Technical Paper Series

Congressional Budget Office

Washington, D.C.

Macroeconomic Analysis of a 10 Percent Cut in Income Tax Rates

Robert Dennis, Douglas Hamilton, Robert Arnold, Ufuk Demiroglu, Tracy Foertsch, Mark

Lasky, Shinichi Nishiyama, Larry Ozanne, John Peterson, Frank Russek, John Sturrock, and

David Weiner

May 2004

2004-07

Technical papers in this series are preliminary and are circulated to stimulate discussion and

critical comment. These papers are not subject to CBO’s formal review and editing processes.

The analysis and conclusions expressed in them are those of the authors and should not be

interpreted as those of the Congressional Budget Office. References in publications should be

cleared with the authors. Papers in this series can be obtained at www.cbo.gov (select

Publications and then Technical Papers).
Abstract

This paper explores the effects of a simple policy change—a 10 percent tax cut—to shed light on

the different models CBO uses to examine the macroeconomic effects of policy changes. Most

of the models predict that such a simple tax cut will increase GDP and therefore that the revenue

loss from the tax cut will be smaller than the conventional estimate predicts over the first 10

years. None of the models predict that as much as 25 percent of the conventional cost could be

offset, however.

This paper is an expanded version of a paper presented at the National Tax Association’s annual

conference on November 14, 2003.
1. Congressional Budget Office, An Analysis of the President's Budgetary Proposals for Fiscal Year 2004 (March 2003)

and An Analysis of the President's Budgetary Proposals for Fiscal Year 2005 (March 2004). All CBO documents

referred to in this paper are available on CBO’s Web site, www.cbo.gov.

2. Congressional Budget Office, How CBO Analyzed the Macroeconomic Effects of the President's Budget (July 2003).

1

Introduction

The Congressional Budget Office (CBO) has for many years informed Congress of the economic

implications of its fiscal policy decisions. Those analyses, contained in CBO’s periodic reports

on the budget and economic outlook and in other publications, generally refer to policies already

in place and are intended to explain how CBO interprets the effect of fiscal policy on the

economic outlook. They have always, and necessarily, considered the full range of possible

macroeconomic effects.

More recently, in response to congressional demand, CBO has undertaken extensive analyses of

the President’s budget proposals for fiscal years 2004 and 2005; CBO’s analysis examined how

those proposals, if enacted, might affect the outlook for the economy in the subsequent 10 years.1

The first of those analyses, which dealt with a prospective rather than an enacted policy, was a

departure for CBO. However, it used tools that CBO has developed over a number of years.

The details on how CBO conducted its analyses of the President’s budget proposals and on the

models it used are available on CBO’s Web site.2 However, the President’s proposals were

complex, including changes in many different provisions of both taxes and spending. In this

paper, we use the same tools to examine a much simpler proposal: a 10 percent reduction in

personal income tax rates. This experiment illustrates how CBO’s models work and provides

some insight into the implications of alternative assumptions.

A macroeconomic analysis requires a more comprehensive specification of the budgetary

experiment than does a conventional analysis. In the case of a 10 percent reduction in personal

income tax rates, the macroeconomic analysis requires making specific assumptions about how

the tax cut will be financed—for example, by borrowing, raising other taxes, or spending

less—in each year in the 10-year budgetary window. Moreover, to the extent that the tax cut

induces cumulative budgetary shortfalls or surpluses, the analysis must specify the corresponding

offsetting policy outside the budgetary window. The additional specificity allows for a more

comprehensive accounting of budgetary consequences than the conventional estimates made for

scoring purposes can provide. Those budgetary consequences include the initial decline in

receipts; revenue gains and outlay decreases stemming from higher GDP; and additional interest

costs from higher borrowing.

The paper reviews the details of the experiment; the macroeconomic models we used in the

analysis; the calculation of impacts on effective marginal tax rates; and the results of the analysis.
3. The levels of effective marginal tax rates in Table 1 are lower than some others in the literature because they include

untaxed capital such as housing, and they also reflect the proportion of income that accrues to untaxed or tax-preferred

entities such as pension funds.

2

The Budget Experiment

The analysis is based on CBO’s January 2003 economic baseline, adjusted to use tax rates

consistent with the Jobs and Growth and Tax Relief Reconciliation Act of 2003 (JGTRRA).

Because the experiment looks at additional tax cuts beyond those included in JGTRRA, the

estimated effect of further tax cuts is somewhat smaller in the years 2004 and 2005 than if preJGTRRA tax rates had been used.

The experiment cuts all federal individual income tax rates by 10 percent, including the

following:

• rates on ordinary income;

• rates on long-term capital gains and dividend income; and

• alternative minimum tax rates.

