to data from JOLTS and from two measures of online job 

advertising, the number of job openings has increased significantly, though it remains 

a good deal below its prerecession level. Moreover, employment by temporary help 

services, a leading indicator for the labor market, has experienced large gains since late 

last year. However, new claims for unemployment insurance, which fell sharply in late 

2009, have stayed stubbornly high throughout this year. 

Several aspects of the rise in unemployment point to both a protracted recovery in 

employment and a greater degree of hardship for people who have lost their job than 

what people experienced following previous recessions. The share of unemployed 

workers whose jobs were permanently lost (or whose temporary job ended) rose much 

more sharply in the past few years than in previous downturns, and it has dipped only 

slightly since late 2009. Workers on temporary layoff have represented a smaller
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CBO

Figure 4.

Labor Force Participation and Unemployment Rate, 

1980 to 2010

(Percent)

Source: Congressional Budget Office based on data from the Bureau of Labor Statistics.

Note: Data are quarterly and are plotted through the second quarter of 2010. The shaded bars 

indicate recessions.

percentage of the unemployed than they did in previous downturns. In addition, the 

incidence of longterm unemployment (lasting longer than 26 weeks) has been the

highest by far in the past 60 years; it continued to rise during the first half of 2010 

and has fallen only a little during the past two months. 

Effects of Job Losses. Some workers who have lost a job during this downturn are fac

ing, and will continue to face, serious difficulties.8

 Some of those people will rely on 

unemployment insurance benefits for an extended period, and others may stop look

ing for work altogether.9

 Loss of a job often means a loss of health insurance for the

8. See Congressional Budget Office, Losing a Job During a Recession, Issue Brief (April 22, 2010).

9. Among those who lost a job involuntarily between 1981 and 2003, three groups of workers—

women, older people, and lesseducated people—were more likely to leave the labor force than 

were others who lost a job. See Henry S. Farber, “What Do We Know About Job Loss in the United 

States? Evidence from the Displaced Workers Survey, 1984–2004,” Economic Perspectives (Spring 

2005), pp. 13–28.

1980 1985 1990 1995 2000 2005 2010

70

68

66

64

0

11

10

9

8

7

6

5

4

0

Labor Force Participation Rate

(Left scale)

Unemployment Rate

(Right scale)
14

CBO

worker and perhaps for his or her family. People with health problems that make it 

difficult to work may decide to apply for disability benefits instead.10

Even among workers who find a new job, many will end up with lower earnings, not 

only in the short term but for many years to come. For example, among the men who 

lost their job in a mass layoff during the 1982 recession, earnings 15 to 20 years later 

were about 20 percent lower than those of similar men who did not lose their job.11

Declines in earnings during the first few years after losing a job tend to be larger for 

people who become unemployed during or shortly after a recession. Those earnings 

losses can be particularly pronounced for older workers, who often have more tenure 

on the job and, as a consequence, more firmspecific knowledge or more skills that do 

not transfer readily to a new job. For example, among men who lost their job in a 

mass layoff during the 1982 recession, older workers—those ages 50 to 55—had their 

earnings decline in the following year by 40 percent more than did workers in their 

20s and 30s.12

Factors Hindering Reemployment. In CBO’s assessment, weak demand for labor 

owing to weak demand for goods and services accounts for much of the current high 

level of unemployment, and a smaller portion is attributable to structural changes in 

the economy that go beyond those that normally occur in a recession.

Regarding structural changes, the end of the housing boom and the recession have 

induced a reshuffling of jobs among businesses, occupations, industries, and geo

graphical areas. Those developments suggest that gains in employment in the next 

several years will rely more than usual on the creation of new jobs—with different 

businesses, in different industries and locations, and requiring workers with different 

skills than those needed for the jobs that have disappeared. As a result, the movement 

of unemployed workers into new jobs will probably be more difficult in this recovery 

than in past ones. 

For many workers who have lost their job, the process of acquiring new skills can take 

considerable time. One important example arises from the bubble in house prices and 

resulting surge in homebuilding, which generated a large increase in construction 

employment. The subsequent downsizing of the housing sector helps explain a much 

larger rise in the unemployment rate for men than for women (see Figure 5). Because 

the skills used in that sector are not readily transferable to most new jobs in expanding 

sectors, former construction workers can face a long search for work. Moreover, some 

10. Relying on unemployment insurance for an extended period or applying for disability benefits both 

create additional pressure on the federal budget.

11. Till M. von Wachter, Jae Song, and Joyce Manchester, LongTerm Earnings Losses Due to Mass Lay

offs During the 1982 Recession: An Analysis Using U.S. Administrative Data from 1974 to 2004 

(working paper, Columbia University, April 2009), www.columbia.edu/~vw2112/papers/

mass_layoffs_1982.pdf.

12. See von Wachter, Song, and Manchester, LongTerm Earnings Losses Due to Mass Layoffs During the 

1982 Recession.
15

CBO

Figure 5.

Unemployment Rate, for Men and for Women, 

1980 to 2010

(Percent)

Source: Congressional Budget Office based on data from the Bureau of Labor Statistics.

Note: Data are quarterly and are plotted through the second quarter of 2010. The shaded bars 

indicate recessions.

employers have reorganized and upgraded their production systems during the reces

sion to improve productivity. In such cases, unemployed workers may not be able to 

return to a job in the same industry because their skills have become obsolete. 

Workers who are unemployed for long periods of time can face even greater obstacles 

in finding a new job. Such workers are more likely not to have learned about the latest 

technologies and, because of a diminished social network, may have less knowledge 

of job opportunities. In addition, some employers may assume that longterm 

unemployment is a signal that a worker is not good at his or her job.

Furthermore, the sharp reduction in house prices, which left many homeowners 

owing more on their mortgage than their home is worth, is making relocating more 

difficult than usual.13 Such immobility can prevent unemployed workers from finding 

13. Homeowners who owe more on their mortgage than their house is worth are less likely to move. 

See Fernando Ferreira, Joseph Gyourko, and Joseph Tracy, “Housing Busts and Household Mobil

ity,” Journal of Urban Economics, vol. 68, no. 1 (July 2010), pp. 34–45.

      













-EN

7OMEN
16

CBO

Figure 6.

Unemployment Rate, by State, August 2010

Source: Congressional Budget Office based on data from the Bureau of Labor Statistics.

potential employers. The unemployment rates in different states vary greatly, as some 

states that were hit hardest by the bursting of the housing bubble (such as California 

and Nevada) continue to have rates that are much higher than those of other states 

(see Figure 6).14 The extent to which workers’ immobility contributes to the current 

high unemployment rate nationally is unclear, because demand for labor is weak in so 

many parts of the country. However, immobility could play a larger role when the 

demand for labor strengthens in certain areas.

The labor market has also been affected by the extensions of unemployment insurance 

benefits enacted in the past few years. Those extensions have encouraged some people 

to stay in the labor force and collect benefits instead of leaving the labor force, and 

they have reduced the intensity of some workers’ efforts to search for a new job 

because the benefits reduce the hardship of being unemployed.15 Those effects of the 

14. In previous bouts of high unemployment, unemployment rates in some states decreased signifi

cantly only when many of the unemployed workers moved to different states. See William H. Frey, 

The Great American Migration Slowdown: Regional and Metropolitan Dimensions (Washington, 

D.C.: Brookings Institution, December 2009).

15. Recent research suggests that the effect of extended unemployment insurance benefits on the dura

tion of unemployment for the average worker who receives such benefits is rather small. See Daniel 

Aaronson, Bhashkar Mazumder, and Shani Schechter, “What Is Behind the Rise in LongTerm 

Unemployment?” Economic Perspectives, Federal Reserve Bank of Chicago (2010); and Rob Valetta 

and Katherine Kuang, “Extended Unemployment and UI benefits,” Economic Letter, Federal 

Reserve Bank of San Francisco (April 19, 2010).

