MACROECONOMIC ANALYSIS OF VARIOUS PROPOSALS 

TO PROVIDE $500 BILLION IN TAX RELIEF 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

March 1, 2005 

JCX-4-05 
ii 

CONTENTS 

Page

INTRODUCTION .......................................................................................................................... 1 

EXECUTIVE SUMMARY ............................................................................................................ 2 

I. OVERVIEW AND COMPARISON OF PROPOSALS ............................................................. 4 

A. Policies Simulated............................................................................................................... 4 

B. Overview of Macroeconomic Effects ................................................................................. 6 

C. Graphic Comparison of Simulation Results ....................................................................... 8 

II. MODELS AND RESULTS FORMAT.................................................................................... 23 

A. Description of the Models................................................................................................. 23

B. Results Format .................................................................................................................. 26 

III. DETAILED SIMULATION RESULTS................................................................................. 28 

A. Reduction in the Individual Income Tax Rate .................................................................. 28 

B. Increase in the Personal Exemption.................................................................................. 36 

C. Reduction in the Corporate Income Tax Rate................................................................... 43 

APPENDIX A: DATA AND ASSUMPTIONS .......................................................................... 51 

APPENDIX B: ALTERNATE FEEDBACK MEASURE .......................................................... 59 
1

INTRODUCTION 

This document,1

 prepared by the staff of the Joint Committee on Taxation, provides a 

macroeconomic analysis of various proposals to provide $500 billion in tax relief. The staff of 

the Joint Committee on Taxation (“Joint Committee staff”) reports the results of simulations of 

three different tax policies using both the Joint Committee staff’s Macroeconomic Equilibrium 

Growth model and an overlapping generations life cycle model. This document provides an 

analysis of how changes in tax policy may affect the nation’s economy. This is part of the Joint 

Committee’s work to model the macroeconomic effects of proposed tax legislation and to 

provide information about macroeconomic models and their assumptions. 

 1

 This document may be cited as follows: Joint Committee on Taxation, Macroeconomic 

Analysis of Various Proposals to Provide $500 Billion in Tax Relief, (JCX-4-05), March 1, 2005. 
2

MACROECONOMIC ANALYSIS OF VARIOUS PROPOSALS TO PROVIDE 

$500 BILLION IN TAX RELIEF 

EXECUTIVE SUMMARY 

This document, prepared by the staff of the Joint Committee on Taxation (“Joint 

Committee staff”), provides macroeconomic analyses of three different proposals to reduce taxes 

by $500 billion over the period from 2005-2014, as measured by conventional revenue estimates 

of Federal fiscal year revenues. The three proposals are a decrease in individual income tax 

rates, an increase in the personal exemption, and a decrease in the corporate income tax rate. 

Each of the proposals would be effective for taxable years beginning after December 31, 2004. 

Each proposal is simulated both as a stand-alone policy, and assuming that Federal government 

spending will be contemporaneously reduced to offset the budget effects of the policy. Both the 

Joint Committee staff ’s Macroeconomic Equilibrium Growth model and an overlapping 

generations life cycle model (provided through a contract with Tax Policy Advisers, LLC.) are 

used in the simulations. 

Despite the fact that each of these tax cuts reduces revenues by the same amount 

according to conventional revenue estimates, their effects on the economy vary greatly, both 

within the ten-year budget planning horizon and in the longer run. Accordingly, the net effect of 

the policies on Federal receipts as measured including macroeconomic effects is also different 

among policies. In the short run, depending on the response of Federal fiscal and monetary 

policy, increases in after-tax income are likely to lead to increases in consumption of goods and 

services, providing a temporary demand stimulus to the economy, increasing the tax base and 

revenues. The reductions in individual income tax rates and the increase in the personal 

exemption amount, when not offset by government spending cuts, provide the largest temporary 

stimulus by creating the largest increases in after-tax income. 

These policies also have more permanent economic effects through their impact on aftertax return to labor and capital. Reductions in the corporate tax burden affect the economy 

primarily by increasing business incentives to invest in productive capital like machinery, 

equipment and technology, thereby gradually increasing the productive capacity of the economy. 

Reductions in taxes on labor affect the economy by changing both average income and the aftertax return to labor, thereby immediately affecting the willingness of people to work at market 

wage rates. Thus, the corporate tax rate reduction has the greatest effect on long-term growth, as 

the stock of productive capital accumulates and leads eventually to higher labor productivity. 

Reductions in individual income tax rates change both after-tax income and the after-tax return 

to labor, immediately affecting the willingness of people to supply labor to the economy. The 

resulting increase in both consumption demand and available labor hours has the greatest effect 

on short-term growth. 

Growth effects eventually become negative without offsetting fiscal policy for each of the 

proposals, because accumulating Federal government debt crowds out private investment. When 

Federal government spending is reduced to prevent debt accumulation, all three policies result in 

some long-term growth. 
3

The exact magnitude of these effects is sensitive to a number of different modeling 

assumptions, including Federal Reserve Board policy, Federal fiscal policy, the extent to which 

taxpayers accurately anticipate the economic effects of the polices, and the magnitude of 

assumed behavioral parameters. The analysis below presents the effects of these different 

policies on total output, employment, capital stock, consumption, and Federal receipts under an 

array of different policy and behavioral assumptions. 

Section I provides a description of the policies analyzed and an overview and 

comparative analysis of the simulation results. Section II provides a brief description of the 

macroeconomic models used to simulate the proposals, including a brief discussion of key 

differences in the models. A description of the format of detailed model results is also provided 

in Section II. In Section III, detailed simulation results are provided separately for each 

proposal, with a discussion of the effects of various modeling assumptions on these results. 

Specific data information and parameter assumptions are provided in a technical appendix. 
4

I. OVERVIEW AND COMPARISON OF PROPOSALS 

A. Policies Simulated 

This document, prepared by the staff of the Joint Committee on Taxation, provides 

macroeconomic analyses of three proposals to revise the Internal Revenue Code to reduce the tax 

burden on different sectors of the economy. Each proposal is designed to result in a loss of $500 

billion, as measured by conventional revenue estimates, in Federal fiscal year revenues over the 

period from 2005-2014. (Detailed annual conventional estimates appear in Table A.1. in 

Appendix A.) Each of the proposals would be effective for taxable years beginning after 

December 31, 2004. The analysis presents the results of simulating the changes contained in 

these proposals using two models of the economy. The models employ a variety of assumptions 

regarding Federal fiscal policy, monetary policy, and behavioral responses to the proposed 

changes in law. The following proposals are analyzed: 

• Reduction in individual income tax rates.−Reduce individual income tax rates by four 

percent through 2014 and 2.9 percent thereafter, for each bracket for both ordinary 

income and capital gains and dividend income. The four percent tax rate reduction 

would also apply to the alternative minimum tax; 

• Increase in the personal exemption.−Increase the personal exemption amount for 

individual taxpayers by 65 percent, which would be from $3,150 per person to $5,200 

per person in 2005, indexed for inflation thereafter; and 

• Reduction in the corporate income tax rate.−Reduce statutory corporate income tax 

rates by 20 percent for both ordinary income and capital gains income; the same 

percentage tax rate reduction would also apply to the alternative minimum tax. 

In addition to simulations of the above three tax reductions as stand-alone policies, each 

proposal is simulated assuming that Federal government spending will be contemporaneously 

reduced to offset the budget effects of the policy. Finally, a revenue neutral version of the 

corporate tax rate reduction proposal is simulated, by offsetting the corporate tax rate reduction 

with a reduction in the personal exemption amount for individual taxpayers by 47 percent, which 

would be from $3,150 to $1,670 per person in 2005. 

All of these proposals are analyzed relative to present law as of January 1, 2004; thus, in 

the present law baseline, the sunsets of existing income tax rates enacted in the Economic 

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

Relief Reconciliation Act of 2003 (“JGTRRA”) are assumed to occur as enacted. Thus, 

individual income tax rates are assumed to increase after 2010 in the baseline forecast for present 

law, while there is no parallel increase in corporate rates in the baseline forecast. For this reason, 

tax policies that carry the same conventional revenue cost for individual and corporate taxes 

within the budget window will show different amounts of revenue loss outside the budget 

window. In order to conform the sizes of the conventional revenue losses from each policy 

beyond the ten-year budget period, the individual income tax rate is reduced by 2.9 percent 

(rather than four percent) after 2015, and the personal exemption amount is increased by 63 

percent (rather than 65 percent) after 2015. 
5

Details of the marginal and average tax rates used to represent these policies in the 

macroeconomic analysis appear in Appendix A. It should be noted that we do not take into 

account the recently enacted tax bills, the American Jobs Creation Act of 2004 or the Working 

Families Tax Relief Act of 2004. 

Despite the fact that each of the tax rate reductions described above reduces conventional 

revenues by the same $500 billion amount, they have different effects on the economy, both 

within the ten-year budget planning horizon, and in the longer run. As discussed in more detail 

below, this is primarily due to the longer time frame for the reduction in the cost of capital to 

impact the economy relative to the increase in the return to work for individuals. 
6

B. Overview of Macroeconomic Effects 

For all of the policies considered, the reduction in tax rates results in higher after-tax 

income, which stimulates consumer demand. But the extent of the stimulus depends on whether 

there are offsetting monetary or fiscal policy changes. The Federal Reserve Board may offset 

demand stimulus by increasing interest rates, which increases the cost of borrowing for both 

personal consumption and investment, thus reducing consumer demand and slowing the build up 

of capital stock. Offsetting fiscal policy is generally modeled in this analysis as a cut in Federal 

government spending via a cut in non-taxed Federal transfer payments, which reduces after-tax 

income available for consumer purchases. Offsetting monetary or fiscal policy that counteracts 

the demand stimulus of the uncompensated tax rate cuts reduces the strength of the economy’s 

response to the tax rate cut within the ten-year budget horizon. 

In addition, for all of the policies considered, the extent to which there are long-run 

increases in output, income, or employment depends on whether the loss in revenues due to the 

policy is accompanied by offsetting monetary or fiscal policy. Without an offsetting fiscal 

policy, the uncompensated loss of revenues from the Federal budget requires additional Federal 

government borrowing, which may raise interest rates enough to crowd out private business 

activity and thereby reduce the benefits of the policy, particularly if the Federal Reserve Board 

acts aggressively to counteract the fiscal policy. 

Each of the tax policies considered here represents a relatively small change in fiscal 

policy, relative to the total amount of Federal receipts. The $500 billion ten-year conventional 

revenue estimate associated with each policy represents approximately three percent of the 

forecasted $16,377 billion in receipts from individual and corporate income taxes for fiscal years 

2005-2014. (See Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 

2005-2014, Table 1-2, January 2004, for the receipts forecast used in this analysis.) The effect of 

each of these proposals on economic growth is thus commensurately small. 