Rates are assumed to be cut on January 1, 2004, and the reduction in revenues is matched by

increased deficits for 10 years. Some of our simulations involve forward-looking models, for

which policy after the 10-year horizon is also important. We examined a range of policy

assumptions in those cases, as discussed below.

While this experiment cuts federal income tax rates by a uniform amount, the effective tax rates

on labor and capital would drop non-uniformly and by smaller amounts. The experiment does

not change either state taxes or social insurance tax rates; as a result, the effective tax on labor,

which includes those taxes, would drop by only 5 percent to 6 percent, not 10 percent. Similarly,

because neither corporate taxes nor state taxes on capital income would change, effective tax

rates on capital income would drop by only about 3 percent (see Table 1).3

Conventional Estimate

CBO’s analysis of the effects of a tax proposal starts with the conventional or scoring estimate

that the Joint Committee on Taxation (JCT) provides. That estimate reflects the following:

• JCT’s estimate of the “static” cost of the tax cut, that is, the effect of reducing rates

assuming that taxable incomes do not change; and

• JCT’s estimate of changes in taxable income as a result of the tax cut that can be

accounted for even under the fixed GDP convention. Those include changes in the

timing and form of income and deductions as well as changes in compliance. For

example, with a lower personal income tax rate, individuals may receive more in taxable
4. CBO’s analysis of the President's budget for fiscal year 2004 calculated the effects of the proposed dividend tax

changes on the cost of capital and on stock prices under two alternative views of how dividend taxation affects the

economy. That analysis also estimated efficiency effects from capital reallocation. However, the change in the

dividend tax rate is small in the proposal examined here and is likely to have little effect on the overall results, so we

did not repeat that extensive analysis.

3

wages and less in non-taxed fringe benefits, and businesses may choose the non-corporate

organization form in order to qualify for the lower individual tax rates.

For these experiments, we also started with estimates kindly provided by JCT (see Table 2). JCT

estimated a conventional revenue loss of $466 billion over the first five years (2004 through

2008) and $775 billion over second five years. The reductions in ordinary and AMT rates

account for almost all of the revenue loss, and very little (less than $28 billion over 10 years)

comes from reductions in rates on capital gains and dividends.4

The macroeconomic analysis would not be complete unless it also took into account the effects

of the proposal on interest costs, which are not reflected in the conventional scoring estimate for

any proposal. Interest costs cannot be calculated without knowing how the proposal is to be

financed—information that is not generally available for specific tax or spending proposals

without more assumptions than a legislative proposal provides. In this exercise, we have made

an explicit assumption that the tax cut is to be financed by borrowing in the first 10 years. That

assumption allows us to calculate the implications for debt service—again, before taking into

account any macroeconomic effects such as changes in interest rates. Adding debt service

increases the budgetary cost of the tax cut by about 25 percent over 10 years.

Models for Macroeconomic Analysis

CBO does not believe that any single model can adequately explore the macroeconomic

implications of fiscal policy: the best that analysts can do is to combine the separate insights that

they can glean from different models. For example, the President’s 2004 budget proposal, put

forward at a time of economic weakness, was intended to accelerate recovery from recession.

But it also had implications for incentives to work and to save, as well as for overall national

saving. The simple tax cut examined here would also have those effects. To examine how the

tax cut would stimulate demand in the short run, we used models that allowed for

macroeconomic disequilibrium and for a role for fiscal policy in stimulating aggregate demand

relative to aggregate supply. For that reason, we used two commercially available Keynesian

models in our analysis, those of Macroeconomic Advisers (MA) and Global Insight (GI).

Those models cannot address the effects of alternative assumptions about the financing of tax

cuts, however, because they do not allow consumers and workers to anticipate the likely

implications of current policies for future taxes and government spending. For that reason, we

also use two forward-looking general-equilibrium growth models developed by CBO staff.

Those are the same models as CBO used in its analyses of the President’s budget for fiscal years

2004 and 2005.
5. In the GI model, total factor productivity depends in part on spending on R&D.

6. For details of the GI model, contact Cynthia Latta at Global Insight Inc., 1-800-933 3374. For the MA model, see

Macroeconomic Advisers, LLC, WUMMSIM for Windows: Version 1.6 Model Book (September 2000).

4

All of those models are fairly complex, with results that can be quite difficult to interpret. For

comparison purposes, therefore, we also include results from a simple textbook growth

model—the same one that CBO regularly uses to make its 10-year baseline projections.