Percent

12.0 to 15.0

9.6 to 12.0

7.0 to 9.6

5.0 to 7.0

0 to 5.0
17

CBO

benefit extensions tend to increase the unemployment rate. However, other effects of 

the extensions work in the opposite direction, making it difficult to assess their net 

impact. For example, jobs that are not sought by workers receiving unemployment 

insurance may go instead to individuals who are not eligible for such benefits (such as 

new entrants to the labor force) and might otherwise be unemployed themselves. In 

addition, unemployment insurance facilitates mobility to new occupations by provid

ing a safety net if such transitions do not work out. Moreover, the benefit extensions 

have led to greater spending by the recipients and thereby greater demand for goods 

and services in the economy as a whole; that effect tends to lower unemployment and 

boost employment. In CBO’s assessment, the extensions of unemployment insurance 

benefits have increased employment, although because they have affected labor force 

participation as well, their effect on the unemployment rate is less clear.

Policy Options

Although policy actions could not offset all of the effects of the boom in the housing 

and credit markets, the subsequent bust and financial crisis, and the severe recession, 

both monetary and fiscal policy could, if applied sufficiently vigorously, accelerate the 

recovery in output and employment during the next few years. However, fiscal policy 

options that would improve circumstances in the short term would have economic 

costs in the longer term. In particular, the cuts in taxes or increases in spending that 

would provide a shortterm economic boost would also increase federal budget defi

cits and debt, thereby weakening economic growth in the long run. Policies that offer 

more bang for the buck in providing shortrun stimulus could help minimize those 

longterm costs. 

Monetary Policy Options

Given current economic conditions and CBO’s projection of continued high 

unemployment and low inflation next year, the agency assumes that the Federal 

Reserve will not begin to raise the federal funds rate until 2012.16 Indeed, based on 

previous experience, most variants of a widely recognized rule (the Taylor Rule) for 

adjusting the funds rate imply that the Federal Reserve should lower that rate consid

erably in order to boost economic activity and inflation. That traditional approach 

is not feasible, however, because the funds rate has been barely above zero since 

December 2008. 

Still, as Federal Reserve Board Chairman Bernanke explained in a speech in late 

August, the Federal Reserve has several monetary policy tools available, although use 

of those tools involves risks.17 According to Chairman Bernanke, the most important 

tool appears to be the ability to buy additional longerterm securities in order to bring 

16. The federal funds rate is the interest rate that financial institutions charge each other for overnight 

loans of their monetary reserves, and it is the principal tool of monetary policy.

17. See Ben S. Bernanke, “The Economic Outlook and Monetary Policy,” speech at the Federal Reserve 

Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming (August 27, 2010).
18

CBO

down longerterm interest rates. To be sure, the effects of such purchases are quite 

uncertain. The Federal Reserve has not typically bought and sold such assets with the 

intention of moving longerterm interest rates, so it is not clear how much a given 

amount of purchases would reduce interest rates. Also, even if the Federal Reserve was 

successful in lowering longerterm interest rates, it is not clear how much a given 

reduction in interest rates would spur borrowing and spending in the current eco

nomic environment. However, there seems little reason to doubt that asset purchases 

in sufficient volume would encourage spending—although that volume might be 

quite large. In his talk, Chairman Bernanke acknowledged the risk that people would 

be uncertain about the Federal Reserve’s ability to withdraw such stimulus later, and 

other observers worry about greater government involvement in capital markets, 

especially if the Federal Reserve purchased securities other than ones issued by the 

government.

Chairman Bernanke also discussed other tools, including making clear in its policy 

statements its intention that interest rates will remain extraordinarily low for an 

extended period; reducing the interest paid on excess reserves; and raising the target 

for inflation in the medium term. Again, the effects of using those tools would be very 

uncertain, and, as Chairman Bernanke described, such actions would incur a number 

of risks.

Fiscal Policy Options

Changes in taxes and government spending can affect the economy both by changing 

the potential supply of goods and services and by changing demand for them. Over 

the long run, the nation’s potential to produce goods and services depends on the size 

and quality of its labor force, on the stock of productive capital (such as factories, 

vehicles, and computers), and on the efficiency with which labor and capital are used 

to produce goods and services.18 Changes in those determinants of potential output 

can have a lasting influence on the economy’s ability to supply goods and services. In 

particular, changes in tax rates affect people’s willingness to work and to save, influ

encing shortrun demand but also affecting longterm supplies of labor and capital. 

Changes in tax rates can also affect businesses’ decisions about investment and hiring, 

and they can affect decisions about the allocation of capital investment among sectors 

and locations.

As the recent severe recession has shown, economic activity can deviate for substantial 

periods from its potential level in response to changes in aggregate demand (the total 

purchases of a country’s output of goods and services by consumers, businesses, gov

ernments, and foreigners). When demand for goods and services falls short of the 

economy’s ability to produce them, as is the case currently, tax cuts or government 

spending increases can increase demand and thereby hasten a return to the potential 

level of output. Nevertheless, demandside effects are usually only temporary: They 

18. Efficiency in turn depends on such factors such as production technology, the way businesses are 

organized, and the regulatory environment.
19

CBO

raise or lower output relative to what it would be otherwise only for a while because, 

over time, stabilizing economic forces tend to move output back toward its potential. 

Fiscal policies that aim to increase demand are likely to decrease output and income in 

the long run because such policies usually increase government borrowing and reduce 

the nation’s saving and capital stock. Therefore, policies that increase demand often 

involve a tradeoff between shortterm benefits and longerterm costs. Indeed, to pre

vent unchecked growth in government debt, future policy changes are usually needed 

to offset the budgetary impact of stimulative policies.19

Depending on the policy enacted, the future policy changes that would be needed to 

maintain fiscal sustainability could be substantial. For example, CBO projects that, 

under current law, the gap between revenues and spending in 2020 would be about 

$700 billion. Under an alternative policy assumption that the 2001 and 2003 tax cuts 

are extended and the AMT is indexed for inflation, the gap would grow to $1.4 tril

lion, about 6 percent of GDP. If policymakers enacted those policy changes and 

wanted to balance the budget in 2020, they would need to increase tax revenues by 

onethird, reduce spending by onequarter, or enact some combination of those 

approaches.

What would it mean to raise tax revenues by onethird in 2020? One possibility 

would be to increase revenues from the individual income tax by about twothirds; 

another possibility would be to increase revenues from the corporate income tax by 

threeandahalf times. On the other side of the government budget, what would it 

mean to cut spending by onequarter in 2020? That amount would be a bit more 

than total projected spending on Social Security; almost as much as the combined 

spending on Medicare, Medicaid, and other health programs; much more than the 

spending on defense; and slightly more than all other federal spending apart from net 

interest. 

Estimated Short-Term Effects of Alternative Tax and 

Spending Policies

In its January 2010 report, CBO analyzed various policies for promoting economic 

growth and increasing employment.20 That analysis focused on the effects of the poli

cies in 2010 and 2011, assuming that they would be enacted in early 2010. If CBO 

repeated the analysis today, the precise estimates would be somewhat different because

19. If a policy changes revenues and spending in a way that increases the deficit, the resulting shortfall 

will compound over time as the government’s interest payments rise. Unless the government enacts 

an offsetting policy, the ratio of debt to output will be driven ever higher (under the assumption, 

which CBO’s analysis incorporates, that the rate of interest on government debt will be higher than 

the rate of economic growth).

20. Congressional Budget Office, Policies to Increase Economic Growth and Employment in 2010 and 

2011.
20

CBO

of small methodological changes and evolving economic conditions, but the qualita

tive pattern of the estimates would be quite similar.21

Different policy options would work somewhat differently depending on whether 

they sought to support spending by households, businesses, or governments. Policy 

options aimed at assisting households would spur demand for goods and services to 

varying degrees and thereby boost production to varying degrees. Because businesses’ 

decisions on investing and hiring depend on the demand for their products, higher 

demand and production would lead to more investment and hiring. The size of those 

effects would depend largely on which households got the money. Policies that would 

temporarily increase the aftertax income of people who are relatively well off would 

probably have little effect on their spending, but policies that increased the resources 

of families with lower income, few assets, and poor credit would probably have a 

larger impact on their spending. Because of the extent of job losses and declines in 

asset prices in this recession, more families probably have those attributes now than 

was the case in the immediate aftermath of many previous recessions. 