Reduction in the individual income tax rate

A reduction in individual income tax rates affects the economy primarily through its 

effects on after-tax wages and wage rates, since these are the largest portion of the income tax 

base; but it also works through its effects on after-tax capital income, such as dividends, interest 

and capital gains. In the short run, the higher after-tax income resulting from the reduction in 

individual income tax rates may stimulate consumer demand, depending on any offsetting fiscal 

or monetary policy changes. In the longer run, the individual tax rate reduction affects economic 

growth by reducing marginal tax rates on labor and capital income, thus increasing the after-tax 

return to working and saving, resulting in increased in labor force participation and productivityenhancing, additional business investment and economic growth. 

Increase in the personal exemption 

An increase in the personal exemption for individual taxpayers has its most direct effect 

from stimulating consumer demand, by increasing after-tax income, depending on offsetting 

fiscal or monetary policy changes. But a second, small effect occurs because changing the 

personal exemption has a small effect on an individual’s marginal income tax rates, as a change 
7

to taxable income moves some taxpayers into a lower tax bracket, which increases work and 

savings incentives. The increase in after-tax income experienced by all taxpayers provides 

offsetting incentives to work and save less. Thus, the personal exemption increase has a smaller 

effect on short-run demand growth, and a smaller effect on long-run labor supply than observed 

with the individual tax rate reduction. 

Reductions in the corporate income tax rate

A decrease in the corporate income tax rate primarily affects the economy through 

increasing the after-tax rate of return on corporate capital, which provides incentives for 

increased investment in corporate capital. Over time, this increased investment results in more 

goods and services and higher total output. It also results in higher labor productivity, leading to 

increased wages and employment. As a result, after-tax income rises, which may stimulate 

additional growth due to increased consumer demand, depending on offsetting monetary or fiscal 

policy. 
8

C. Graphic Comparison of Simulation Results 

The figures below illustrate the different effects of these policies by depicting together 

the effects of each of the three tax policies on economic growth, employment, investment, 

consumption, and the Federal government budget. Each set of illustrations is based on 

simulations using the MEG model (described in section II, below). For each tax policy, four 

graphs are shown for each variable discussed. These differ by whether or not there is offsetting 

fiscal policy and by the assumed Federal Reserve Board policy. The “a” and “b” graphs show 

tax rate reductions with no fiscal offset. The “c” and “d” graphs show tax rate reductions that are 

offset with changes in Federal government transfer payments (and in the case of the corporate 

rate decrease, alternatively by a decrease in the personal exemption) that match the dollar 

amount of the conventional revenue estimate. Each set of policies is presented under two 

different assumptions about the Federal Reserve Board response to the policy. The “a” and “c” 

graphs show MEG simulations that assume the Federal Reserve Board acts aggressively to 

counteract any changes in aggregate demand due to the proposals. The “b” and “d” graphs show 

MEG simulations that assume the Federal Reserve Board targets fixed money growth, thus 

neither counteracting nor accommodating the tax policy change. 

Growth

As Figures 1a-d show, a cut in the corporate tax rate has the greatest effect on long-term 

growth, while the decrease in individual income tax rates has a greater growth effect in the short 

run. There is more variability from year to year in short-run growth effects because the short-run 

MEG simulations include temporary demand effects. In the short run, the growth due to the 

reduction in corporate income tax rates is slowed relative to growth from the other policies 

because, unlike the other policies that directly increase after-tax personal income, the corporate 

tax rate reduction provides some incentive to save rather than consume, because it directly 

increases the after-tax return to capital. Growth effects eventually become negative without 

offsetting fiscal policy for each of the proposals, because accumulating Federal government debt 

crowds out private investment. When Federal government spending is reduced to prevent debt 

accumulation, all three policies result in some long-term growth. 

Because neutral monetary policy allows for more short-run fluctuations in demand than does 

aggressive Federal Reserve Board policy, the path of economic growth differs depending on the 

monetary policy assumption. As explained in more detail in Section II.A., below, the two 

Federal Reserve Board policies depicted in the following graphs are not meant to represent actual 

predicted Federal Reserve board behavior. They represent two possible extremes: perfectly 

counteracting any external economic shocks (“Aggressive Fed Policy”), or completely ignoring 

any external economic shocks (“Neutral Fed Policy”). Thus, the aggressive “a” and “c” graphs 

show smoother growth paths than would be expected to occur in a world where the Federal 

Reserve Board acts with lagged information; while the neutral “b” and “d” graphs show greater 

fluctuations in the growth path response to tax policy than would be expected, given that Federal 

Reserve Board policy is rarely completely neutral. When tax rate reductions are not offset by 

spending reductions, the tax policy is likely to stimulate demand in the short run; thus the neutral 

Federal Reserve Board simulations in Figure 1b shows more immediate growth in the short run, 

with a corresponding downward correction in the out years, than the aggressive Federal Reserve 

Board simulations in Figure 1a. 
9

Figure 1a.−Percent Change from Baseline in Real GDP: No Fiscal Offset; Aggressive Fed 

Policy 

Figure 1b.−Percent Change from Baseline in Real GDP: No Fiscal Offset; Neutral Fed Policy 

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

2005 2010 2015 2020 2025 2030 2035

Corporate Rate Cut Exemption Increase Individual Rate Cut

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

2005 2010 2015 2020 2025 2030 2035

Corporate Rate Cut Exemption Increase Individual Rate Cut
10

Figure 1c.−Percent Change from Baseline in Real GDP; with Fiscal Offset; 

Aggressive Fed Policy 

Figure 1d.−Percent Change from Baseline in Real GDP; with Fiscal Offset; 

Neutral Fed Policy 

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

2005 2010 2015 2020 2025 2030 2035

Corp Rate Cut, Personal Exemption Decreased Corporate Rate Cut, Transfers Decreased

Personal Exemption Increased, Transfers Decreased Individual Rate Cut, Transfers Decreased

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

2005 2010 2015 2020 2025 2030 2035

Corp Rate Cut, Personal Exemption Decreased Corporate Rate Cut, Transfers Decreased

Personal Exemption Increased, Transfers Decreased Individual Rate Cut, Transfers Decreased
11

Employment

Figures 2a-d show the commensurate effects of each policy on employment. The 

individual tax rate reduction increases employment immediately by reducing marginal tax rates, 

thus increasing the after-tax return to additional labor, and this increase persists in the long run. 

The exemption increase has a much smaller impact on marginal tax rates on labor, and a 

commensurately smaller effect on employment. Both tax policies that affect individual income 

taxation have a greater impact on labor force participation and employment because they both 

provide direct incentives to individuals to work by directly increasing the after-tax return to 

labor. In contrast, the reduction in the corporate tax rate increases the after-tax wage rate 

indirectly, as the gradual increase in the capital stock leads to increasing labor productivity, and 

eventually higher wage rates. Because the impact of the corporate tax rate reduction on 

employment occurs more gradually, as it develops over time in response to the buildup of capital 

from the corporate tax rate reduction, the effect of the corporate tax rate reduction on 

employment is relatively small and takes time to build up. 

Translating these employment changes into jobs, calculated as full-time equivalents 

based on hours worked, the percent changes in employment shown on figure 2a correspond to a 

long-run increase of approximately 50,000 jobs due to the corporate rate decrease, 160,000 due 

to the personal exemption increase, and 300,000 due to the individual income tax rate cut. 

When the corporate rate cut is offset with either a decrease in transfers or a decrease in 

the personal exemption, as shown in Figures 2c-d, there is a small, short-term decline in 

employment. In the latter simulation, that decrease is sustained in the long run, while the 

corporate rate cut accompanied by a decrease in government spending modestly increases 

employment over time. The individual rate cut and personal exemption increase that are offset 

by spending decreases have employment effects that are very similar to those of the same 

policies with no fiscal offset. 
12

Figure 2a.−Percent Change from Baseline in Employment: No Fiscal Offset; 

Aggressive Federal Reserve Policy 

Figure 2b.−Percent Change from Baseline in Employment: No Fiscal Offset; 

Neutral Federal Reserve Policy 

-1.20%

-1.00%

-0.80%

-0.60%

-0.40%

-0.20%

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

2005 2010 2015 2020 2025 2030 2035

Corporate Rate Cut Exemption Increase Individual Rate Cut

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

2005 2010 2015 2020 2025 2030 2035

Corporate Rate Cut Exemption Increase Individual Rate Cut
13

Figure 2c.−Percent Change from Baseline in Employment: With Fiscal Offset; 

Aggressive Federal Reserve Policy 

Figure 2d.−Percent Change from Baseline in Employment: With Fiscal Offset; 

Neutral Federal Reserve Policy

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

2005 2010 2015 2020 2025 2030 2035

Corp Rate Cut, Personal Exemption Decreased Corporate Rate Cut, Transfers Decreased

Personal Exemption Increased, Transfers Decreased Individual Rate Cut, Transfers Decreased

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

2005 2010 2015 2020 2025 2030 2035

Corp Rate Cut, Personal Exemption Decreased Corporate Rate Cut, Transfers Decreased

Personal Exemption Increased, Transfers Decreased Individual Rate Cut, Transfers Decreased
14

Business investment

As Figures 3a-d illustrate, the relative effects of the individual income tax cut and the 

corporate tax rate reduction on producer’s capital stock are reversed relative to the effects on 

employment. The corporate tax rate reduction directly increases the after-tax return to capital, 

thus increasing investment. This effect is much smaller for the relatively smaller portion of 

business capital (roughly 30 percent) that receives a tax cut through the reduction in individual 

income tax rates. Because the increase in the personal exemption has little effect on the cost of 

capital, it provides little incentive for an increase in the capital stock. With no fiscal offset, the 

effects of Federal debt crowd out almost immediately any demand-induced investment from the 

individual income tax cut and the increase in the exemption. 
15

Figure 3a.−Percent Change from Baseline in Producers’ Real Capital Stock: 

No Fiscal Offset; Aggressive Federal Reserve Policy 

Figure 3b.−Percent Change from Baseline in Producers’ Real Capital Stock: 

No Fiscal Offset; Neutral Federal Reserve Policy

-2.50%

-1.50%

-0.50%

0.50%

1.50%

2.50%

3.50%

2005 2010 2015 2020 2025 2030 2035

Corporate Rate Cut Exemption Increase Individual Rate Cut

-2.5%

-1.5%

-0.5%

0.5%

1.5%

2.5%

3.5%

2005 2010 2015 2020 2025 2030 2035

Corporate Rate Cut Exemption Increase Individual Rate Cut
16

Figure 3c.−Percent Change from Baseline in Producers’ Real Capital Stock: 

With Fiscal Offset; Aggressive Federal Reserve Policy 

Figure 3d.−Percent Change from Baseline in Producers’ Real Capital Stock: 

With Fiscal Offset; Neutral Federal Reserve Policy 

-2.5%

-1.5%

-0.5%

0.5%

1.5%

2.5%

3.5%

2005 2010 2015 2020 2025 2030 2035

Corp Rate Cut, Personal Exemption Decreased Corporate Rate Cut, Transfers Decreased

Personal Exemption Increased, Transfers Decreased Individual Rate Cut, Transfers Decreased

-2.5%

-1.5%

-0.5%

0.5%

1.5%

2.5%

3.5%

2005 2010 2015 2020 2025 2030 2035

Corp Rate Cut, Personal Exemption Decreased Corporate Rate Cut, Transfers Decreased

Personal Exemption Increased, Transfers Decreased Individual Rate Cut, Transfers Decreased
17

Consumption

Figures 4a-d show the effects of the policies on consumption. Consumption is 

particularly of interest in the short run as an indicator of demand stimulus. In the long run, 

consumption is sometimes used as an indicator of the effects of the policies on individuals’ wellbeing, under the assumption that increased consumption indicates increased availability of goods 

and services to the economy. Consumption is sometimes viewed in combination with changes in 

employment or hours worked, as well, to take into account changes in the amount of leisure 

people are enjoying. 