Keynesian Models. The two Keynesian models embody what is often known as the neoclassical

synthesis—that is, they model short-run demand dynamics while imposing the long-run structure

of a neoclassical growth model. They include all the major macroeconomic variables, describing

demand, supply, and inflation processes; they also include financial sectors. While prices are

sticky and markets do not clear in the short run, excesses of aggregate demand eventually

dissipate through higher inflation. (Thus, the long-run Phillips curves in these models are

vertical.) The models have as their supply-side core a growth model in which potential GDP

depends on investment and on labor supply, along with largely exogenous total factor

productivity growth5

. Generally speaking, shocks to such models generate cycles that are about

the same length as business cycles, though the characteristics of those cycles depend a great deal

on the monetary policy assumptions made. Personal tax cuts increase GDP in these models in

the short run mainly because they increase after-tax incomes and hence consumption spending.

Both models are estimated econometrically, using historical time-series data.6

We used the results of the Keynesian models for only the first five years. We did this for two

reasons. First, the models’ strength is in their analysis of demand effects, which are increasingly

harder to estimate as the projection extends into the future. Second, although the models contain

an underlying growth model, their results do not converge to growth-model results within the 10-

year budget window. Instead, they continue to cycle. However, the timing of those cycles is

highly uncertain and extremely sensitive to parameters of the models that are likely to be poorly

estimated. Thus the results could be quite unreliable after a few years.

We made three different kinds of adjustments to the models. The first, uncontroversial, set of

adjustments realigned the models’ baselines to approximate real and nominal incomes, spending,

revenues, investment, and interest rates in CBO’s baseline. In CBO’s experience, some effort to

approximate a standard baseline is an important, though time-consuming, step.

The second set, perhaps a little more controversial, corrected for some behaviors in the models

that seemed unhelpful to the analysis. Large macro models such as these are built mainly with

the commercial forecasting market in mind and may have features that diminish their usefulness

for policy analysis. For example, the GI model includes what appears to be a poorly supported

feedback from changes in capacity utilization to stock prices. When CBO staff use such models,

they scan the results to find elements that appear questionable and, by eliminating them, hope to

improve the estimates of the effects of fiscal policy. The staff of MA and GI, the model
5

providers, make similar adjustments when they use their models for policy analysis. The

downside is that other users of the same models may make different adjustments and thus get

somewhat different results for the same policy simulations.

Finally, we strengthened the supply-side effects in the models. In the MA model, labor supply

does not respond to changes in after-tax wages and therefore is not directly affected by a

reduction in tax rates. In the GI model, labor supply does respond to tax rates but only weakly.

As a result, without adjustment, the models would predict that tax cuts would yield a relatively

small increase in potential GDP, which would limit the extent to which increases in demand

could add to GDP without causing inflation. To allow the models to describe the demand

response appropriately, we forced the labor supply in both models to increase according to our

calculations (see Box 1).

The Keynesian models require assumptions about monetary policy. Different monetary policy

assumptions may be appropriate at different times. For example, when a policy change occurs in

the middle range of a business cycle, with GDP close to its sustainable level, it may be

appropriate to assume that the Federal Reserve will not alter its target for the unemployment rate

and thus will tend, on average, to offset much of fiscal policy’s effect on aggregate demand. On

the other hand, when the economy is very weak and the Federal Reserve is running out of options

for stimulating demand through monetary policy, it may welcome a boost to aggregate demand

from fiscal policy. In that case, there will be little or no monetary offset to a tax cut or other

stimulative fiscal policy.

We examined two alternative assumptions about monetary policy. In the first, the Federal

Reserve follows a Taylor rule, setting the real federal funds rate to reflect what is happening to

both inflation and real GDP. In the second, the Federal Reserve adjusts monetary policy to keep

the unemployment rate at baseline, thus completely offsetting any demand effects from the policy

but allowing supply-side effects to go though. Those alternative assumptions—especially the

second—are not meant to be realistic predictions of how the Federal Reserve might actually

respond but are included to show the range of implications of alternative assumptions. The

second assumption is also useful analytically because it helps isolate the supply-side impacts of

tax cuts in the models.
6

General-Equilibrium Growth Models. The general-equilibrium (GE) growth models that we

used, although complex, are still in some ways much simpler than the Keynesian models. They

have no aggregate prices, money, or financial sectors; they do not contemplate disequilibrium, so

they cannot be used to examine the ways fiscal policy can shift demand relative to supply; and

they assume that agents (workers and savers) are forward-looking and know as much about

future fiscal policy as does the modeler.

The GE growth models also have two important strengths relative to the Keynesian models:

• Agents’ decisions are based on utility functions rather than on historical relationships that

reflect mixtures of fundamental parameters and accidental circumstances; and

• Government policies obey an intertemporal budget constraint.