Policy options that supported businesses would operate somewhat differently. For 

example, if firms faced a temporary reduction in labor costs, they would probably 

respond through a combination of four channels. First, some firms would respond to 

lower employment costs by reducing the prices they charge in order to sell more goods 

or services. Those higher sales would in turn spur production, which would then 

increase hours worked and hiring. Second, some firms would pass the tax savings on 

to employees in the form of higher wages or other forms of compensation, which in 

turn would encourage more spending by those employees. Third, some firms would 

retain the tax savings as profits, and the resulting greater wealth would encourage 

more consumption by some households. Fourth, some firms would use slightly more 

labor during a period when it was temporarily less expensive. Or, if firms could realize 

the tax benefits of depreciation deductions more quickly, they would have a greater 

incentive for investment because a dollar of tax benefit this year is more valuable than 

a dollar of tax benefit in a future year.

Additional government spending would also boost output and employment. Effects 

would occur directly through the governmentfunded activity and indirectly through 

increases in demand for goods and services resulting from the higher income of the 

households and firms that directly benefited from the government activity.

In CBO’s analysis, the effect of a policy on output was measured by the cumulative 

effects on GDP for each dollar of total budgetary cost (that cost equals the additional 

federal spending or reduction in federal tax revenues). The effect of a policy on 

employment was measured by the cumulative effects on years of fulltimeequivalent 

21. The methodology used for those estimates was comparable to the methodology used in CBO’s esti

mates of the economic effects of ARRA. See Congressional Budget Office, Estimated Impact of the 

American Recovery and Reinvestment Act on Employment and Economic Output From April 2010 

Through June 2010 (August 2010).
21

CBO

employment for each dollar of total budgetary cost (a year of fulltimeequivalent 

employment is 40 hours of employment per week for one year). By focusing on full

timeequivalent employment, the calculations included increases in the hours worked 

by people in parttime employment and possibly some overtime work by fulltime 

employees. To account for uncertainty, the analysis included both a “low” estimate 

and a “high” estimate for the effects of each policy. 

For this analysis, policies were assumed to be temporary, although some of the policies 

could also be designed to be permanent. The total effect of a policy on economic 

growth and employment would depend critically on the magnitude of the reduction 

in taxes or increase in spending that occurred. The largest feasible magnitude of the 

budgetary change varies among policies, but all of the options considered are suffi

ciently scalable to allow tens of billions of dollars of tax cuts or spending increases 

per year. 

The key results of the analysis of alternative policy options are as follows (see Table 1):

B The largest effect on the economy per dollar of budgetary cost would arise from a 

temporary increase in aid to the unemployed. Such an increase would slightly raise 

unemployment among the affected individuals. However, the households receiving 

the additional benefits would tend to spend a very large share of them (rather than 

saving them) and to do that spending quickly; the increase in spending would raise 

demand and thereby increase output and employment in the economy overall.

B The nextlargest effect on the economy per dollar of budgetary cost would arise 

from a temporary reduction in employers’ payroll taxes. Firms would probably 

respond to such a tax cut through a combination of lower prices, higher wages, and 

higher profits. The changes in prices, wages, and profits would spur additional 

spending, which would boost employment. In addition, the reduced cost of labor 

would directly encourage the use of more labor in production. Reducing employ

ers’ payroll taxes for firms that increased their payroll would have an even higher 

bang for the buck because the tax cut would be linked to payroll growth and there

fore would use fewer dollars to cut employers’ taxes for workers who would have 

been employed anyway.

B Smaller but still significant effects on the economy per dollar of budgetary cost 

would result from a number of other policies. One such policy is a temporary 

reduction in employees’ payroll taxes. This option would not immediately affect 

employers’ costs, but instead would have effects similar to those of reducing other 

taxes for those workers—that is, it would raise spending and thus production and 

employment. Other policies with similar effects are providing additional onetime 

Social Security payments and additional temporary refundable tax credits for 

lower and middleincome households. The people receiving those funds would be 

likely to spend a significant share of the amounts they received. Allowing for tem

porary expensing of business investment would have a similar bang for the buck, as 

would providing additional aid to states for purposes other than infrastructure, 

which would lead to fewer layoffs of state employees and fewer increases in state 

taxes.
22

CBO

Table 1.

Effects of Policy Options on Output and Employment in 

2010 to 2015, Assuming Enactment in Early 2010

Source: Congressional Budget Office, Policies to Increase Economic Growth and Employment in 2010 and 

2011 (January 2010).

Notes: Different elements of spending and tax policies would have different effects on economic output per 

dollar of budgetary cost. CBO grouped the elements into general categories. For each category, CBO 

judgmentally chose low and high estimates of the effects on economic output per dollar of budgetary 

cost. CBO combined those estimates with projections of how changes in output affect participation in 

the labor force and the unemployment rate to produce estimates of effects on employment, hours per 

worker, and full-time-equivalent employment (40 hours of employment per week for one year).

Unless otherwise specified, spending policy options were assumed to provide budget authority as of 

April 2010, tax policy options were assumed to be in effect for 2010 only, and the total budgetary cost 

is the amount of tax revenues or budget authority over the full duration of the policies’ effects.

* = between zero and 0.5.

a. Estimated as gross domestic product (GDP) with the policy option in effect relative to GDP without the 

policy option.

b. Estimated as years of full-time-equivalent employment with the policy option in effect minus years of fulltime-equivalent employment without the policy option.

c. Assumed spending began in March 2010, and no benefit payments would be made after July 2011.

Increasing Aid to the Unemployedc 0.7 1.9 4 7 8 19 6 15

Reducing Employers' Payroll Taxes 0.4 1.2 3 5 5 13 4 11

Reducing Employers' Payroll Taxes for

FirmsThat Increase Their Payroll 0.4 1.3 5 9 8 18 7 16

Reducing Employees' Payroll Taxes 0.3 0.9 2 4 3 9 2 7

Providing an Additional One-Time

Social Security Payment 0.3 0.9 2 6 3 9 2 8

Allowing Full or Partial Expensing of

Investment Costsd 0.2 1.0 1 3 2 9 1 8

Investing in Infrastructuree 0.5 1.2 * 1 2 4 4 10

Providing Aid to States for Purposes

Other Than Infrastructuree 0.4 1.1 1 1 3 7 3 9

Providing Additional Refundable Tax

Credits for Lower- and Middle-Income 

Households in 2011 0.3 0.9 * * 3 6 3 7

Extending Higher Exemption Amounts

for the Alternative Minimum Tax 0.1 0.4 * * 1 4 1 4

Reducing Income Taxes in 2011f 0.1 0.4 * * 1 3 1 4

Policy Options with a Substantial Proportion of Impacts 

Beginning in 2010

Policy Options with a Substantial Proportion of Impacts 

Beginning in 2011

2010

Low High

 total budgetary cost)

Low High Low High

2010–2015

Low High

2010–2011

per million dollars of total budgetary cost)

(Years of full-time-equivalent employment 

Cumulative Effects on Employmentb Cumulative Effects on 

GDP, 2010–2015a 

(Dollars per dollar of
23

CBO

d. Initial reductions in revenues would be nearly fully offset by later increases. The policy’s effects were therefore estimated per dollar of the present discounted value of the policy (discounted at the businesses’ cost 

of debt and equity) instead of per dollar of total budgetary cost.

e. Timing of spending from new funding would follow historical experience.

f. Assumed to extend, through 2011, the provisions of the Economic Growth and Tax Relief Reconciliation Act 

of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003 that are scheduled to expire at the 

end of 2010, and to provide relief from the individual alternative minimum tax by extending the higher 

exemption amounts that were in effect in 2009 (indexed for inflation) for 2010 and 2011.

B The other options that CBO analyzed would have still smaller effects on the econ

omy per dollar of budgetary cost. One option in this category is a temporary 

increase in investment in infrastructure. Because many infrastructure projects 

involve substantial startup lags and because considerable infrastructure financing 

was already provided through ARRA, most of the increases in output and employ

ment from this policy would probably occur a few years in the future. Another 

option in this category is extending higher exemption amounts for the AMT in 

2010. That policy would have a limited impact on spending because it would 

largely affect households whose spending is not constrained by their income in a 

given year.