By increasing after-tax income directly, and providing individuals with more incentive to 

work, the cut in individual income tax rates increases consumption the most in the short run. 

The personal exemption increase also increases consumption more in the short run than the 

corporate tax rate reduction; but because it does not provide significant incentives to taxpayers to 

work more, the exemption increases consumption by less than the income tax rate cut. In the 

long run, because the corporate rate cut results in greater economic growth, consumption rises 

more as a result of the corporate rate cut than from the other two policies. Without a fiscal offset 

to prevent crowding out, consumption eventually declines in the case of the individual tax cut 

policies. 
18

Figure 4a.−Percent Change from Baseline In Real Consumption: No Fiscal Offset; 

Aggressive Federal Reserve Policy 

Figure 4b.−Percent Change from Baseline In Real Consumption: No Fiscal Offset; 

Neutral Federal Reserve Policy 

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

2005 2010 2015 2020 2025 2030 2035

Corporate Rate Cut Exemption Increase Individual Rate Cut

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

2005 2010 2015 2020 2025 2030 2035

Corporate Rate Cut Exemption Increase Individual Rate Cut
19

Figure 4c.−Percent Change from Baseline in Real Consumption: With Fiscal Offset; 

Aggressive Federal Reserve Policy 

Figure 4d.−Percent Change from Baseline in Real Consumption: With Fiscal Offset; 

Neutral Federal Reserve Policy

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

2005 2010 2015 2020 2025 2030 2035

Corp Rate Cut, Personal Exemption Decreased Corporate Rate Cut, Transfers Decreased

Personal Exemption Increased, Transfers Decreased Individual Rate Cut, Transfers Decreased

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

2005 2010 2015 2020 2025 2030 2035

Corp Rate Cut, Personal Exemption Decreased Corporate Rate Cut, Transfers Decreased

Personal Exemption Increased, Transfers Decreased Individual Rate Cut, Transfers Decreased
20

Federal surplus or deficit

To the extent that a policy results in a net decrease in Federal receipts, with no offsetting 

expenditure reductions, the policy results in the Federal surplus becoming more negative. 

Decreases in the Federal surplus generate additional debt service costs. To determine how 

changes in tax policy affect the ability of the government to meet its current and future 

obligations it is helpful to compare tax-induced changes in the deficit and GDP. If GDP is 

growing faster than the deficit, the fiscal situation is improving, whereas if the deficit is growing 

faster, the fiscal situation is worsening. If deficits are growing faster (slower) than GDP, then 

the ratio of Federal debt to GDP would increase (decrease), which implies that future generations 

would have less (more) income with which to consume and invest. 

Figures 5a-d illustrate directly the impacts of the different policies on Federal debt 

accumulation, by showing the change in the ratio of Federal surplus to GDP as a result of the 

policies. Negative values on the graph indicate decreases in the ratio of surplus to GDP (or, 

equivalently, increases in the absolute value of the deficit to GDP ratio). In Figure 5a-b where 

simulations are done with no fiscal offset, the net effect of all of the policies on the Federal 

budget is to decrease surpluses (increase deficits), as expected, and thus decrease the ratio of 

Federal surplus to GDP. Moreover, the decrease in Federal surpluses accelerates over time by 

increasing interest costs associated with a growing Federal debt. In contrast, Figure 5c-d shows 

the change in the Federal surplus for the simulations that include a fiscal offset. The change in 

the surplus to GDP ratio starts out, by construction, to be essentially zero over the first ten years. 

As the growth effects of the policies take hold the economy starts to generate surpluses relative 

to the baseline. 
21

Figure 5a.−Change from Baseline: Ratio of Surplus to GDP: No Fiscal Offset; 

Aggressive Federal Reserve Policy 

Figure 5b.−Change from Baseline: Ratio of Surplus to GDP: No Fiscal Offset; 

Neutral Federal Reserve Policy 

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

2005 2010 2015 2020 2025 2030 2035

Corporate Rate Cut Exemption Increase Individual Rate Cut

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

2005 2010 2015 2020 2025 2030 2035

Corporate Rate Cut Exemption Increase Individual Rate Cut
22

Figure 5c.−Change from Baseline: Ratio of Surplus to GDP: With Fiscal Offset; 

Aggressive Federal Reserve Policy 

 

Figure 5d.−Change from Baseline: Ratio of Surplus to GDP: With Fiscal Offset; 

Neutral Federal Reserve Policy 

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

2005 2010 2015 2020 2025 2030 2035

Corp Rate Cut, Personal Exemption Decreased Corporate Rate Cut, Transfers Decreased

Personal Exemption Increased, Transfers Decreased Individual Rate Cut, Transfers Decreased

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

2005 2010 2015 2020 2025 2030 2035

Corp Rate Cut, Personal Exemption Decreased Corporate Rate Cut, Transfers Decreased

Personal Exemption Increased, Transfers Decreased Individual Rate Cut, Transfers Decreased
23

II. MODELS AND RESULTS FORMAT 

This section provides information about the models used to analyze the three tax policy 

proposals, and the type of information that will be supplied about each proposal. For a more 

detailed description of these models, the economic assumptions underlying them, and the format 

in which results are presented, see Joint Committee on Taxation, Overview of the Work of the 

Staff of the Joint Committee on Taxation to Model the Macroeconomic Effects of Proposed Tax 

Legislation to Comply with House Rule XIII.3.(h)(2), (JCX-105-03), December 22, 2003. 

A. Description of the Models 

The Macroeconomic Equilibrium Growth (“MEG”) model

This model is based on the standard, neoclassical assumption that the amount of output is 

determined by the availability of labor and capital, and in the long run, prices adjust so that 

demand equals supply. Individuals are assumed to make decisions based on observed 

characteristics of the economy, including current period wages, prices, interest rates, tax rates, 

and government spending levels. Consumption in MEG is determined according to the life-cycle 

theory, which implies that individuals attempt to even out their consumption patterns during their 

lifetimes. Business production and housing production are modeled separately, and may 

substitute for each other. 

The supply of labor to the economy over time is determined by the size of the working 

age population and their willingness to work in response to changes in after-tax wages. (See 

Appendix A for more detail on how labor supply is modeled.) Population and age profile 

projections are calibrated to the Census Bureau middle-series projections, which reflect the 

changing age structure of the population. Baseline receipts forecasts beyond the ten-year budget 

window are generated by the relevant taxable income streams generated by the MEG 

simulations, assuming the tax law existing in 2014 is permanently continued. The path of 

Federal government expenditures on the two largest transfer payment programs, Social Security 

and Medicare, is calibrated to projections in the intermediate scenario (5) in the Congressional 

Budget Office in The Long-Term Budget Outlook, December 2003 (pp. 3-12). This expenditure 

path assumes that all currently promised benefits, including prescription drugs, will be paid as 

promised under present law. 

Individuals do not anticipate changes in the economy or government finances, thus this 

type of model is often referred to as a “myopic” behavior model. This feature of the MEG model 

allows the simulation of tax and government expenditure policy that results in a non-sustainable 

growth path. Specifically, policies that result in the Federal debt increasing or decreasing at a 

faster rate than the growth of GNP can be modeled. This feature allows the MEG model to 

incorporate in its simulation baseline fiscal policy that is consistent with present law for a period 

far beyond the ten year budget planning period. 

MEG differs from a simple neoclassical growth model in that prices in MEG adjust to 

balance supply and demand with a delay rather than instantaneously. This feature allows the 

model to simulate an adjustment path, in which resources may be under-employed or used at an 

unsustainable rate in response to policies that depress or stimulate economic activity. This 
24

feature also allows analysis of tax policy under different monetary policies by the Federal 

Reserve Board. 

 MEG simulations are run for each policy using two extreme assumptions about Federal 

Reserve Board behavior. In one variation (referred to as “MEG aggressive Fed response”) it is 

assumed that the Federal Reserve Board acts aggressively by changing interest rates to 

counteract any demand effects provided by the simulated policy in each period. These 

simulations model Federal Reserve Board policy as if the Federal Reserve Board were 

omniscient and able to counteract fiscal policy effects almost completely with interest rate 

adjustments. In the other variation (referred to as “MEG neutral Fed response”), it is assumed 

that the Federal Reserve Board remains neutral with respect to any changes in fiscal policy, 

maintaining a fixed growth rate in the money supply, and thereby allowing temporary changes in 

demand to affect levels of employment and output. Neither of these simulations is an empirical 

prediction of actual Federal Reserve Board policy; rather, they are both stylized representations 

of opposite approaches to monetary policy. 

For simulations of permanent policy changes that can be expected to alter demand 

relative to present law in each year, the different Federal Reserve Board responses (aggressive 

and neutral) will produce persistently different economic results throughout the period of policy 

stimulation. For the simulations presented in this document, this observation would apply, in 

particular, to the proposals that increase consumers’ after-tax income (income tax rate reduction 

and personal exemption increase). In the simulations of tax cuts that are implemented without 

any offsetting reduction in Federal government transfer payments, the aggressive Federal 

Reserve Board reaction would raise interest rates to offset the demand stimulated by the extra 

after-tax income taxpayers receive; therefore, the aggressive reaction simulations would show 

less growth than the neutral simulations. 