Box 1. Out-of-Model Labor Supply Calculations

The impact of lower tax rates on labor supply is an important part of the overall

macroeconomic effect of tax cuts. In CBO’s general-equilibrium models, those labor-supply

effects come from more fundamental assumptions about utility functions and the maximum

number of hours people can work in a year. In the textbook growth model and the commercial

macroeconomic models, by contrast, labor supply effects must be specified directly. The

models show either a small (GI) or zero (MA and the textbook growth model) elasticity of

labor supply to after-tax wages. Both small and zero elasticities can be found in the literature

on labor supply, but our best estimate is that uncompensated labor supply elasticities are

positive and larger than GI’s prediction, averaging about 0.1 for men and 0.5 for women. See

Congressional Budget Office, Labor Supply and Taxes (January 1996); CBO’s informal

review of later studies does not significantly alter its estimates.

Our calculations used a microsimulation model based on tax returns that reflects the tax code

in great detail. For each taxpayer in the sample, the model calculates changes in after-tax

income and wage rates. Labor supply changes are calculated based on elasticities that are

fixed for secondary workers (where the data are thinner) but vary by income class for primary

workers. The spread of elasticities for primary workers across income classes comes from

Juhn et al., Current Unemployment, Historically Contemplated (BPEA 2002:1), adjusted to

yield an overall uncompensated elasticity of 0.1. The implied substitution elasticity is 0.15 for

primary workers and 0.75 for secondary workers.

That microsimulation model predicts that the 10 percent cut in taxes would increase labor

supply by about 0.5 percent. We imposed that estimate in both of the commercial

macroeconomic models and in the textbook growth model. The general-equilibrium models

predicted much larger changes in labor supply impacts (see Appendix Table A-2).
7

We used two GE growth models in this analysis. One is a stochastic OLG model, in which

agents’ decisions reflect the uncertainty of both their own life span and their own relative

income. There is no aggregate uncertainty in the model, so agents can know with certainty what

prices (interest rates and wage rates) they face. But the uncertainty about an individual’s life

span and future income means that agents have a precautionary as well as a life-cycle motive for

saving. The amount of uncertainty is enough to generate a plausible volume of accidental

bequests. The model can be run in both closed-economy and open-economy versions, which

provides a useful check on the robustness of results. This model, developed by Shinichi

Nishiyama, is described in a number of papers on CBO’s Web site, most recently in Nishiyama ,

Analyzing Tax Policy Changes Using a Stochastic OLG Model with Heterogeneous Households,

Technical Paper 2003-12 (December 2003).

The other GE growth model is an infinite-horizon model along lines originally suggested by

Frank Ramsey. The model assumes that agents are alike and that they value the utility of future

generations as much as they do their own, discounting it in the same way. Thus, in essence,

agents in the model behave as if they had infinite lives. The model focuses on the incentive

effects of changes in tax rates. A summary description of the Ramsey model can be found in

How CBO Analyzed the Macroeconomic Effects of the President's Budget, cited previously.

Both of the GE growth models impose an intertemporal budget constraint on the government, so

that the tax cut must be offset at some point either by increased future taxes or by lower future

spending. That financing, by the definition of the experiment, does not occur during the 10-year

budget window; we assume in all simulations that the government simply increases its borrowing

in that period. However, different assumptions about financing outside the budget window affect

the results, even in the first 10 years.

We explored two different financing assumptions for the tax cut:

1. Government spending (on goods and services, not transfers) is cut gradually over the 10-

year period starting in 2014. By 2024, those cuts are deep enough to stabilize the ratio of

debt to GDP. In these models, such government spending is assumed to be quite different

from private spending, and differing levels of government spending do not directly enter

into private decisions about saving or spending. But lower government spending leaves

more resources available for private consumption.

2. Federal income tax rates are raised gradually over the same 10-year period by enough to

stabilize the ratio of debt to GDP in 2024. The tax increase ultimately has to be larger

than the initial 10 percent tax cut in order to pay interest on the additional debt that

accrues between 2004 and 2024. From a welfare point of view, this is an unfavorable

assumption because the distortion caused by raising tax rates in the long run exceeds the

distortions avoided by reducing tax rates in the short run.

The GE growth models assume that agents know how the tax cut will ultimately be financed.

Workers who anticipate that income taxes will rise in the future will tend to increase their hours
7. For a detailed description of the textbook growth model, see Congressional Budget Office, CBO’s Method for

Estimating Potential Output: An Update (August 2001).

8

worked before the taxes go up, with the expectation that they will work less when rates are

higher. There is no such anticipatory increase in labor supply when people expect the tax cut to

be financed by reduced government spending on goods and services.

Textbook Growth Model. The simple textbook growth model is an enhanced version of the

model developed by Robert Solow.7 The model determines output (GDP) using the number of

hours of labor supplied by workers, the size and composition of the capital stock, and total factor

productivity. Unlike the GE growth models, the textbook growth model is not forward-looking:

people do not respond to expected changes in future policy. Unlike the Keynesian models, the

model does not incorporate any demand or cyclical effects; rather, it assumes that output is

always at its potential level.