B The final option that CBO studied for the January report was a oneyear deferral of 

the increase in income taxes scheduled to occur in 2011, combined with an 

increase in the exemption amounts for the AMT for 2010 and 2011. CBO esti

mated that this option would have a small effect on the economy per dollar of bud

getary cost because only a fraction of such a tax cut would probably be spent. CBO 

focused on the effects of policy options during 2010 and 2011, and most of this tax 

cut would not occur until halfway through that period. If CBO updated those esti

mates today and examined the impact during the 2011–2012 period, a temporary 

acrosstheboard reduction in income taxes would have a larger effect per dollar of 

budgetary cost but would still, by that measure, significantly trail most of the other 

options studied. 

B A oneyear deferral of all of the increases except certain provisions that apply to 

higherincome taxpayers would have a larger effect on the economy per dollar of 

budgetary cost than would a deferral of all of the increases because the higher

income households that would be excluded would probably save a larger fraction of 

their increase in aftertax income. However, the difference between the two options 

would be small, because much of the remaining tax reduction would still go to 

higherincome taxpayers. 

Estimated Short-Term and Longer-Term Effects of Four 

Alternative Tax Policies

Changes in tax law related to the 2001 and 2003 tax cuts that are scheduled to expire 

at the end of 2010, as well as changes to provisions of the AMT that expired at the 
24

CBO

end of last year and to the estate tax, could have a significant impact on the federal 

budget and on the economy. In response to a request from the Chairman, CBO ana

lyzed four possible approaches to changing those provisions of current law:

B Full Permanent Extension. This option would extend the provisions of EGTRRA 

and JGTRRA that are scheduled to expire at the end of 2010; extend the higher 

exemption amounts from the AMT that were in effect in 2009 and index them for 

inflation for 2010 and subsequent years; and reinstate the estate tax—which 

expired completely in 2010—for 2011 and subsequent years at the rates in effect in 

2009 and with the exemption amounts (adjusted for inflation) that applied in that 

year, rather than at the higher rates and lower exemption amounts scheduled to 

take effect in 2011.

B Partial Permanent Extension. This option is the same as the full extension, except 

that it would not extend certain provisions of EGTRRA and JGTRRA that apply 

to married couples with income of $250,000 or more and single taxpayers with 

income of $200,000 or more. Those provisions include the lower tax rates in the 

top two income tax brackets, the lower 15 percent tax rates on capital gains and 

dividends, and the elimination of the phaseout of itemized deductions and per

sonal exemptions.

B Full Extension Through 2012. This option would make the same changes as the 

full permanent extension, but through 2012 rather than permanently.

B Partial Extension Through 2012. This option would make the same changes as the 

partial permanent extension, but through 2012 rather than permanently.

To analyze how these four policy options would affect the economy, CBO used an 

approach very much like its method for analyzing the macroeconomic effects of the 

President’s budgetary proposals. The agency used several models that make different 

simplifying assumptions about people’s behavior, and, for some of the models, the 

agency produced estimates under alternative assumptions about the response of 

labor supply to changes in tax rates. Still, the effects of these policy options are quite 

uncertain, and the actual effects could be outside CBO’s ranges of estimates. The esti

mates incorporate the assumption that no other tax or spending policies would be 

changed through 2020, although some of the estimates incorporate the effects of pol

icy changes assumed to be made after 2020 to put fiscal policy on a sustainable path. 

To estimate effects on the economy in 2011 and 2012, CBO used models that focus 

on the policies’ effects on the demand for goods and services, because the agency 

thinks that weak demand will constrain economic growth in the short term. All else 

being equal, lower tax revenues increase demand for goods and services and thereby 

boost economic activity. By contrast, to estimate effects on the economy in 2020 and 

beyond, CBO used models that focus on the policies’ effects on the supply of labor 

and capital, because the agency thinks that supply factors will restrain economic 
25

CBO

growth over that longer horizon. All else being equal, lower tax revenues increase bud

get deficits, and, in turn, the federal government’s increased borrowing displaces some 

productive investment in the private sector; at the same time, lower tax rates increase 

people’s saving and work effort. The net effect on economic activity and income 

depends on the balance of those forces. 

Estimated Effects on Federal Revenues and Marginal Tax Rates

CBO estimates that a full extension of the tax provisions would reduce federal reve

nues as a share of gross national product (GNP) by 1.2 percent in 2011 and 1.7 per

cent in 2012 (see Table 2).22,23 A partial extension would reduce revenues by about 

onefifth to onequarter less, CBO estimates—by 0.9 percent of GNP in 2011 and 

1.4 percent in 2012. If the extension of the tax provisions continued through 2020, 

the full extension would reduce revenues by 2.1 percent of GNP in that year, and the 

partial extension would reduce them by 1.6 percent of GNP.24

Extending the expiring tax provisions would reduce the marginal federal tax rates (the 

rates that would apply to the last dollar of income subject to taxes) on both capital 

income and labor income, by keeping in place lower individual income tax rates on 

ordinary income, dividends, and capital gains. Under current law, the 25 percent, 

28 percent, and 33 percent income tax rates would all rise by 3 percentage points in 

2011, and the top tax rate would rise from 35 percent to 39.6 percent. The current 

maximum 15 percent tax rate on dividends and longterm capital gains would also 

rise. Under current law, the tax rate on longterm capital gains would increase to 

20 percent in 2011, and dividends would be taxed at the same rates as other income. 

The full extension would reduce the effective marginal tax rate on capital income 

by 2.0 percentage points in 2011 and by 2.3 percentage points in 2020, CBO 

22. GNP measures the total market value of goods and services produced during a given period by 

labor and capital supplied by residents of the United States, regardless of where the labor and capi

tal are located. That value is conceptually equal to the total income accruing to residents of the 

country during that period (national income) and thus, compared with gross domestic product 

(GDP), is a better measure of the wellbeing of U.S. residents. GNP differs from GDP primarily by 

including the capital income that residents earn from investments abroad and excluding the capital 

income that nonresidents earn from domestic investment. 

23. The revenue estimates are based on preliminary estimates provided by the staff of the Joint Com

mittee on Taxation. The estimates include the effects of increased outlays for refundable credits and 

do not incorporate any impact that the policy options might have on GNP or other broad measures 

of economic activity.

24. Under CBO’s baseline projections, which incorporate the assumption that current tax law 

continues in effect, federal revenues in 2020 would amount to about 21 percent of GNP.
26

CBO

Table 2.

Effects of Four Tax Policy Options on Federal Revenues and 

Marginal Tax Rates, 2011, 2012, and 2020

Source: Congressional Budget Office.

Note: * = less than 0.1 percentage point.

a. Estimated as revenues with the policy in effect minus revenues without the policy. The impact 

on outlays for refundable tax credits is included.

b. The difference relative to current law in the rate applicable to the last dollar of capital income 

subject to federal individual income and corporate income taxes.

c. The difference relative to current law in the rate applicable to the last dollar of labor income 

subject to federal individual income and payroll taxes.

d. This option would extend the provisions of the Economic Growth and Tax Relief Reconciliation 

Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003 that are scheduled to 

expire at the end of 2010; extend the higher exemption amounts from the individual alternative 

minimum tax that were in effect in 2009 (adjusted for inflation) for 2010 and subsequent years; 

and reinstate the estate tax—which expired completely in 2010—for 2011 and subsequent 

years at the rates in effect in 2009 and with the exemption amounts (adjusted for inflation) 

that applied in that year. 

e. This option is the same as the full extension, except that certain provisions would expire that 

would otherwise have applied to married couples with income of $250,000 or more and single 

taxpayers with income of $200,000 or more. Those provisions include the lower tax rates in the 

top two income tax brackets, the lower 15 percent tax rates on capital gains and dividends, and 

the elimination of the phaseout of itemized deductions and personal exemptions.

f. This option would make the same changes as the full extension, but through 2012 rather than 

permanently.

g. This option would make the same changes as the partial extension, but through 2012 rather 

than permanently.