In the MEG simulations that include offsetting fiscal policy, non-taxed government 

transfer payments are reduced to match the conventionally-estimated revenue loss generated by 

the tax policy. Because it makes up a relatively small amount of total government spending 

when compared to transfer payments, Federal government spending on consumption of goods 

and services is unchanged in these simulations. Reduced transfer payments have the effect of 

reducing disposable income, or the amount of income available for personal consumption, and 

thus reducing the demand for goods and services. To the extent that the dynamically estimated 

revenue loss is smaller than the conventionally estimated loss, the reduction in transfer payments 

may be slightly larger than the size of the tax cut for consumers, so that the net effect of the tax 

cut plus transfer payment cut on disposable income could be negative. In this case, the 

aggressive Federal Reserve Board response would be to stimulate demand to offset the effects of 

the reductions in after-tax income from the reduced Federal government transfer payments; 

therefore, the aggressive Federal Reserve Board simulations would show slightly more short-run 

growth than the neutral simulations. 

The Tax Policy Advisers' overlapping generations (“OLG”) life cycle model

The Joint Committee staff contracts with Tax Policy Advisers, LLC, for the use of its 

overlapping generations life cycle model to provide an additional perspective in the 

macroeconomic analysis of tax policy. In this model, individuals are assumed to make 
25

consumption and labor supply decisions with perfect foresight of economic conditions, such as 

wages, prices, interest rates, tax rates, and government spending, over their lifetimes. The 

economic decisions are modeled separately for each of 55-adult-age cohorts. 

One consequence of the perfect foresight assumption is that if a policy results in an 

unsustainable growth path, such as increasing government deficits indefinitely into the future, the 

model will not solve. Therefore, to run simulations in this model, it is necessary to assume a 

“present law” baseline policy that follows a stable path, and in analyzing tax cut policies, it is 

necessary to assume that an offsetting budget balancing fiscal policy will be enacted. Hence, for 

all simulations using the OLG model, it is assumed in the baseline that both tax receipts and 

government expenditures follow a stable growth path outside the ten-year budget-planning 

horizon. In the OLG simulations presented here, the debt/GDP ratio is held fixed throughout the 

simulation period; and, the fully dynamically estimated cost of the tax policies is the amount 

offset by reductions in Federal government transfer payments. The increase in individual income 

tax rates that occurs in 2011 under present law is not implemented in the OLG simulations. In 

addition, because the OLG model assumes that the age profile of the population does not change 

over time, Social Security and Medicare payments are assumed to grow at a constant rate (as 

opposed to increasing with the aging of the baby boom generation as assumed in the MEG 

model). In simulations of tax rate cuts, it is assumed that Federal government spending will be 

contemporaneously reduced to offset the budget effects of the tax policy. As with the fiscal 

offset simulations in the MEG model, the fiscal offset in the OLG model is a reduction in nontaxed Federal government transfer payments. 

As in the MEG model, the OLG model has separate production sectors for business and 

housing, which allows for an analysis of the effects of the different policies on the allocation of 

investment between housing and business. Unlike the MEG model, the OLG also treats the 

purchase of housing as a consumption decision, thus making investment in housing more 

responsive to changes in after-tax income. Also unlike the MEG model, the OLG model assumes 

that prices adjust instantaneously to any changes in economic conditions (such as a change in 

fiscal policy) so that supply always equals demand, and resources are never under- or overutilized. Therefore, the model has no inflation and no monetary sector, and alternative monetary 

policy assumptions cannot be simulated with the OLG model. 
26

B. Results Format 

Although the models provide information on numerous macroeconomic variables, the 

following analysis focuses on real (inflation adjusted) Gross Domestic Product (“GDP”), real 

business and residential capital stock, employment, labor supply, and consumption. Results for 

each variable are presented as percent changes in the post-tax-cut simulations from the presentlaw baseline forecast values for the variable. Specifically, the percent change in each variable 

for the first five years is calculated by summing the change in the reported variable due to the 

proposal over the period from 2005 to 2009, and dividing that change by the sum of the baseline 

values of each variable over the same period. The same calculation is applied to the period from 

2010 to 2014. The Joint Committee staff configures the present-law baseline forecasts for 

Federal receipts and spending in each of the macroeconomic models to approximate the January, 

2004 forecast of the Congressional Budget Office (The Budget and Economic Outlook: Fiscal 

Years 2005-2014, January 2004) as closely as possible and extrapolates the baseline beyond 

2014 as outlined above in the two model descriptions. While it is impossible to incorporate 

unknowable intervening circumstances, such as major resource or technological discoveries or 

shortages, these models are designed to predict the long-run effects of policy changes, assuming 

other unpredictable influences are held constant. To provide information about the longer run 

effects of the policy, the tables also report the percent change in each economic variable 30 years 

in the future (2034), which is referred to in the tables as “long run.” 

Another focus of the analysis is to compare the conventional revenue estimate of each tax 

proposal, which does not explicitly incorporate macroeconomic effects, with the revenue 

estimate obtained using macroeconomic models like the MEG and OLG models, which take into 

account macroeconomic effects of tax policy. Hence, the analysis also provides information on 

“revenue feedback,” which is defined as the difference between the revenue effect of the 

proposal produced by the MEG or the OLG model and the conventional estimate for the same 

proposal, divided by the amount of the conventional revenue estimate. For most of the 

simulations, the estimated revenue feedback is presented for the first and second five years as 

well as the entire ten years following enactment of the policy, coinciding with the Congressional 

budgeting time frames. 

 Generally, Joint Committee staff’s conventional revenue estimates are provided in 

nominal (unadjusted for inflation) dollars. However, when the macroeconomic effects of a tax 

proposal are taken into account, the tax change may result in inflation as well as real economic 

growth. Inflation causes increases in nominal revenues without necessarily increasing the 

purchasing power of the Federal government. Measuring budget variables in real terms provides 

a more accurate picture of the budget situation relative to economic growth. Thus, as with the 

other variables reported here, the revenue feedback results are reported in real terms. 

Consistent with the model descriptions above, results of MEG simulations assuming 

different monetary policy responses are provided to show the influence monetary policy 

assumptions can have on the simulation results. Also for simulations using the MEG model, 

different fiscal policy responses are shown for each policy. Finally, for the simulations of the 

individual tax rate reduction, which is the policy likely to have the most effect on incentives to 

work, additional MEG simulations are used to show the sensitivity of results to alternate 

assumptions about labor supply elasticities, which measure the responsiveness of labor to the 
27

policy incentives. Unlike the monetary policy regimes, which represent opposite extremes of 

possible Federal Reserve Board responsiveness, the labor supply elasticities represent the median 

and the lower end of mainstream econometric estimates of this parameter. For simulations of the 

other policies with only one labor supply response, the median elasticity is used. 

As explained above, the OLG model is not designed to analyze monetary policy 

responses or to allow the simulation of a policy that results in a constantly increasing 

government deficit. Similarly, there are no alternate OLG simulations varying labor supply 

responsiveness, primarily because the OLG model explicitly links individuals’ labor supply to 

their consumption and savings decisions, thus making it impractical to isolate the labor supply 

effects. 

A description of the behavioral response mechanisms incorporated in both the MEG and 

OLG models, along with specific labor supply elasticities and other behavioral parameters, is 

provided in Appendix A, Data and Assumptions. 
28

III. DETAILED SIMULATION RESULTS 

This section outlines the detailed results from both the MEG and the OLG model 

simulations for each of the three tax policy proposals considered. As mentioned in section I.B., 

the changes to the individual income tax and corporate profits tax simulated here are relatively 

small fiscal policy changes; the change in revenues due to these policies before consideration of 

any macroeconomic feedback effects is equal to approximately three percent of projected 

receipts from the individual and corporate tax under the present-law baseline. Changes in the 

variables described below, economic growth, capital stock, and employment and labor force are 

correspondingly small relative to their present-law baselines. 

A. Reduction in the Individual Income Tax Rate 

A reduction in individual income tax rates may affect the economy in the short run by 

increasing after-tax income for individuals, thus stimulating consumer demand. The importance 

of this effect depends on whether fiscal or monetary policy changes are made to offset the 

demand stimulus provided by the tax rate reduction. In the longer run, the individual tax rate 

reduction affects economic growth primarily by changing the average and marginal tax rates on 

labor income. Specifically, the reduced average tax rate and resulting increase in after-tax 

income provides some incentive to reduce labor hours, while the reduced marginal tax rates 

increase the after-tax return to additional labor hours, thus providing an incentive for some 

individuals to work more. On net, there is a small increase in labor force participation and hours 

worked, which leads to an increase in GDP. 

In addition, since the tax rate reduction on individual income is applied to income earned 

from all sources, including dividends, interest, and capital gains, as well as to wage income, this 

policy also works to some extent through increasing after-tax returns to investment. As with the 

labor supply effects, the effects of changes in tax rates on capital income can provide competing 

incentives to savings and investment. The increase in after-tax income resulting from a 

reduction in average taxes on capital can reduce incentives to save to the extent that the 

individual has a target savings amount in mind. In contrast, the increase in the after-tax return to 

capital that results from a decrease in its marginal tax rate provides an incentive for individuals 

to save and invest more. As modeled in these simulations, the change in the after-tax return to 

investment encourages additional business investment, which results in an increase in 

productivity that, in turn, increases wages in the long run. The effect of the individual tax rate 

reduction on investment is small relative to the effect on labor supply because wages make up 

most of the individual income tax base. For the simulations in which the revenue loss from the 

tax rate reduction is not offset by a reduction in government spending, as the Federal government 

debt accumulates over time, the positive effects of the tax rate reduction are eventually offset by 

the negative effects of growing government debt, which crowds out private business activity. 

Because the most important behavioral response to the individual tax rate reduction is its 

effect on individuals’ willingness to supply labor to the economy, the growth effects of this 

proposal are particularly sensitive to assumptions about how responsive individuals are to this 

incentive. Therefore, results are shown for MEG simulations using two different labor supply 

elasticities. 
29

Economic growth

Table 1 shows the effects of a cut in individual income tax rates, conventionally 

estimated to reduce receipts by $500 billion over ten years, on real output under varying 

assumptions about accompanying fiscal and monetary policy, as well as differing assumptions 

about the responsiveness of labor supply to changes in labor income tax rates. The change in 

real Gross Domestic Product (“GDP”) ranges from negligible to a 0.3 percent increase over the 

first five years, with the upper bound increasing to 0.5 percent over the second five years. The 

equivalent average annual real dollar amount ranges from $17 billion to $163 billion in the first 

five years and $18 billion to $319 billion in the second five years. In the simulations in which 

neither fiscal policy nor monetary policy is employed to counteract demand stimulus (the neutral 

Fed, no-offset simulations), growth is greater in the second five years than in the first five years. 