The estimates using the textbook growth model incorporated the same increase in labor supply as

was imposed on the Keynesian models (see Box 1). The model also reflects the government’s

increased borrowing, which “crowds out” private investment—much less than one-for-one, but

still a significant effect. The model is calibrated to reduce private investment by 36 cents for

every dollar of government borrowing—a calibration that reflects estimates of both how much an

increase in the government’s borrowing directly adds to private saving and how much of a

reduction in national saving is financed by increased capital inflows.

Economic Effects (GDP)

All of the models predict that a 10 percent cut in income tax rates will increase real GDP within

the first 10 years (see Table 3). The results fall into two groups: the textbook growth model and

the Keynesian models, with unemployment held at baseline, predict relatively small effects; the

remainder of the model simulations fall into a narrow range of larger effects. CBO’s previously

published estimates of the macroeconomic effects of the President’s budget have sometimes

found much wider differences among models (see An Analysis of the President's Budgetary

Proposals for Fiscal Year 2004, cited earlier).

The narrow range of results, especially among the GE models, reflects both the simplicity of the

experiment and the fact that the reduction in marginal tax rates is large compared with the overall

budget cost of the tax cut. The models differ most in the way that they handle the increase in the

deficit, and in this experiment the deficit increases play a much smaller role than they did in the

analysis of the President’s budget for 2004 (which also included spending and tax proposals that

did not reduce marginal rates).

Textbook Growth Model. The smallest effects on GDP come from the textbook growth model,

reflecting two offsetting effects: the increase in labor supply and the “crowding out” of private

investment from the increased deficit. The labor supply is assumed to respond quickly to the tax

cut, but the decline in investment has a cumulative effect, which starts out small, on the capital
9

stock. Consequently, in the first five years GDP rises, on average, but by the second five years

the crowding out catches up, and the net effect on GDP is very close to zero. (Because the model

assumes that some government borrowing will be financed from abroad, the effect on GNP,

which reflects the cost of servicing that debt, is generally more negative than the effect on GDP).

GE models (OLG and Ramsey). All of the GE growth model simulations showed significantly

more growth in the short run than did the textbook growth model. In these models, unlike the

textbook growth model, a cut in income taxes means a cut in taxes on capital as well as labor.

The result is to encourage both private saving and work effort in the short run. The increase of

labor supply is significantly larger than in the textbook growth model. A lot of the increased

income from labor goes to higher investment, and as a result, in these models, the private capital

stock is actually higher in the short run; there is “crowding in” rather than crowding out.

By the second five years, however, the models’ results, while remaining positive, begin to

diverge as two opposing effects become important. In the closed-economy OLG model,

crowding out becomes increasingly important in the second five years as the deficit grows and

private capital begins to fall. If the tax cut is ultimately expected to be financed with lower

government spending, the result is that the tax cut increases GDP by less in the second five years

than in the first five. If the initial budget cost is eventually expected to be financed by raising tax

rates, by contrast, the prospect of imminently higher rates causes workers to supply more labor.

Paradoxically, therefore, a tax cut will increase GDP by more in the second five years if it is

expected to be reversed.

In the open-economy version of the OLG model, the results for GDP are higher and more stable

because that model has no crowding out; higher government borrowing is entirely met by

increased capital inflows from abroad. Of course, those capital inflows mean that foreigners will

own an increased proportion of U.S. output. GNP, which reflects that change in ownership,

looks very much like the closed-economy results for GDP.

The Ramsey model has generally more optimistic predictions than the OLG models in the second

five years because that model predicts that the worsening of the government deficit from a tax cut

will be entirely offset by an increase in private saving, thus ruling out any crowding out of

investment when the deficit increases because of tax cuts. But the Ramsey model predicts an

even larger increase in the labor supply than the OLG models do when tax rates are expected to

rise, thereby producing the largest increase in GDP among the models examined (see Table 3).

The GE models are able to compute a long-run economic impact, which, not surprisingly,

depends on how the short-run tax cut is eventually financed. Financing through tax increases

reduces GDP (or GNP) in the long run in both GE models because the higher rates discourage

work effort and saving. However, financing through cutting government spending produces an

increase in long-run GDP in the Ramsey model and a small decrease in the OLG closed-economy

model. The difference arises because, as noted above, the Ramsey model does not permit

crowding out, so the capital stock is permanently larger in that model than in the OLG model,

which does incorporate crowding out.
10

Keynesian models (MA and GI). The Keynesian model results also show larger supply-side

increases in GDP than the textbook growth model for the first five years. (Supply-side effects are

imperfectly approximated by the results from the Keynesian models that hold the unemployment

rate at its baseline value.) Because the impact on labor supply is constrained to be the same as in

the textbook growth model, all of the difference is in capital; that difference arises because

private saving increases by more than it does in the growth models.