Full Extension, Permanentd -1.2 -2.0 -2.6

Partial Extension, Permanente -0.9 -0.4 -2.0

Full Extension, Through 2012f -1.2 -2.0 -2.6

Partial Extension, Through 2012g -0.9 -0.4 -2.0

Full Extension, Permanentd -1.7 -2.1 -2.7

Partial Extension, Permanente -1.4 -0.4 -2.0

Full Extension, Through 2012f -1.7 -2.1 -2.7

Partial Extension, Through 2012g -1.4 -0.4 -2.0

Full Extension, Permanentd -2.1 -2.3 -3.0

Partial Extension, Permanente -1.6 -0.4 -2.1

Full Extension, Through 2012f * 00

Partial Extension, Through 2012g * 00

Impact on Effective 

Federal Marginal 

Tax Rate on 

Labor Incomec 

(Percentage points)

Impact on Effective

 Federal Marginal 

Tax Rate on

 Capital Incomeb 

(Percentage points)

Impact on Revenuesa 

(Percentage of 

Gross National

Product)

2011

2012

2020
27

CBO

estimates.25 The partial extension would have a much smaller effect, reducing that tax 

rate by an estimated 0.4 percentage points in both 2011 and 2020. The effect is 

smaller because of the disproportionate share of capital income accruing to high

income households, who would not see a decline in marginal tax rates under the par

tial extension.

The full extension would reduce the effective marginal tax rate on labor income by 

2.6 percentage points in 2011 and by 3.0 percentage points in 2020, CBO estimates; 

the partial extension would reduce those rates by an estimated 2.0 percentage points 

in 2011 and 2.1 percentage points in 2020. The projected effects on the effective mar

ginal tax rate are greater for labor income than capital income because a substantial 

amount of capital income is not taxed under the individual income tax. For example, 

capital income in the form of implicit rent on owneroccupied homes and capital 

income earned from taxpreferred retirement accounts are not subject to income 

taxes. 

Estimated Economic Effects in 2011 and 2012

For 2011 and 2012, CBO’s estimates of effects on GDP incorporate both supplyside 

effects (influences on the economy’s potential output; that is, the amount of produc

tion that corresponds to a high level of resource use) and demandside effects (tempo

rary movements of actual output relative to potential output). However, the estimated 

economic effects depend predominantly on the demandside effects because CBO 

projects that actual output will fall well short of potential output during the next two 

years. CBO analyzed the effects of the policies on total income (as measured by real 

GNP), the unemployment rate, employment, and fulltimeequivalent employment.

According to CBO’s estimates, all four policy options would add to income and 

employment in 2011 and 2012, largely because they would increase aftertax income 

and thereby encourage people to spend more. In 2011, for example, by CBO’s esti

mates, the partial extension of the tax cuts through 2012 would increase real GNP by 

between 0.2 percent and 0.7 percent, reduce the unemployment rate by between 0.1 

and 0.3 percentage points, and add between 0.3 million and 0.7 million fulltime

equivalent jobs (see Table 3).

The full extension of the tax cuts through 2012 would increase GDP and employ

ment more in 2011 and 2012 than would the partial extension through 2012 because 

it would have a greater overall impact on aftertax income. However, the economic 

impact per dollar of revenue reduction from the full extension would be smaller than 

that from partial extension because a greater proportion of the tax savings from the

25. The effective marginal tax rate on capital income is the rate that would apply to the return on addi

tional investment. That rate is averaged across all the businesses, people, and institutions that 

would receive that investment income (and that could face different tax rates). For a description of 

CBO’s method for estimating effective tax rates, see Congressional Budget Office, Computing Effec

tive Tax Rates on Capital Income, Background Paper (December 2006).
28

CBO

Table 3.

Effects of Four Tax Policy Options on Macroeconomic 

Outcomes in 2011 and 2012 

Source: Congressional Budget Office.

Notes: For a description of the tax policy options, see the notes to Table 2.

Different elements of tax policy options would have different effects on economic output per 

dollar of change in tax revenues. CBO grouped the provisions of the tax policies into general 

categories. For each category, CBO judgmentally chose low and high estimates of the effects 

on economic output per dollar of changes in tax revenues. Multiplying estimates of those 

per-dollar effects by the change in tax revenues from each element of a tax policy yields low 

and high estimates of the policy’s total impact on output. CBO combined those estimates 

with projections of how changes in output affect participation in the labor force and the 

unemployment rate to produce estimates of effects on employment, hours per employed 

worker, and full-time-equivalent employment. 

a. Estimated as gross national product adjusted for inflation (real GNP) with the policy option in 

effect relative to real GNP without the policy option.

b. Estimated as the unemployment rate with the policy option in effect minus the unemployment 

rate without the policy option.

c. Estimated as the number of people who work for pay with the policy option in effect minus the 

number without the policy option.

d. Estimated as full-time-equivalent employment (40 hours of employment per week for one year) 

with the policy option in effect minus full-time-equivalent employment without the policy 

option.

Low High Low High Low High Low High

Estimate Estimate Estimate Estimate Estimate Estimate Estimate Estimate

Full Extension, 

Permanent 0.5 1.4 -0.2 -0.5 0.4 1.0 0.6 1.4

Partial Extension, 

Permanent 0.4 1.1 -0.2 -0.4 0.3 0.8 0.5 1.2

Full Extension, 

Through 2012 0.3 0.9 -0.1 -0.3 0.2 0.6 0.3 0.9

Partial Extension, 

Through 2012 0.2 0.7 -0.1 -0.3 0.2 0.5 0.3 0.7

Full Extension, 

Permanent 0.6 1.9 -0.3 -1.0 0.7 1.9 0.9 2.7

Partial Extension, 

Permanent 0.5 1.5 -0.3 -0.8 0.5 1.6 0.8 2.3

Full Extension, 

Through 2012 0.3 1.1 -0.2 -0.6 0.3 1.1 0.5 1.7

Partial Extension, 

Through 2012 0.3 0.9 -0.2 -0.5 0.3 1.0 0.4 1.4

Equivalent 

(Millions)

2012

Full-TimeReal GNPa Unemployment Rateb Employmentc Employmentd

(Percent) (Percentage points) (Millions)

2011
29

CBO

full extension would go to relatively high income households, which tend to spend 

less of an increase in income than lowerincome households do. 

The full permanent extension and partial permanent extension of the tax cuts would 

have larger economic effects in the next two years than would the corresponding 

extensions through 2012 because people tend to spend a larger portion of permanent 

changes in aftertax income than of temporary changes.26 However, the economic 

effects in the next two years, per dollar of revenue reduction over the long run, would 

be smaller than those of the corresponding temporary extensions because the revenue 

loss would continue for many more years.

Estimated Economic Effects in 2020 and Later Years 

For 2020 and later years, CBO’s estimates incorporate only supplyside effects, 

because the magnitude of demandside effects depends on the state of the economy, 

which is especially difficult to predict over longer horizons. In addition, the Federal 

Reserve would probably offset much of the demandside effects of policies that are 

foreseen well in advance in order to maintain economic stability. Because changes in 

unemployment caused by fiscal policy changes come largely from those policies’ 

effects on demand, CBO did not estimate effects on unemployment in 2020 and 

beyond.

CBO used two different models (described more fully in the appendix) to project the 

economic effects of the alternative tax policies in 2020. One is a “textbook” growth 

model, an enhanced version of a model developed by economist Robert Solow. The 

other is a lifecycle growth model, which is designed to capture supplyside effects in a 

relatively complete and consistent way and to capture the fact that people make deci

sions based not only on their current circumstances but also on their expectations of 

future economic conditions. Among the crucial expectations are those for fiscal policy. 

The model imposes the commonsense rule that people believe that increases in debt 

arising from spending increases and tax cuts must eventually be paid for by spending 

cuts, tax increases, or some combination of the two. Therefore, an assumption is 

required about how increased deficits in the near term will be made up in later years. 