But the negative effects of the accumulating Federal debt eventually outweigh the demand 

stimulus. The accumulation of public debt reduces the extent to which the individual tax rate 

reduction lowers the cost of capital, thus slowing the growth of the capital stock. In the 

simulations that include a government spending decrease to offset the revenue loss, real GDP 

continues to increase in the long run. The growth effects increase over time because the 

reduction in the individual tax rate affects growth by increasing labor supply, and because of the 

increase in the after-tax return to investment in business capital (structures and equipment), 

which causes a gradual buildup in the capital stock available for business production. In turn, 

this increase in the capital stock increases labor productivity over time. As the low labor supply 

elasticity simulations show, regardless of whether the demand stimulus is offset by fiscal or 

monetary policy, lower responsiveness of labor supply to changes in the marginal tax rate on the 

labor supply results in lower real GDP growth. 

Table 1.−Effects of Individual Tax Rate Reduction on Real GDP 

in Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.1 0.1 -0.5 

 MEG aggressive Fed - low labor elasticity 0.1 0.0 -0.6 

 MEG neutral Fed 0.3 0.5 -0.2 

 MEG neutral Fed - low labor elasticity 0.3 0.4 -0.3 

 OLG n.a. n.a. n.a. 

Fiscal Offset: decrease in Government spending 

 MEG aggressive Fed 0.1 0.3 0.4 

 MEG aggressive Fed - low labor elasticity 0.1 0.2 0.3 

 MEG neutral Fed 0.0 0.2 0.4 

 MEG neutral Fed - low labor elasticity 0.0 0.1 0.3 

 OLG 0.2 0.3 0.4 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
30

Investment

As the results in Table 2 indicate, the cut in individual tax rates may increase producers’ 

capital stock in the first five years by up to 0.3 percent. In the simulations without an offsetting 

decrease in government spending, the effect on the capital stock turns negative in the second five 

years and in the long run regardless of the monetary response. As the increasing Federal debt 

crowds out business investment, the capital stock could decline by as much as 1.4 percent. In the 

fiscal-offset policy simulations, the individual tax rate reduction unambiguously increases 

producers’ capital stock, with the largest effect taking place in the long run, as the returns to 

capital increase over time in response to increasing labor effort, as well as to the small decrease 

in the cost of capital resulting from reduced dividend and capital gains taxation. 

Table 2.−Effects of Individual Tax Rate Reduction on 

Producers' Real Capital Stock in 

Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.0 -0.1 -1.3 

 MEG aggressive Fed - low labor elasticity 0.0 -0.1 -1.4 

 MEG neutral Fed 0.1 0.1 -1.0 

 MEG neutral Fed - low labor elasticity 0.1 0.1 -1.1 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending

 MEG aggressive Fed 0.3 0.7 1.1 

 MEG aggressive Fed - low labor elasticity 0.3 0.7 1.1 

 MEG neutral Fed 0.2 0.6 1.1 

 MEG neutral Fed - low labor elasticity 0.2 0.6 1.0 

 OLG 0.1 0.4 0.9 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 

Table 3 shows the effects of the individual tax rate reduction on the real residential 

capital stock. In the MEG model, the individual tax rate reduction reduces the preferential 

treatment of the housing sector relative to the business sector; therefore the proposal is likely to 

shift some investment from housing to business capital. As a result, the residential capital stock 

is reduced by up to 0.4 percent in the first five years, by as much as 1.1 percent in the second five 

years, and 3.0 percent in the long run. Note that across all simulations under the MEG model, 

the negative effects on residential capital stock are bigger without offsetting government 

spending reductions than those with fiscal offsets. Because the Federal government deficit 

crowds out private investment when a tax cut is not offset by a spending cut, the negative impact 

on residential investment from the individual tax rate reduction is exacerbated by the increased 

deficit. As expected, the crowding out effect is most prominent in the long run. 
31

In contrast to the MEG model, the OLG model predicts that the impact on private 

residential capital stock from the individual tax rate reduction is negligible for the first five years 

and turns positive for the second five years. In the OLG model, housing is both a consumption 

good and an investment good. As people have more disposable income resulting from the 

individual tax rate reduction and increasing work effort, they increase both their consumption of 

housing and their investment in residential capital stock. The positive effects from increased 

disposable income on residential investment outweigh the negative effects from decreased 

relative preferential tax treatment to the housing sector. 

Table 3.−Effects of Individual Tax Rate Reduction on 

Real Residential Capital Stock in 

Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed -0.4 -1.1 -2.9 

 MEG aggressive Fed - low labor elasticity -0.4 -1.1 -3.0 

 MEG neutral Fed -0.3 -0.7 -2.9 

 MEG neutral Fed - low labor elasticity -0.3 -0.7 -3.0 

 OLG n.a. n.a. n.a. 

Fiscal Offset: decrease in Government spending

 MEG aggressive Fed -0.2 -0.4 -0.2 

 MEG aggressive Fed - low labor elasticity -0.2 -0.5 -0.3 

 MEG neutral Fed -0.2 -0.5 -0.3 

 MEG neutral Fed - low labor elasticity -0.2 -0.5 -0.4 

 OLG 0.0 0.2 0.6 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
32

Employment and Labor Supply

The employment variable measures the number of people who are working in each 

period. Labor supply measures the number of people who are willing to work for the wages 

being offered by employers. When the economy is operating in equilibrium, or full employment, 

these two measures are equal. In the OLG model, which assumes the economy is always 

operating in equilibrium, these measures are always equal. In the MEG model, which 

incorporates periods of temporary under- or over-employment as the economy adjusts to outside 

shocks, these measures may not always be equal. Both variables are shown in this analysis to 

illustrate the contrast in the effects of the different policies on demand versus supply incentives. 

Changes in employment reflect both effects, while changes in labor supply reflect primarily 

incentives to supply more labor effort. 

Table 4 shows changes in employment due to the tax cut. The impact in the first five 

years after the individual tax rate reduction ranges from an increase of less than 0.1 percent to 

0.3 percent, and in the second five years from an increase of 0.1 percent to 0.6 percent. These 

changes correspond to an increase ranging from 60,000 to 400,000 jobs (calculated as full-time 

equivalents based on hours worked) during the first five years, and from 160,000 to 765,000 jobs 

in the second five years after implementation of the policy. 

Table 4.−Effects of Individual Tax Rate Reduction on Employment 

in Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.2 0.2 0.2 

 MEG aggressive Fed - low labor elasticity 0.1 0.2 0.2 

 MEG neutral Fed 0.3 0.6 0.5 

 MEG neutral Fed - low labor elasticity 0.3 0.6 0.4 

 OLG n.a. n.a. n.a. 

Fiscal Offset: decrease in Government spending

 MEG aggressive Fed 0.2 0.2 0.2 

 MEG aggressive Fed - low labor elasticity 0.1 0.2 0.2 

 MEG neutral Fed 0.0 0.1 0.2 

 MEG neutral Fed - low labor elasticity 0.0 0.1 0.1 

 OLG 0.3 0.3 0.3 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 

In the short run, most of the employment effects come from changes in demand due to 

the policy. When the individual tax rate reduction is not offset by a spending cut, and the 

Federal Reserve Board does not counteract the demand stimulus from the tax cut, the reduction 

in individual tax rates stimulates employment growth. However, in these “neutral Federal 

Reserve Board” simulations, when the tax cut is offset by a spending cut, the demand stimulus 
33

provided by the individual tax rate reduction is partially cancelled by the reduction in transfer 

payments. This difference persists into the long run, as the simulations showing alternate 

assumptions for Federal Reserve Board reactions maintain continuing differences in Federal 

Reserve Board policy throughout the simulation period. 

Table 5 shows the effects of the individual tax rate reduction on individuals’ willingness 

to work. The larger labor supply responses in the OLG simulations relative to those in the MEG 

budget neutral simulations arise from the difference in the foresight assumptions between the 

two models. In the MEG model, taxpayers are myopic and do not have knowledge about future 

policy, while in the OLG model, taxpayers have perfect foresight about future policy. As a 

result, taxpayers in the OLG model foresee the reduction in transfer payments as reducing both 

their current and future disposable income. Knowledge of the future state of the economy causes 

them to work harder to accumulate savings against the loss of future disposable income. This 

contrast between the two models can be seen more clearly by looking at the changes in labor 

force participation in Table 5. The OLG simulations start out with an increase of 0.3 percent 

over the baseline, while the MEG simulations’ increases range from 0.1 to 0.2 percent. In 

addition to the responses described earlier, workers in the OLG model anticipate the reductions 

in transfer payments and increase their work in all periods in order to compensate for their future 

decrease in income. 

In the MEG model, the determinant of peoples’ willingness to work is current period 

after-tax average and marginal wage rates. Results in Table 5 show that the assumed 

responsiveness within the model (labor supply elasticity) has an effect on labor force 

participation in MEG. Other factors, such as fiscal and monetary policy, that might affect aftertax income do not affect labor force participation in MEG except to the extent that they affect 

after-tax wage rates. 

Table 5.−Effects of Individual Tax Rate Reduction on Labor Force Participation 

in Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.2 0.2 0.2 

 MEG aggressive Fed - low labor elasticity 0.1 0.2 0.2 

 MEG neutral Fed 0.2 0.2 0.2 

 MEG neutral Fed - low labor elasticity 0.1 0.2 0.2 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed 0.2 0.2 0.2 

 MEG aggressive Fed - low labor elasticity 0.1 0.2 0.2 

 MEG neutral Fed 0.2 0.2 0.2 

 MEG neutral Fed - low labor elasticity 0.1 0.2 0.2 

 OLG 0.3 0.3 0.3 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
34

Consumption

Table 6 shows the effects of the individual tax rate reduction on consumption of goods 

and services. In the first five years, consumption increases by between 0.4 percent and 0.5 

percent when the individual tax cut is not offset by a spending cut, and by less than 0.1 percent 

when the stimulus is offset by a spending cut. In the first 10 years after the policy 

implementation consumption rises more when there is no fiscal offset because government 

transfer payments directly reduce consumers’ disposable income. In the long run, however, the 

positive consumption response is reduced, or even turns negative, when there is no fiscal offset, 

reflecting the effects of an accumulating Federal debt on the economy. On the other hand, when 

there is a fiscal offset, consumption has a relatively small positive response immediately after the 

tax cut, but a much bigger positive response in the long run. 