The textbook growth model assumes that a fixed 40 percent of any increase in the government

deficit will be offset by increased private saving—a calculation that does not depend on the

source of the larger deficit. The Keynesian models, by contrast, assume that the size of the offset

depends on what causes the deficit to grow; the deficit will be a lot larger when it results from a

tax cut. In those models, cutting taxes increases personal consumption spending only slowly and,

even in the long run, increases consumption less than the tax cut does. The difference is the

increase in private saving.

Because of that difference, the Keynesian models predict supply-side effects in the first five years

that are between those of the textbook growth model and the GE models. (Recall that we

imposed a labor-supply response in the models; running the models without that adjustment

would again reduce their predicted effects.) The Keynesian models produced somewhat larger

effects on GDP in the simulations run with a Taylor rule for monetary policy because under that

assumption, the models predict demand as well as supply effects.

Further details of the simulations are provided in Appendix Tables A1 and A2.

Budget Implications

The budgetary implications of the macroeconomic results reflect much more than increases in

GDP. In the GE models, the calculations reflect the changes in depreciation as investment

increases. In the Keynesian models, the calculations also reflect changes in tax bases as a result

of increased inflation, as well as changes in incomes and interest rates induced by the assumed

response of the Federal Reserve. Details are provided in How CBO Analyzed the

Macroeconomic Effects of the President's Budget, cited above.

In the first five years, up to 22 percent of the cost of a simple cut in personal income taxes is

offset by the revenue flowing from higher GDP (see Table 4). Similar numbers apply for the

second five years, although we did not continue the Keynesian model simulations into those

years. The Ramsey model predicts as much as a 26 percent feedback if taxes are later expected to

rise. (The textbook growth model predicts negligible budget effects from its small

macroeconomic feedbacks.) It is also interesting to note that almost all of the budgetary

consequences of the macroeconomic feedbacks that the models predict are smaller over 10 years

than the additional debt service that a tax cut implies, even without an increase in interest rates.
11

Table 1. Effective Marginal Rates on Labor and Capital (Percent)

Tax on Labor Tax on Capital

Calendar Current Percent Current Percent

Year Law Proposal Change Change Law Proposal Change Change

Effective Federal Income Tax Rates (Corporate and Individual Combined)

2004 18.1 16.3 -1.8 -10 13.9 13.4 -0.4 -3

2005 19.0 17.1 -1.8 -10 13.9 13.5 -0.4 -3

2006 19.0 17.2 -1.8 -10 14.0 13.5 -0.4 -3

2007 19.3 17.4 -1.9 -10 14.0 13.6 -0.4 -3

2008 19.5 17.6 -1.9 -10 13.9 13.5 -0.4 -3

2009 19.7 17.8 -1.9 -10 14.9 14.3 -0.5 -4

2010 20.0 18.1 -1.9 -10 14.9 14.3 -0.5 -4

2011 21.8 19.7 -2.1 -10 15.5 14.9 -0.6 -4

2012 22.0 19.8 -2.2 -10 15.5 14.9 -0.6 -4

2013 22.0 19.8 -2.2 -10 15.5 14.9 -0.6 -4

Effective Federal and State Income Tax Rates and Federal Social Insurance Tax Rates

2004 32.0 30.3 -1.7 -5 16.8 16.4 -0.4 -3

2005 32.8 31.0 -1.8 -5 16.9 16.4 -0.4 -3

2006 32.9 31.1 -1.8 -5 16.9 16.5 -0.5 -3

2007 33.1 31.3 -1.9 -6 17.0 16.5 -0.5 -3

2008 33.3 31.5 -1.9 -6 16.9 16.5 -0.4 -3

2009 33.6 31.7 -1.9 -6 17.8 17.3 -0.5 -3

2010 33.8 31.9 -1.9 -5 17.8 17.3 -0.5 -3

2011 35.5 33.5 -2.0 -6 18.4 17.8 -0.6 -3

2012 35.8 33.7 -2.1 -6 18.4 17.8 -0.6 -3

2013 35.8 33.6 -2.2 -6 18.4 17.8 -0.6 -3
12

Table 2. Conventional Estimate of the Budgetary Costs of Cutting Federal

Individual Income Tax Rates by 10 Percent (Billions of Dollars)

2004-2008 2009-2013

10% Cut in statutory rates (except gains and dividends) -452 -761

10% Cut in dividend and gains rates -14 -13

Total revenue loss (conventional estimate) -466 -775

Debt service 56 261

Total effect on the budget surplus -522 -1,035

SOURCE: Joint Committee on Taxation.