CBO applied two different assumptions about what people would expect—that gov

ernment spending would be reduced after 2020, or that tax rates would be raised after

26. In The Budget and Economic Outlook: An Update (August 2010), CBO described what its economic 

forecast would be if, instead of the current law that CBO must assume for its baseline, the Congress 

followed an alternative fiscal policy similar to what many private forecasters assume. A principal ele

ment of that alternative policy was a partial permanent extension of the tax cuts as proposed in the 

President’s 2011 budget. The estimated effects of a partial permanent extension reported here differ 

somewhat from the estimated effects reported in the Update both because the policy considered 

here is a little different and because the effects are reported here on an annualaverage basis rather 

than on a fourthquartertofourthquarter basis as in the Update. 
30

CBO

2020.27 Because of the forwardlooking nature of people’s decisions in that model, 

those different assumptions lead to different projected outcomes in 2020 (and earlier). 

A key assumption in both of the models is the responsiveness of labor supply to 

changes in aftertax compensation from employment. Because researchers are 

uncertain about the magnitude of this responsiveness, CBO estimated the effects 

of the tax policy options using two different assumptions, incorporating one of the 

lower estimates and one of the higher estimates in the research literature.28

By CBO’s estimates, the partial extension of the tax cuts through 2012 would reduce 

real GNP in 2020 by between 0.2 percent and 0.3 percent relative to what would oth

erwise occur, depending on the model and assumptions used (see Table 4). The full 

extension of the tax cuts through 2012 would have a slightly larger negative effect of 

about 0.3 percent. Those projected reductions in GNP occur primarily because the 

negative effect on GNP of the crowding out of investment resulting from extra gov

ernment borrowing outweighs the positive effect on GNP of extra labor supply and 

saving resulting from the lower tax rates during the next two years.29

The partial permanent extension of the tax cuts would have a larger negative effect on 

real GNP in 2020, reducing it by between 0.9 percent and 1.8 percent, depending on 

the model and assumptions. The reduction in GNP is larger for this policy than for 

the partial extension through 2012 because the additional government borrowing 

would diminish income by more than the persistence of lower tax rates would raise it. 

The reduction in GNP in 2020 is less pronounced when tax rates are assumed to 

increase after 2020 than when government spending is assumed to decrease after 

2020, because the anticipation of an increase in tax rates would lead people to work 

more in the years up to and including 2020. Greater responsiveness of labor supply to 

changes in aftertax compensation from employment has an ambiguous impact on the 

effects of tax reductions on labor supply and GNP because the boost to labor supply 

from lower tax rates is offset at least in part by the reduction in labor supply from 

lower pretax compensation due to the crowding out of investment. In cases in which 

the fall in pretax compensation outweighs the cut in tax rates, greater responsiveness 

27. Other assumptions are possible. For example, if tax revenues were increased through broadening 

the calculation of taxable income for the individual income tax rather than raising the rates at 

which that income is taxed, then the estimated effects of the policy would more closely resemble the 

estimated effects of cutting government spending. Alternatively, if the reduction in government 

spending was concentrated only in purchases of goods and services or only in transfer payments, 

then the estimated effects of the policy would be different. 

28. For a review of the estimates in the research literature and for an explanation of the labor supply 

response in the lifecycle model that CBO uses, see Juan Contreras and Sven Sinclair, “The Labor 

Supply Response in Macroeconomic Models,” CBO Working Paper 200807 (September 2008).

29. In contrast with the analysis presented here, the analysis of different budgetary policies presented in 

CBO’s The LongTerm Budget Outlook (June 2010, revised August 2010) did not incorporate the 

effects on labor supply of changes in marginal tax rates on labor income or the effects on saving of 

changes in marginal tax rates on capital income.
31

CBO

Table 4.

Effects of Four Tax Policy Options on Real GNP in 

2020 and the Long Term

(Percent)

Source: Congressional Budget Office.

Notes: Estimated as gross national product adjusted for inflation (real GNP) with the policy option in 

effect relative to real GNP without the policy option. Weak and strong labor responses correspond to the respective number of hours worked when the response to tax rate changes is 

weak and when it is strong. For a description of the tax policy options, see the notes to 

Table 2.

n.a. = not available; these estimates were not calculated for this analysis.

a. Based on a “textbook” growth model, which is an enhanced version of a model developed by 

Robert Solow. 

b. Based on a life-cycle growth model, developed by CBO, which is an overlapping-generations 

general-equilibrium model in which people are forward-looking in their behavior. Because the 

U.S. economy is open to flows of foreign capital, but also large enough to influence world interest rates and wage rates, the results reported for this model are an average of results using 

assumptions of a closed economy and a small open economy. For this model, CBO had to make 

assumptions about how fiscal policy would be put on a sustainable path. CBO chose two alternatives: reducing government purchases of goods and services and transfer payments after 2020, 

and increasing marginal tax rates after 2020. 

c. Based on estimates for 2040.

Weak Strong Weak Strong Weak

Labor Labor Labor Labor Labor

Response Response Response Response Response

Full Extension, Permanent -1.6 -1.1 -1.4 -0.9 -0.8 0.1

Partial Extension, Permanent -1.3 -0.9 -1.6 -1.8 -1.1 -0.9

Full Extension, Through 2012 -0.3 -0.3 -0.3 -0.3 -0.3 -0.3

Partial Extension, Through 2012 -0.3 -0.3 -0.2 -0.3 -0.2 -0.3

Full Extension, Permanent n.a. n.a. -2.9 -2.3 -8.4 -10.5

Partial Extension, Permanent n.a. n.a. -2.9 -3.5 -7.8 -11.2

Full Extension, Through 2012 n.a. n.a. -0.6 -0.6 -0.7 -0.8

Partial Extension, Through 2012 n.a. n.a. -0.5 -0.6 -0.6 -0.7

Effects with Additional Policy Changes 

Effects Without

Additional 

Policy Changesa

Government Spending 

Reduced After 2020

Needed to Put Fiscal Policy on a 

Tax Rates Increased 

After 2020

Strong

Response

Labor

Sustainable Pathb

2020

Long Termc
32

CBO

implies a larger decrease in output rather than a smaller one; in this analysis, that 

occurs under the assumption that government spending is reduced after 2020. 

The estimated effect of the full permanent extension of the tax cuts on GNP in 2020 

varies substantially—ranging from a reduction of 1.6 percent to an increase of 

0.1 percent—depending on the model and assumptions used. In results from the text

book growth model, the effect is more negative than that of the partial permanent 

extension because the greater government borrowing diminishes income by more than 

the existence of lower tax rates for more workers and savers raises it. In contrast, in 

results from the lifecycle growth model, the effect is less negative than for the partial 

permanent extension (or is positive) in large part because the greater reduction in tax 

rates has a larger effect on labor supply and saving than the additional crowding out 

from the larger deficits. In addition, as under the partial permanent extension, people 

would work more in the years up to and including 2020 in anticipation of the 

increase in future tax rates.

Estimates using the lifecycle growth model show that all four tax policy options 

would reduce GNP in the long term relative to what would otherwise occur (for all of 

the assumptions used in the analysis). Those negative effects would stem from the 

reduced capital stock and from the impact of the policy changes that are assumed to 

take place after 2020 to put fiscal policy on a sustainable path. The permanent exten

sions of the tax cuts would have much larger negative effects in the long term than the 

temporary extensions because the amount of additional government debt would be so 

much larger. CBO did not complete estimates beyond 2020 using the textbook 

growth model. However, such estimates would show larger negative effects on GNP 

beyond 2020 than in 2020—especially for the permanent extensions—because the 

additional government debt would compound over time, and the extent of crowding 

out would increase.

The estimated effects from the lifecycle model depend importantly on when further 

policy changes to put fiscal policy on a sustainable path are assumed to be made. For 

example, if subsequent cuts in government spending or increases in tax rates were 

made sooner than 2020, the permanent extensions would reduce GNP by more in 

2020 but less in the long term.
33

CBO

Appendix: 

Additional Information on the Estimated 

Effects of the Four Alternative Tax Policies

The four tax policy options that the Congressional Budget Office (CBO) examined 

would influence the economy through both demand and supply effects.1 By reducing 

taxes relative to CBO’s baseline projections, all four options would generate demand

side effects that would raise output relative to what would otherwise occur in 2011 

and 2012. In particular, lower tax payments imply that disposable income would 

increase, encouraging consumers’ demand for goods and services.