Table 6.−Effects of Individual Tax Rate Reduction on Consumption 

in Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.4 0.5 0.0 

 MEG aggressive Fed - low labor elasticity 0.4 0.5 -0.1 

 MEG neutral Fed 0.5 0.7 0.3 

 MEG neutral Fed - low labor elasticity 0.5 0.6 0.2 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed 0.1 0.3 0.5 

 MEG aggressive Fed - low labor elasticity 0.1 0.2 0.4 

 MEG neutral Fed 0.0 0.2 0.4 

 MEG neutral Fed - low labor elasticity 0.0 0.1 0.4 

 OLG 0.2 0.3 0.4 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
35

Revenue feedback 

Table 7 shows the revenue feedback for changes in receipts generated using 

macroeconomic analysis relative to those generated using conventional revenue estimates. A 

positive percentage indicates the estimated revenue loss is less when macroeconomic effects are 

taken into account than when they are not. The relative magnitudes across simulations generally 

correspond to those in real GDP; simulations with larger GDP effects have larger revenue 

feedback effects. The revenue feedback ranges from 2.8 percent to 17.7 percent in the first five 

years, and 5.8 percent to 23.0 percent over the ten-year budget period. 

Table 7.−Effects of Individual Tax Rate Reduction on Real Revenue Feedback 

in Percent Changes Relative to Conventional Estimates 

Calendar Year Period 2005-2009 2010-2014 2005-2014 

 

No fiscal offset 

 MEG aggressive Fed 8.9 10.2 9.7 

 MEG aggressive Fed - low labor elasticity 7.3 8.0 7.7 

 MEG neutral Fed 17.7 26.7 23.0 

 MEG neutral Fed - low labor elasticity 17.0 24.9 21.7 

 OLG n.a. n.a. n.a. 

Fiscal Offset: decrease in Government spending 

 MEG aggressive Fed 9.6 16.1 13.5 

 MEG aggressive Fed - low labor elasticity 7.9 13.6 11.3 

 MEG neutral Fed 3.5 9.8 7.2 

 MEG neutral Fed - low labor elasticity 2.8 8.0 5.8 

 OLG 16.9 20.4 18.6 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
36

B. Increase in the Personal Exemption 

The most direct effect from an increase in the personal exemption for individual 

taxpayers operates in the short run by increasing after-tax income for individuals, thus 

stimulating consumer demand. The importance of this effect depends on whether the Federal 

Reserve Board decides to suppress this demand stimulus. As with the individual tax rate 

reduction, another channel for the increase in the personal exemption to impact economic growth 

is through changing incentives for labor supply via changes in average and marginal individual 

income tax rates. However, an increase in the personal exemption from $3,150 to $5,200 per 

qualifying person reduces the total tax payment made by most taxpayers, but reduces marginal 

tax rates only for those near breakpoints in the individual income tax brackets. The negative 

incentive for labor supply from higher disposable income is not generally outweighed by the 

positive incentive due to slightly lowered marginal tax rates in the first and second five years. 

Thus, the personal exemption increase has a smaller effect on short-run demand growth, and a 

smaller effect on long-run labor supply than observed with the individual tax rate reduction. 

Economic growth

Table 8 shows the effects on real output of a $500 billion tax cut over the budget window 

arising from increasing the personal exemption under varying assumptions about accompanying 

fiscal and monetary policy. The change in real GDP ranges from negligible to an increase of 0.2 

percent over the first five years, with a slightly larger range from less than -0.1 percent to 0.2 

percent over the second five years. The equivalent average annual real dollar amount ranges 

from a decline of $21 billion to an increase of $125 billion in the first five years and a decline of 

$80 billion to an increase of $164 billion in the second five years. Unlike the results from the 

individual tax rate reduction, which show positive growth effects in the first and second five 

years after the policy implementation across simulations, the exemption increase has mixed 

results in its effect on growth. Most of the growth effects due to the personal exemption increase 

in the MEG model are caused by fluctuations in the incentives it provides for consumer 

purchases. If the demand stimulus provided by the reduction in the average tax rate is largely 

offset by either aggressive monetary policy or spending cuts, the major economic effect of the 

exemption increase is to reduce incentives to work by increasing after-tax income without 

reducing marginal tax rates for most taxpayers. 

In the long run, for an exemption increase without offsetting spending cuts, the buildup of 

public debt results in a decline in GDP. This is consistent with the results of the simulations for 

the individual tax rate reduction. The declines shown in the exemption simulations are larger 

than those in the individual tax rate reduction simulations; and the long-term growth in the 

simulations with offsetting fiscal policy is smaller than the growth in the individual tax rate 

reduction simulations. In the MEG simulations, when the conventional revenue cost of the 

personal exemption increase is offset by a reduction in government transfer payments, the net 

effect of the policy is to reduce after tax income of consumers, thus dampening demand in the 

short run. This is because within the simulations, the cost of the tax decrease is slightly reduced 

relative to the conventional estimate (as shown in Table 14 below), so the reduction in transfer 

payments is slightly greater than the reduction in tax liability. In this case, the neutral Federal 

Reserve Board policy allows a slight slowdown in the economy, while the aggressive Federal 

Reserve Board policy slightly reduces interest rates to stimulate consumption. In the longer run, 
37

this policy leads to an increase in GDP in the MEG simulations because the fiscal offset leads to 

a slight decrease in Federal government debt, and thus reduces crowding out. 

 In the OLG simulation, transfer payments are reduced to match the dynamically 

calculated cost of the tax proposal, thus resulting in no change in after-tax income, and no 

reduction in consumer purchasing power. In this simulation, the primary effect on growth comes 

from the small increase in incentives to work and save due to the marginal rate reductions for 

taxpayers near the boundaries of their tax rate brackets. 

Table 8.−Effects of Personal Exemption Increase on Real GDP 

in Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.0 -0.1 -0.7 

 MEG neutral Fed 0.2 0.2 -0.4 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending

 MEG aggressive Fed 0.0 0.1 0.2 

 MEG neutral Fed -0.0 0.0 0.1 

 OLG 0.0 0.1 0.2 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
38

Investment

Table 9 shows that without a fiscal offset, the increase in Federal debt resulting from the 

exemption increase crowds out business investment by up to 0.2 percent in the first five years, by 

up to 0.5 percent over the second five years, and by up to 2.0 percent in the long run. Although 

we observe the negative impact on business investment in the proposal of the individual tax rate 

reduction, the negative effect does not show up until the second five years after the policy 

implementation. In the simulations that include a reduction in government expenditures to offset 

the cost of the increase in the personal exemption, the policy increases the stock of producers’ 

capital by as much as 0.1 percent in the first five years, by as much as 0.3 in the second five 

years, and by as much as 0.4 percent in the long run. In the short run, there is some induced 

response to the temporary increase in aggregate demand. The largest effects take place in the 

long run as the small reductions in the cost of capital, through the reductions in marginal rates, 

build up over time. 

Table 9.−Effects of Personal Exemption Increase on Producers' Real Capital Stock 

in Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed -0.2 -0.5 -2.0 

 MEG neutral Fed -0.1 -0.3 -1.7 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending

 MEG aggressive Fed 0.1 0.3 0.4 

 MEG neutral Fed 0.1 0.2 0.4 

 OLG 0.0 0.1 0.4 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
39

Table 10 shows the effects of the increase in the personal exemption on the real 

residential capital stock. The stock of residential capital is reduced by up to 0.2 percent in the 

first five years, and by as much as 0.7 percent in the second five years. In the long run the results 

show the stock of residential capital declining as much as 2.6 percent in the simulations without 

a fiscal offset where debt accumulates, and increasing by as much as 0.3 percent with a fiscal 

offset. The pattern of the response follows those in the individual tax rate reduction, but is 

smaller in magnitude. Because there are smaller marginal tax rate changes with the exemption 

increase, there is less incentive to shift away from residential capital than in the individual tax 

rate reduction simulations. With no fiscal offset, the shift from housing to producers’ capital is 

not enough to overcome the negative incentives to investment from the crowding out of private 

investment by public debt. In addition, as with the individual income tax rate reduction, the 

OLG model shows an increase in housing capital because housing consumption increases with 

GDP growth. 

Table 10.−Effects of Personal Exemption Increase on 

Real Residential Capital Stock in 

Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed -0.2 -0.7 -2.6 

 MEG neutral Fed -0.2 -0.3 -2.5 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed 0.0 -0.1 0.1 

 MEG neutral Fed -0.1 -0.1 0.1 

 OLG 0.0 0.1 0.3 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
40

Employment and labor supply

As shown in Table 11, the impact in the first five years after the increase in the personal 

exemption ranges from a loss of employment of less than 0.1 percent to an increase of 

employment of 0.3 percent, and in the second five years from an increase of less than 0.1 percent 

to an increase of 0.4 percent. These changes correspond to a range of employment effects from 

an annual loss of 53,000 jobs (calculated on a full-time equivalent basis) to an annual increase of 

60,000 jobs during the first five years, and an annual increase of 9,000 to 490,000 jobs in the 

second five years after implementation of the policy. As expected, the largest increases in 

employment occur when the policy is not offset with a reduction in government expenditures. 

Table 11.−Effects of Personal Exemption Increase on Employment 

in Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.0 0.1 0.1 

 MEG neutral Fed 0.3 0.4 0.4 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending

 MEG aggressive Fed 0.0 0.1 0.1 

 MEG neutral Fed -0.0 0.0 0.1 

 OLG 0.0 0.0 0.1 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 

Finally, because the exemption increase provides a smaller decrease in individuals’ 

average marginal tax rates than the rate reduction does, the labor response to the exemption 

increase is smaller than the corresponding increase due to the individual tax rate reduction. 

Table 12.−Effects of Personal Exemption Increase on Labor Force Participation 

in Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.0 0.1 0.1 

 MEG neutral Fed 0.0 0.1 0.1 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending

 MEG aggressive Fed 0.0 0.1 0.1 

 MEG neutral Fed 0.0 0.1 0.1 

 OLG 0.0 0.0 0.1 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
41

Consumption

Table 13 shows the effects of the exemption increase on consumption. In the first five 

years, the percent changes in consumption vary from a decline of 0.1 percent to an increase of 

0.4 percent, and in the second five years, it ranges from less than 0.1 percent to 0.4 percent. As 

with the individual tax rate reduction, changes in consumption reflect changes in disposable 

income due to the exemption increase. For the simulations without a fiscal offset, consumption 

patterns generally follow those under the proposal of the individual tax rate reduction but are 

smaller in magnitude, resulting from the smaller growth impact of the exemption increase. In the 

short run, the neutral Fed without a fiscal offset raises aggregate demand. 

In the simulations with a fiscal offset, there is no incentive to increase consumption in the 

short run in the myopic MEG simulations because the reduction in transfer payments reduces 

after-tax income available to consumers. Because the changes in marginal rates are so small, any 

growth effects due to labor supply responses that could generate consumption are also minimal. 

In the long run, the economic growth associated with the reduction in government transfer 

payments increases consumption. In the OLG simulation, in which consumers foresee the future 

growth in GDP in the long run, they adjust their lifecycle consumption immediately. 