NOTE: Estimate against January 2003 baseline, adjusted for the effects of JGTRRA.
13

Table 3. Impact on Real GDP of a Deficit-Financed 10 Percent Cut in Federal

Income Tax Rates (Average Percent Difference from Baseline)

Model

2004-

2008

2009-

2013

Long Run

Textbook Growth Model 0.2 0 NA

OLG—Closed Economy Model

Financed by cuts in government spending after 10 years 0.6 0.3 -0.1

Financed by increases in tax rates after 10 years 0.6 0.5 -1.5

OLG—Open Economy Model

Financed by cuts in government spending after 10 years 0.8 0.5 0.5

Financed by increases in tax rates after 10 years 0.9 0.7 0.2

Ramsey Model

Financed by cuts in government spending after 10 years 0.6 0.5 0.6

Financed by increases in tax rates after 10 years 0.8 1.1 -0.9

Global Insight Model

Taylor Rule 0.4 NA NA

Unemployment rate at baseline 0.2 NA NA

Macroadvisers’ Model

Taylor Rule 0.6 NA NA

Unemployment rate at baseline 0.3 NA NA

Memo: Effect on Real GNP

Textbook Growth Model 0.2 -0.1 NA

OLG—Open Economy Model

Financed by cuts in government spending after 10 years 0.5 0.2 -0.4

Financed by increases in tax rates after 10 years 0.6 0.3 -2.1

Global Insight Model

Taylor Rule 0.4 NA NA

Unemployment rate at baseline 0.1 NA NA

Macroadvisers’ Model

Taylor Rule 0.5 NA NA

Unemployment rate at baseline 0.3 NA NA

NOTE: NA = Not applicable
14

Table 4. The Cumulative Impact on the Budget Surplus of a 10 Percent Cut in Federal

Income Tax Rates (Billions of Dollars)

2004- 2009- 2004-

2008 2013 2013

Conventional Estimate -466 -775 -1,241

Additional Debt Service on Conventional Estimate 56 261 317

Conventional Estimate plus Debt Service -522 -1,035 -1,557

Macroeconomic Feedbacks from Various Models

Textbook Growth Model 6 -39 -33

OLG—Closed Economy Model

Financed by cuts in government spending after 10 years 77 107 184

Financed by increases in tax rates after 10 years 82 132 214

OLG—Open Economy Model

Financed by cuts in government spending after 10 years 98 142 240

Financed by increases in tax rates after 10 years 104 154 258

Ramsey Model

Financed by cuts in government spending after 10 years 58 99 158

Financed by increases in tax rates after 10 years 81 199 280

Global Insight Model (Taylor Rule) 62 NA NA

Macroadvisers' Model (Taylor Rule) 67 NA NA

Memo: Macroeconomic Feedbacks (As a Percent of the Conventional Estimate)1

Textbook Growth Model 1% -5% -3%

OLG—Closed Economy Model

Financed by cuts in government spending after 10 years 17% 14% 15%

Financed by increases in tax rates after 10 years 18% 17% 17%

OLG—Open Economy Model

Financed by cuts in government spending after 10 years 21% 18% 19%

Financed by increases in tax rates after 10 years 22% 20% 21%

Ramsey Model

Financed by cuts in government spending after 10 years 12% 13% 13%

Financed by increases in tax rates after 10 years 17% 26% 23%

Global Insight Model (Taylor Rule) 13% NA NA

Macroadvisers’ Model (Taylor Rule) 14% NA NA

NOTES: Totals may not add due to rounding.

NA = Not applicable

1. Excludes debt service on the conventional estimate
15

Appendix: Detailed Macroeconomic Results

Table A-1. Effects of a 10 Percent Cut in Income Tax Rates: Results from

Keynesian Macroeconomic Models (Percent Difference from

Baseline, Except Where Noted)

2004-

2004 2005 2006 2007 2008 2008

Global Insight Model (Taylor Rule)

Nominal GDP 0.5 0.7 0.7 0.8 0.8 0.7

Real GDP 0.4 0.5 0.4 0.5 0.4 0.4

Real Gross Private Domestic

Investment

0.9 0.8 -0.1 -0.1 -0.4 0.2

Real Consumption 0.6 0.9 0.9 1.0 1.0 0.9

Employment 0.5 0.6 0.6 0.6 0.6 0.6

Full-employment labor force 0.4 0.5 0.5 0.5 0.5 0.5

Unemployment rate (in percentage

points)

-0.1 -0.1 -0.1 -0.1 0.0 -0.1

CPI inflation (in percentage points) 0.1 0.1 0.1 0.1 0.1 0.1

3-month T-bill rate (in percentage

points)

0.1 0.1 0.1 0.1 0.2 0.1

10-year T-note yield (in percentage

points)