The options would also generate supplyside effects that would help determine the 

course of potential economic output. The supplyside effects of the options would 

arise primarily from two factors:

B The policies would result in a smaller stock of domestically owned capital, mainly 

as a consequence of increased budget deficits relative to those projected under cur

rent law. That effect is larger when the impact of the policy on the deficit is greater, 

and it becomes stronger over time as budget deficits accumulate. Therefore, full 

extensions of the tax cuts would have larger negative effects on the capital stock 

than partial extensions, and permanent extensions would have larger negative 

effects than extensions through 2012.

B While the policies are in effect, they would result in an increase in the supply of 

labor and saving by reducing the effective marginal tax rates on labor and saving. 

Those reductions, and therefore the positive impact on labor supply and saving, 

would be larger for full extensions than partial extensions and would last longer for 

permanent extensions than for extensions through 2012. 

How the Policies Would Affect the Economy

The alternative tax policies would influence the size of the nation’s capital stock by 

affecting national saving, which consists of private saving (saving by households and 

businesses) plus public saving (the budget surpluses or deficits—which represent dis

saving—of state and local governments and the federal government). An increase in 

1. For a similar discussion of CBO’s approach to estimating the macroeconomic effects of the Presi

dent’s budgetary proposals, see Congressional Budget Office, An Analysis of the President’s Budgetary 

Proposals for Fiscal Year 2011 (March 2010), Chapter 2 and Appendix B.
34

CBO

the federal deficit represents a reduction in public saving and, therefore, in national 

saving. Federal policies also can affect private saving; increases in private saving raise 

national saving, and decreases diminish national saving. A decline in national saving 

reduces the capital stock owned by U.S. citizens over time through a decrease in 

domestic investment, an increase in net borrowing from abroad, or both.

The policy options’ largest consequences for national saving would come from their 

effects on the federal budget deficit. Each year between 2011 and 2020, the options 

would expand the federal deficit relative to that in CBO’s baseline, which would 

reduce national saving, other things being equal.

Extending the tax cuts would also influence the size of the nation’s capital stock by 

altering effective marginal tax rates on capital income (income derived from wealth, 

such as stock dividends, realized capital gains, or the owner’s profits from a business) 

and thus the aftertax rate of return on saving and the amount of saving that people 

chose to do.2

 CBO’s estimates of marginal tax rates reflect both corporate and individ

ual income taxes.3

The reduction in the effective marginal tax rate on capital income would result pri

marily from the extension of lower income tax rates and the maximum 15 percent tax 

rate on dividends and capital gains. Under current law, for example, the top tax rate 

would rise from 35 percent to 39.6 percent, the top tax rate on capital gains would 

rise to 20 percent, and dividends would be taxed at the same rates as other income. 

The decrease in the tax rate on capital income relative to the rate prevailing under cur

rent law could have larger or smaller effects on private saving depending on how peo

ple responded.4

 However, even the upper end of reasonable estimates for the respon

siveness of saving would imply relatively small consequences for the capital stock and 

output of the economy if the extension of the lower rates was limited to two years. 

Extending the tax cuts except for provisions applying to higherincome taxpayers 

would have a much smaller effect on the marginal effective tax rate on capital because 

a disproportionate share of capital income accrues to highincome households. 

2. The effective marginal tax rate on capital income is the rate that would apply to the return on addi

tional investment. That rate is averaged across all the businesses, people, and institutions that 

would receive that investment income (and that could face different tax rates).

3. For a description of CBO’s method for estimating effective tax rates, see Congressional Budget 

Office, Computing Effective Tax Rates on Capital Income, Background Paper (December 2006).

4. By increasing the aftertax return on saving, the tax policy options would influence private saving in 

two opposing ways: Higher aftertax returns would tend to increase saving and thus reduce con

sumer spending, but they also would boost the value of existing assets, making households wealth

ier and thus tending to encourage spending. On balance, the combined effect on spending of 

higher aftertax returns can be positive or negative, and researchers generally conclude that the 

effect is small. CBO’s models incorporate different assumptions about how households might 

respond to changes in the aftertax return on saving. 
35

CBO

Potential output is strongly tied to the amount and quality of labor supplied in the 

economy. A sustained longterm increase in total hours worked or in the capability of 

the labor force improves the economy’s potential to generate output. CBO’s analysis 

focused on channels through which the policy options could affect the number of 

hours of labor supplied because the evidence for those channels is stronger than is the 

evidence for channels through which government policies can affect the quality of 

labor. 

Extending the tax provisions could affect the quantity of labor in two main ways. 

First, extending some of the provisions would change people’s overall aftertax income 

but not their aftertax compensation for each additional hour of work. In the absence 

of a change in marginal rates, an increase in aftertax income tends to reduce the 

number of hours of labor supplied because people can maintain their standard of 

living with less work; conversely, a decline in income tends to increase the hours 

supplied.

Second, some provisions would change both aftertax income and aftertax compensa

tion for each additional hour of work. For example, the extension of the lower mar

ginal tax rates on income that were enacted in 2001 would increase both aftertax 

income and aftertax compensation per hour. Provisions that raised aftertax income 

and incremental aftertax compensation (and provisions that reduced both) would 

have opposing effects on people’s incentives. In the case of extending lower tax rates, 

for example, the affected workers would be encouraged to work longer hours because 

they would earn more for each extra hour of labor they supplied. But a disincentive 

also exists: Those same workers would earn more aftertax income at their current 

working hours, which would encourage them to decrease their work hours.

For many people, the opposing incentives from reducing marginal tax rates largely 

offset each other, although most economists conclude that, on average, the positive 

effects of greater aftertax earnings for each additional hour worked slightly outweigh 

the negative effects of higher aftertax income from current working hours. Responses 

to changes in tax rates can also vary among family members, with secondary earners 

(for example, the spouse of a household’s primary breadwinner) generally responding 

to a greater extent than primary earners.5

 All told, CBO assumes that reductions in 

marginal tax rates will tend to increase modestly the hours of labor that workers sup

ply, and increases in marginal tax rates will modestly decrease hours worked.

5. See Congressional Budget Office, Labor Supply and Taxes, CBO Memorandum (January 1996). 

Since that memorandum was published, CBO has revised downward its estimates of total wage 

elasticity and substitution elasticity for secondary earners because of evidence that their responsive

ness has declined over time as their participation in the labor force has grown. (The highestearning 

member of each household is the primary earner; other household members with earnings are sec

ondary earners.) See also Congressional Budget Office, The Effect of Tax Changes on Labor Supply in 

CBO’s Microsimulation Tax Model, Background Paper (April 2007); and Francine D. Blau and 

Lawrence M. Kahn, “Changes in the Labor Supply Behavior of Married Women: 1980–2000,” 

Journal of Labor Economics, vol. 25, no. 3 (2007), pp. 393–438.
36

CBO

The policy options would affect labor supply not only by affecting tax rates on labor 

income, but also through their impact on the capital stock. Because higher deficits 

would crowd out capital, pretax wage rates would be lower than those under current 

law (all else being equal), weakening people’s incentives to work.

Quantifying the Short-Term Effects of the Policies

CBO used a set of models to estimate the effects of the policy options relative to cur

rent law. The estimated effects for 2011 and 2012 depend primarily on an analysis of 

demandside impacts, although the estimates incorporate some supplyside influences 

as well. Specifically, CBO analyzed the effects of the policy options in 2011 and 2012 

using macroeconometric forecasting models and historical relationships to determine 

estimated “multipliers” for each of the provisions. Each multiplier represents the 

effects on the nation’s output of a dollar’s worth of a given provision. A provision’s 

multiplier can be applied to the budgetary cost of that provision to estimate its overall 

impact on output. 

A policy’s direct effects on the nation’s output consist of immediate (or firstround) 

effects on economic activity. The size of the direct effects depends on the policy’s 

impact on the behavior of recipients. If someone receives a tax reduction of a dollar 

and spends 80 cents (saving the other 20 cents), production increases over time to 

meet the additional demand generated by that spending, and the direct impact on 

output is 80 cents. 