Table 13.−Effects of Personal Exemption Increase on Consumption 

Percent Change in Consumption Relative to Present Law 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.3 0.3 -0.2 

 MEG neutral Fed 0.4 0.4 0.0 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed 0.0 0.1 0.2 

 MEG neutral Fed -0.1 0.0 0.2 

 OLG 0.1 0.1 0.2 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
42

Revenue feedback 

Table 14 shows the revenue feedback for changes in receipts generated using 

macroeconomic analysis relative to those generated by conventional revenue estimates. A 

positive percentage indicates the estimated revenue loss is less when macroeconomic effects are 

taken into account than when they are not. A negative feedback effect indicates that when 

macroeconomic effects are taken into account, the revenue cost of the proposal is higher than 

under the conventional estimate. The negative revenue feedback corresponds with a negative 

effect on economic growth. The relative magnitudes across simulations generally correspond to 

the relative magnitudes of changes in real GDP. Real GDP can be regarded roughly as the tax 

base; when a tax cut induces large growth effects, it tends to generate large revenue feedback. 

For example, both GDP growth and revenue feedback are significantly higher for the OLG 

simulations than for the other simulations of an offsetting increase in government spending. The 

revenue feedback ranges from -1.7 percent of the conventional revenue estimate to 12.6 percent 

in the first five years, and 0.4 percent to 15.2 percent over the ten-year budget period. 

Table 14.−Effects of Personal Exemption Increase on Revenue Feedback 

in Percent Changes Relative to Conventional Estimates 

Calendar Year Period 2005-2009 2010-2014 2005-2014 

 

No fiscal offset 

 MEG aggressive Fed 1.2 -0.0 0.5 

 MEG neutral Fed 12.6 17.4 15.2 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed 2.1 6.7 4.6 

 MEG neutral Fed -1.7 2.2 0.4 

 OLG 7.6 8.2 7.9 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
43

C. Reduction in the Corporate Income Tax Rate 

A decrease in the corporate income tax rate primarily affects the economy through 

increasing the after-tax rate of return on corporate capital, which provides incentives for 

investment in corporate capital. As the capital stock in the corporate sector builds up in response 

to this incentive, more goods and services are produced, increasing total output. Also, because 

workers have more technology to use in production, the productivity of labor increases along 

with the growth of business capital stock. Thus, the increase in capital stock leads to increasing 

wage rates and employment. The amount of growth in output and employment generated by the 

corporate tax rate reduction increases gradually over time as the capital stock accumulates. 

Within the second five years, after the capital stock has increased sufficiently to generate 

wage increases, the increase in after-tax income resulting from the corporate tax rate reduction 

may stimulate additional growth due to increased consumer demand. The extent to which this 

occurs depends on whether the Federal Reserve Board acts to counter this demand stimulus, and 

whether the Federal government enacts an offsetting fiscal policy. The Federal Reserve Board 

may offset demand stimulus by increasing interest rates, which increases the cost of borrowing 

for both business investment and personal consumption. Offsetting fiscal policy is modeled in 

this analysis as either a tax increase by decreasing the personal exemption amount, or a Federal 

government spending cut in non-taxed Federal transfer payments. Offsetting fiscal policies 

reduce the demand stimulus from the initial tax cut by reducing after tax income available for 

consumer purchases. Offsetting monetary or fiscal policy that dampens demand reduces the 

strength of the economy’s response within the ten-year budget horizon. 

The extent to which the increases in output, income, and employment resulting from the 

corporate tax rate reduction persist in the long run depends on whether the loss in revenues due 

to the policy is accompanied by offsetting monetary or fiscal policy. Without an offsetting fiscal 

policy, the uncompensated loss of revenues from the Federal budget requires additional Federal 

government borrowing, which may raise interest rates enough to outweigh the benefits of the 

corporate tax rate reduction, particularly if the Federal Reserve Board acts aggressively to 

counteract the fiscal policy. However, to the extent that the corporate tax rate reduction is offset 

by a reduction in spending or a (mostly) non-marginal increase in individual income taxes, in the 

long run GDP is likely to increase by significantly more than it does during the ten-year budget 

period. 

Economic growth

Table 15 shows the real effects of a $500 billion reduction in corporate tax rates on 

output under varying assumptions about accompanying fiscal and monetary policy. The change 

in real GDP ranges from less than a 0.1 percent change to a 0.3 percent increase over the first 

five years, with an increase of 0.1 percent to 0.4 percent over the second five years. The 

equivalent average annual real dollar amount ranges from $20 billion to $185 billion in the first 

five years and $120 billion to $285 billion in the second five years. In the simulations that 

include an alternate tax increase or a spending decrease to offset the revenue loss of the corporate 

tax cut, the effects of this policy are generally greater in the second five years after 

implementation of the policy than in the first five years, and even greater in the long run. 

Growth effects increase over time because the reduction in the corporate tax rate affects growth 
44

in the economy by increasing the after-tax return to investment in business capital, which causes 

a gradual buildup in the capital stock available for business production. In turn, this increase in 

the capital stock enhances the productivity of labor, and hence the wage rate, over time. In the 

simulations that have no fiscal offset, the growth effects are greatest in the second five years, 

especially in the simulation in which the Federal Reserve Board does not counteract the demand 

stimulus created by the tax cut. In the long run, however, growth is reduced when there is no 

offsetting fiscal policy to stem increases in government debt; the buildup of public debt reduces 

the extent to which the corporate tax rate reduction lowers the cost of capital, thus slowing the 

buildup of the capital stock. In contrast, for the simulations in which there is offsetting fiscal 

policy, the results for simulations with neutral Federal Reserve Board policy (middle rows of 

each panel) show lower economic growth. In these cases, because the offsetting fiscal policy 

results in a net reduction in aggregate demand, the aggressive Federal Reserve Board reaction is 

actually more stimulative than the neutral Federal Reserve Board reaction. 

For the budget neutral simulations, in the long run, the simulations that offset the 

corporate tax cut with a reduction in transfer payments have a bigger effect on real GDP than the 

simulations with the reduction in the personal exemption as the fiscal offset. The reduction in 

transfer payments reduces individuals’ disposable income without affecting the marginal tax rate 

on their labor income; thus it provides an unambiguous incentive for individuals to work more, 

supplying more labor. While the reduction in the exemption amount has roughly the same effect 

on disposable income as the reduction in transfer payments, it also slightly increases the 

marginal tax rate on wage income for some taxpayers. Thus, the reduction in the exemption 

amount decreases the after-tax return to work for those taxpayers, and provides some offsetting 

incentive for individuals to reduce their work effort. 

Table 15.−Effects of Corporate Tax Rate Reduction on Real GDP 

in Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.1 0.2 -0.0 

 MEG neutral Fed 0.3 0.4 0.3 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in personal exemption 

 MEG aggressive Fed, 0.1 0.3 0.6 

 MEG neutral Fed 0.1 0.2 0.6 

 OLG 0.2 0.3 0.5 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed, 0.1 0.4 0.9 

 MEG neutral Fed 0.0 0.2 0.8 

 OLG 0.2 0.4 0.5 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
45

Investment

As Table 16 indicates, the reduction in corporate tax rates may increase producers’ real 

capital stock in the first five years by up to 0.8 percent. These effects increase over time, with 

business capital increasing by as much as 1.9 percent in the second five years, and 2.9 percent in 

the long run. This policy lowers the cost of capital by increasing the after-tax return on business 

equipment, thus providing an incentive for more business investment. When Federal revenues 

lost from the tax cut are not offset (in the no fiscal offset simulations), Federal government 

borrowing is increased; the beneficial effects of the corporate tax rate reduction on the cost of 

capital are reduced by the competition of Federal government borrowing in domestic capital 

markets. Therefore, the growth of producers’ real capital stock is much greater in the 

simulations that include fiscal offsets. 

Table 16.−Effects of Corporate Tax Rate Reduction on Producers' 

Real Capital Stock in 

Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.5 1.0 0.5 

 MEG neutral Fed 0.6 1.2 0.7 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in personal exemption 

 MEG aggressive Fed 0.7 1.6 2.3 

 MEG neutral Fed 0.7 1.5 2.3 

 OLG 0.5 1.1 1.9 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed 0.8 1.9 2.9 

 MEG neutral Fed 0.8 1.7 2.9 

 OLG 0.6 1.3 2.7 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
46

Table 17 shows the effects of the corporate tax rate reduction on the residential capital 

stock. Because the reduction in taxation of corporate capital lowers the cost of capital for 

business investment relative to that for housing, the investment incentives for producers’ capital 

in this proposal are likely to shift some investment from housing to business capital. The 

residential capital stock is reduced by up to 0.4 percent in the first five years, by as much as 0.9 

percent in the second five years, and 1.8 percent in the long run. The size of the shift differs 

between the MEG and OLG simulations because of different assumptions about adjustment costs 

associated with business investment and savings responses. Because the corporate rate reduction 

has a smaller effect on consumption incentives, the difference between the consumption 

treatment of housing between OLG and MEG is less important in these simulations than it was in 

the individual income tax simulations. In the long run, the simulations with a fiscal offset result 

in increases in the real residential capital stock relative to the no fiscal offset simulations. This is 

primarily because there is no crowding out in the simulations with a fiscal offset. 

Table 17.−Effects of Corporate Tax Rate Reduction on Real Residential 

Capital Stock In Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed -0.4 -0.9 -1.8 

 MEG neutral Fed -0.3 -0.6 -2.0 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in personal exemption 

 MEG aggressive Fed -0.1 -0.2 0.8 

 MEG neutral Fed -0.1 -0.2 0.5 

 OLG -0.2 -0.4 -0.2 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed -0.2 -0.2 0.9 

 MEG neutral Fed -0.2 -0.4 0.7 

 OLG -0.2 -0.3 0.2 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
47

Employment and labor supply

As shown in Table 18, the impact on employment is highly sensitive to the varying 

assumptions in each simulation. The impact in the first five years after the corporate tax rate 

reduction may range from a decrease of 0.1 percent to an increase of 0.2 percent, and in the 

second five years from a decrease of 0.2 percent to an increase of 0.2 percent. These changes 

correspond to a range of employment effects from a 130,000 decrease to a 280,000 increase in 

jobs (calculated as full-time equivalents based on hours) during the first five years, and a 

250,000 decrease to a 280,000 increase in jobs in the second five years after implementation of 

the policy. 