0.1 0.1 0.2 0.2 0.3 0.2

Global Insight Model (Unemployment Rate at Baseline)

Nominal GDP 0.3 0.4 0.5 0.6 0.6 0.5

Real GDP 0.2 0.3 0.3 0.2 0.2 0.2

Real Gross Private Domestic

Investment

-0.1 -0.3 -0.8 -0.9 -0.7 -0.6

Real Consumption 0.4 0.7 0.9 1.0 1.0 0.8

Employment 0.5 0.5 0.5 0.5 0.5 0.5

Full-employment labor force 0.4 0.5 0.5 0.5 0.5 0.5

Unemployment rate (in percentage

points)

0.0 0.0 0.0 0.0 0.0 0.0

CPI inflation (in percentage points) 0.1 0.1 0.1 0.1 0.1 0.1

3-month T-bill rate (in percentage

points)

0.9 0.6 0.4 0.4 0.0 0.4

10-year T-note yield (in percentage

points)

0.6 0.4 0.3 0.4 0.1 0.4
16

Table A-1 Continued

MacroAdvisers’ Model (Taylor Rule)

Nominal GDP 0.6 0.9 0.9 1.0 0.9 0.8

Real GDP 0.7 0.8 0.6 0.6 0.3 0.6

Real Gross Private Domestic

Investment

2.2 2.4 0.6 0.5 -1.1 0.9

Real Consumption 0.7 0.9 0.8 0.9 0.7 0.8

Employment 0.4 0.8 0.7 0.6 0.5 0.6

Full-employment labor force 0.4 0.5 0.5 0.5 0.5 0.5

Unemployment rate (in percentage

points)

0.0 -0.3 -0.1 -0.1 0.0 -0.1

CPI inflation (in percentage points) -0.2 0.5 0.2 0.2 0.2 0.2

3-month T-bill rate (in percentage

points)

0.0 0.5 0.2 0.3 0.2 0.2

10-year T-note yield (in percentage

points)

0.0 0.3 0.2 0.2 0.3 0.2

MacroAdvisers’ Model (Unemployment Rate at Baseline)

Nominal GDP 0.4 0.3 0.4 0.3 0.4 0.3

Real GDP 0.5 0.2 0.4 0.3 0.3 0.3

Real Gross Private Domestic

Investment

1.5 -0.6 0.2 -0.3 0.0 0.2

Real Consumption 0.6 0.4 0.5 0.6 0.7 0.6

Employment 0.4 0.5 0.5 0.5 0.5 0.5

Full-employment labor force 0.4 0.5 0.5 0.5 0.5 0.5

Unemployment rate (in percentage

points)

0.0 0.0 0.0 0.0 0.0 0.0

CPI inflation (in percentage points) -0.1 0.2 -0.1 0.0 0.0 0.0

3-month T-bill rate (in percentage

points)

0.5 0.3 0.4 0.0 0.1 0.3

10-year T-note yield (in percentage

points)

0.2 0.3 0.3 0.2 0.2 0.2
17

Table A-2. Effects of a 10 Percent Cut in Income Tax Rates on Real GDP:

Estimates from GE Models (Percent Change from

Baseline)

Source of Financing 2004-2008 2009-2013 Long Run

OLG Model—Closed Economy–Financed by Cuts in Government Spending

Real GDP 0.6 0.3 -0.1

Labor Input 0.8 0.6 0.3

Capital Stock 0.1 -0.2 -1.1

Consumption 0.9 1.2 1.7

OLG Model—Closed Economy–Financed by Income Taxes

Real GDP 0.6 0.5 -1.5

Labor Input 0.9 0.7 -0.3

Capital Stock 0.1 0.0 -4.3

Consumption 0.8 1.1 -0.9

OLG Model—Open Economy—Financed by Cuts in Government Spending

Real GDP 0.8 0.5 0.5

Labor Input 0.8 0.5 0.5

Capital Stock 0.8 0.5 0.5

Consumption 1.1 1.3 1.7

OLG Model—Open Economy—Financed by Income Taxes

Real GDP 0.9 0.7 0.2

Labor Input 0.9 0.7 0.2

Capital Stock 0.9 0.7 0.2

Consumption 1.1 1.3 -0.9

Ramsey Model—Financed by Cuts in Government Spending

Real GDP 0.7 0.7 0.8

Labor Input 1.0 1.1 0.3

Capital Stock 0.1 0.0 1.5

Consumption 0.9 1.2 3.4

Ramsey Model—Financed by Income Taxes

Real GDP 0.8 1.1 -1.2

Labor Input 1.2 1.4 -0.5

Capital Stock 0.2 0.7 -2.3

Consumption 0.7 1.0 -1.1