CBO reviewed evidence on the responses of households to various types of tax cuts to 

estimate the size of the provisions’ direct effects on output.6

 For example, temporary 

tax cuts will generally have less impact on a household’s purchases than permanent 

cuts because a temporary cut has a smaller effect on total lifetime disposable income. 

As another example, increases in disposable income are likely to boost purchases more 

for lowerincome than for higherincome households. That difference arises, at least 

in part, because a larger share of people in lowerincome households cannot borrow as 

much money as they would wish in order to spend more than they do currently. 

Tax reductions also can have indirect effects that enhance or offset the direct effects. 

For example, direct effects are enhanced when greater demand for goods and services 

prompts companies to increase investment to bolster their future production. In the 

other direction, direct effects are muted if increases in interest rates in response to the 

6. On household spending, for example, see Jonathan A. Parker and others, Consumer Spending and 

the Economic Stimulus Payments of 2008 (working paper, Northwestern University, February 2010), 

www.kellogg.northwestern.edu/faculty/parker/htm/research/PSJM2010.pdf; Matthew D. Shapiro 

and Joel Slemrod, “Did the 2008 Tax Rebates Stimulate Spending?” American Economic Review, 

vol. 99, no. 2 (May 2009), pp. 374–379; Sumit Agarwal, Chunlin Liu, and Nicholas S. Souleles, 

“The Reaction of Consumer Spending and Debt to Tax Rebates: Evidence from Consumer Credit 

Data,” Journal of Political Economy, vol. 115, no. 6 (December 2007), pp. 986–1019; and David S. 

Johnson, Jonathan A. Parker, and Nicholas S. Souleles, “Household Expenditure and the Income 

Tax Rebates of 2001,” American Economic Review, vol. 96, no. 5 (December 2006), pp. 1589–1610.
37

CBO

tax cuts and associated government borrowing discourage spending by households 

and businesses. In estimating the magnitude of indirect effects, CBO relied heavily on 

estimates from macroeconometric forecasting models, informed by evidence from 

other types of models and from direct estimation using historical data.7

The estimates of policy effects on output were translated into estimates of the effects 

on the unemployment rate, total employment, and fulltimeequivalent employment 

in a series of steps. First, the impact on the output gap—the percentage difference 

between actual and potential output—was calculated.8

 Next, the effect of the change 

in the output gap on the unemployment rate was estimated using the historical rela

tionship between those two measures.9

 Then, the effect of changes in the unemploy

ment rate on the labor force was taken into account: If unemployment declines and 

the economic environment improves, discouraged workers and people who have cho

sen to pursue activities such as education rather than work will tend to return to the 

labor force. Together, the estimated effect on the unemployment rate and the effect on 

the labor force were used to estimate the impact on the number of people employed. 

The change in fulltimeequivalent employment was then estimated using the histori

cal relationship between changes in hours per employed worker and changes in the 

gap between the unemployment rate and CBO’s estimate of the natural rate of 

unemployment.10

A key disadvantage of the modelbased approach used in this analysis is the consider

able degree of uncertainty about many of the economic relationships that are impor

tant in the modeling. Because economists differ on which analytical approaches pro

vide the most convincing evidence about such relationships, they can reach different 

conclusions about them. In addition, each study involves uncertainty about the extent 

to which the results reflect the true effects of a given policy or the effects of other fac

tors. For those reasons, CBO provides ranges of estimates of each policy’s effects.

Quantifying the Longer-Term Effects of the Policies

CBO’s estimated effects for 2020 and later years incorporate supplyside effects only. 

The economic models used in the longerterm analysis represent people’s economic 

decisions in a simplified way that does not capture all aspects of actual behavior. Even 

7. For more details about those sources of information, see Congressional Budget Office, Estimated 

Impact of the American Recovery and Reinvestment Act on Employment and Economic Output From 

April 2010 Through June 2010 (August 2010), Appendix.

8. Potential output is the level of production that corresponds to a high rate of use of labor and capi

tal.

9. Changes in the output gap affect unemployment gradually over several quarters. Initially, part 

of a rise in output shows up as higher productivity and hours per worker rather than as reduced 

unemployment.

10. The natural rate of unemployment is the rate that arises from all sources except cyclical fluctuations 

in economywide demand for goods and services.
38

CBO

so, the results provide a reasonable range of estimated responses to changes in policy. 

CBO used two growth models to analyze the effects of the policy options in 2020.11

The models—a textbook growth model and a lifecycle growth model—differ in their 

assumptions about whether people look to the future in making plans and in the ways 

the models capture people’s responses to changes in marginal tax rates.

Textbook Growth Model

The textbook growth model assumes, in effect, that people do not consider expected 

future policies when they make economic decisions. CBO used the textbook growth 

model to estimate effects under two assumptions about how much people would 

adjust their work hours in response to changes in marginal tax rates: a “strong labor 

response” assumption, under which workers’ response is on the high side of the con

sensus range of empirical estimates from studies based on oneyear changes in labor 

supply, and a “weak labor response” assumption, under which workers respond very 

little.12

Life-Cycle Growth Model

In contrast to the textbook growth model, the lifecycle model is built on the assump

tion that people adjust their decisions about work and saving in response to current 

changes in marginal tax rates, government transfer payments, and aftertax rates of 

return—and in anticipation of future changes in those factors. In particular, the life

cycle model incorporates the assumption that people make lifelong plans for work and 

saving. Moreover, the lifecycle model assumes that people know with certainty how 

the government will resolve its longterm budget imbalance, whether by raising tax 

rates, cutting spending, or implementing some combination of the two. The lifecycle 

model also assumes that households face uncertainty about future wages and could 

become credit constrained (that is, unable to borrow to maintain their spending) if 

their wages declined significantly.13

The forwardlooking characteristics of the lifecycle model necessitate assumptions 

about what people believe will happen in the future, not only during the 10year pro

jection period of CBO’s baseline but into the indefinite future as well. For its analysis, 

CBO assumed that people believe that the policies being assessed—those of the policy 

11. Growth models are often called supplyside models. They assume that the labor market is always in 

equilibrium and thus that overall fiscal policy has no effect on the unemployment rate.

12. CBO’s estimates used data from a large sample of taxpayers to account for the effects of changes in 

marginal tax rates and in aftertax income under the policy options. The models incorporated a 

larger response to changes in marginal tax rates among secondary earners than among primary 

earners.

13. The incorporation of uncertainty and credit constraints has an important effect on the results from 

this model: Unlike models that are similar in other respects but assume certainty and no constraints 

on borrowing, this model produces effects on people’s behavior of increases in disposable income 

from government policies, even if people expect the policies to be fully offset in the future.
39

CBO

options or of CBO’s baseline—will be maintained through 2020. In reality, people 

may well believe that the policies might change at some point during that time.

For the years after 2020, however, the policies that are analyzed here are unsustain

able.14 Therefore, CBO made two assumptions about the manner in which the reduc

tion in revenues under the alternative tax policies would eventually be reflected in 

taxes and spending. Under one assumption, people believe that the initial tax reduc

tions will be financed by gradually adjusting government spending for goods and ser

vices and for transfer payments over the period from 2021 to 2030. Under the other 

assumption, people believe that the initial tax reductions will be financed by gradually 

adjusting marginal tax rates over the same period. In addition, as in the case of the 

textbook growth model, the lifecycle model’s estimates incorporate assumptions 

about the “strong” or “weak” responsiveness of labor supply to changes in marginal tax 

rates. Thus, for each policy option, the lifecycle model produced four estimates of 

economic effects, combining different assumptions about future changes in policy 

and about the responsiveness of labor supply.15

14. See Congressional Budget Office, The LongTerm Budget Outlook (June 2010, Revised August 

2010).

15. In the past, CBO has also presented results from the lifecycle model based on the assumption that 

interest rates and wages in the United States are completely determined by the rest of the world (an 

“open economy” assumption) or that domestic interest rates and wages are unaffected by the rest of 

the world (a “closed economy” assumption). The estimates in this analysis average the results of 

those two assumptions to produce an intermediate result.