Table 18.−Effects of Corporate Tax Rate Reduction on Employment 

in Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.0 0.0 0.0 

 MEG neutral Fed 0.2 0.2 0.3 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in personal exemption 

 MEG aggressive Fed -0.1 -0.1 -0.1 

 MEG neutral Fed -0.1 -0.2 -0.1 

 OLG 0.1 0.0 0.0 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed 0.0 0.0 0.1 

 MEG neutral Fed -0.1 -0.2 0.0 

 OLG 0.1 0.0 0.0 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 

The different employment effects across various simulations arise from different policy 

assumptions and modeling perspectives between the MEG model and the OLG model. Like 

investment, employment responds both to increases in demand for goods and services and to 

long-run growth incentives. In the short run, most of the employment effects come from changes 

in demand due to the policy. When the corporate tax rate reduction is implemented alone, and 

the Federal Reserve Board does not work to counteract the demand stimulus, the increase in 

activity stimulates short-run employment growth. However, when the Federal Reserve Board 

counteracts the demand effects there is a negligible positive effect of the policy on employment. 

Because a fiscal offset reduces the stimulus to demand provided by the corporate tax rate 

reduction, there are no demand-driven increases in employment in the simulations of the 

corporate tax rate reduction combined with the personal exemption decrease or the cut in Federal 

government spending. In fact, the effects are as likely to be negative as they are to be positive. 
48

Cutting the exemption amount produces a more negative result than cutting transfer payments. 

As shown in Table 19, the labor supply incentive is also affected by whether the corporate tax 

rate reduction is offset by a fiscal policy that creates countervailing incentives, and by how that 

offset is viewed by the individual worker. In the case of labor, the long-run growth incentives of 

a corporate tax cut take effect gradually as the capital stock accumulates, increasing the 

productivity of labor and the wage rate. In addition, as shown in Table 19, the employment 

numbers reflect the effects the exemption decrease has on increasing marginal tax rates for some 

taxpayers, thus providing an incentive for them to reduce their labor force participation relative 

to the other sets of simulations presented here. 

Table 19.−Effects of Corporate Tax Rate Reduction on Labor Force Participation 

In Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed 0.0 0.0 0.0 

 MEG neutral Fed 0.0 0.0 0.0 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in personal exemption 

 MEG aggressive Fed -0.1 -0.1 -0.1 

 MEG neutral Fed -0.1 -0.1 -0.1 

 OLG 0.1 0.0 0.0 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed, 0.0 0.0 0.0 

 MEG neutral Fed 0.0 0.0 0.1 

 OLG 0.1 0.0 0.0 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 

The differences in employment responses between the MEG budget neutral simulations 

and the OLG budget neutral simulations highlight a couple of differences in modeling 

perspective between the myopic expectations in the MEG model and the perfect foresight 

expectations in the OLG model. Because taxpayers in the MEG model base their behavior on 

current variables, not expected future variables, the negative demand and marginal rate change 

effects dominate their behavior. In contrast, in the OLG model, taxpayers view the continuing 

reduction in transfer payments as reducing their disposable income currently and in the future, 

and thus work harder throughout the budget window to accumulate savings against this loss of 

disposable income. 
49

Consumption

Table 20 shows the effects of a cut in the corporate tax rate on consumption of goods and 

services. In the first five years, consumption may decrease by as much as 0.4 percent if the 

corporate tax cut is offset by a cut in Federal government spending, or increase by 0.1 percent if 

the stimulus is not offset by either fiscal or monetary policy. In the second five years, 

consumption may decrease by as much as 0.2 percent if there is a reduction in government 

expenditures, and it may increase by as much as 0.3 percent without a fiscal offset. In the long 

run, unlike the first five and ten year results, the buildup of capital stock increases labor 

productivity, and therefore real wages and consumption are higher in all of the simulations. 

Consumption is significantly lower in the short run in the MEG model simulations with a fiscal 

offset, reflecting the reduction in disposable income as a result of the reduction in the personal 

exemption or transfer payments. 

Table 20.−Effects of Corporate Tax Rate Reduction on Real Consumption 

in Percent Changes Relative to Present Law Baseline 

Calendar Year Period 2005-2009 2010-2014 Long Run 

 

No fiscal offset 

 MEG aggressive Fed -0.0 0.2 0.2 

 MEG neutral Fed 0.1 0.3 0.4 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in personal exemption 

 MEG aggressive Fed -0.3 -0.1 0.4 

 MEG neutral Fed -0.3 -0.1 0.4 

 OLG 0.0 0.2 0.3 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed -0.3 -0.0 0.7 

 MEG neutral Fed -0.4 -0.2 0.6 

 OLG -0.1 0.0 0.2 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
50

Revenue feedback 

Table 21 shows the revenue feedback for changes in receipts generated using 

macroeconomic analysis relative to those generated by a conventional revenue estimate. A 

positive percentage indicates the estimated revenue loss is less when macroeconomic effects are 

taken into account than when they are not. The relative magnitudes across simulations generally 

correspond to the relative magnitudes of changes in real GDP. Real GDP can be regarded 

roughly as the tax base; when a tax cut induces big growth effects, it tends to generate big 

revenue feedback. For example, both GDP growth and revenue feedback are both significantly 

higher under neutral Federal Reserve Board policy when there is no offsetting decrease in 

government spending than when there is an offsetting decrease in government spending (middle 

rows of both panels). Depending on how much temporary demand stimulus is generated by the 

proposal, the revenue feedback could range from 3.6 percent of the conventional revenue 

estimate to 17.9 percent in the first five years, and 8.3 percent to 21.0 percent over the ten-year 

budget period. Revenue feedback is not computed for the simulations of the corporate tax rate 

reduction offset by a decrease in the personal exemption because the conventional revenue 

estimate that is in the denominator of all of these calculations is zero for that proposal. See 

Appendix B for an alternate measure. 

Table 21.−Effects of Corporate Tax Rate Reduction on Real Revenues 

in Percent Changes Relative to Conventional Estimates 

Calendar Year Period 2005-2009 2010-2014 2005-2014 

 

No fiscal offset 

 MEG aggressive Fed 7.7 18.2 13.2 

 MEG neutral Fed 17.9 27.5 21.0 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed 9.2 26.7 18.4 

 MEG neutral Fed 3.6 12.6 8.3 

 OLG 8.7 11.8 10.2 

Note: 0.0 indicates a change of zero to 0.05, and -0.0 indicates a change of zero to -0.05. 
51

APPENDIX A: DATA AND ASSUMPTIONS 

Data

All of the macroeconomic models used by the Joint Committee staff are based primarily 

on data from the quarterly National Income and Product Accounts (“NIPA”) data published by 

the Bureau of Economic Analysis, U.S. Department of Commerce. In the MEG model, and to 

the extent possible in the OLG model, the Joint Committee staff uses the forecast for Federal and 

State and local government expenditures and receipts forecast by the Congressional Budget 

Office (The Budget and Economic Outlook: Fiscal Years 2005-2014, January 2004). The 

Internal Revenue Code includes many deductions, credits, exclusions, and phaseouts that can 

cause the actual tax rates faced by taxpayers to differ from their statutory rates. To obtain these 

effective average and marginal tax rates on different sources of income under the present law 

baseline as well as under the tax proposals, the Joint Committee staff uses its individual 

microsimulation tax models, which are based on tax return data provided by the Statistics of 

Income Division of the Internal Revenue Service (“SOI”). Specifically, when using the 

microsimulation models, the tax calculator computes the change in liability due to the proposal 

for each sample tax return. These changes are aggregated for use in the macroeconomic models 

by computing the income-weighted average rate for each income source. 

Table A.1. shows the conventional estimate of the change in Federal fiscal year revenues 

due to the three tax policies analyzed. 

Table A.1.-Conventional Fiscal Year Revenue Estimates 

Billions of Dollars 

 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 05-09 10-14 

Individual 

Tax Cut...... -25 -38 -41 -44 -48 -450 -57 -61 -65 -69 -196 -500 

Corporate 

Tax Cut...... -28 -46 -51 -52 -53 -53 -54 -56 -58 -60 -231 -511 

Exemption 

Increase...... -34 -47 -46 -45 -45 -44 -57 -63 -62 -61 -217 -505 

Table A.2. shows the percent changes in marginal and average effective tax rates due to 

the various proposals. The largest percentage changes in the marginal tax rate on wages result 

from the individual tax rate reduction. The exemption increase has a larger effect on marginal 

rates after the expiration of the tax cuts enacted in EGTRRA. The rate changes in the corporate 

tax rate reduction with the exemption decrease follow an almost identical path to those in the 

exemption increase, but of the opposite sign. Finally, it should be noted that effects on the 

average tax rates on wages are of similar magnitudes across the three proposals because the 

simulations are designed to have a similar conventional estimated revenue loss across proposals. 
52

Table A.2.−Percent Change in Marginal and Average 

Tax Rates on Wages Due to the Proposals

Average Effective Marginal Rates 

on Wages 

Average Effective Rates 

on Wages 

Year 

Individual 

Tax Rate 

Reduction 

Exemption 

Increase 

Corporate Tax 

Rate Reduction 

with Exemption

Decrease 

Individual Tax 

Rate Reduction

Exemption 

Increase 

Corporate Tax 

Rate Reduction 

with Exemption 

Decrease 

2005 -3.9 -1.3 2.2 -4.7 -6.5 7.5 

2006 -3.9 -0.9 1.7 -4.5 -6.3 5.4 

2007 -3.8 -0.4 1.3 -4.2 -5.9 5.0 

2008 -4.2 -0.4 0.4 -4.3 -4.3 5.2 

2009 -4.1 -0.4 0.4 -5.0 -5.0 4.1 

2010 -4.1 -0.4 0.4 -5.0 -4.1 4.1 

2011 -4.1 -1.9 1.9 -4.1 -4.8 4.8 

2012 -3.7 -1.1 1.9 -4.1 -4.1 4.7 

2013 -3.7 -1.1 1.9 -4.6 -4.0 4.0 

2014 -4.0 -1.1 1.5 -4.5 -3.9 3.9 

Table A.3. presents the percentage changes in tax rates on interest, dividend, and capital 

gain income. Similar to the results in Table A.2. for the percentage changes in the marginal tax 

rates on wages, the results presented in the table indicate that the largest marginal changes result 

from the individual tax rate reduction. 

Table A.3.−Percent Changes in Marginal Tax Rates on Interest, 

Dividends, and Capital Gains Due to the Proposals 

Interest Dividends Gains 

Year 

Individual 

Tax Rate 

Reduction 

Exemption 

Increase 

Corporate 

Tax Rate 

Reduction 

with 

Exemption 

Decrease 

Individual 

Tax Rate 

Reduction

Exemption 

Increase

Corporate 

Tax Rate 

Reduction 

with 

Exemption 

Decrease 

Individual 

Tax Rate 

Reduction 

Exemption 

Increase 

Corporate 

Tax Rate 

Reduction 

with 

Exemption 

Decrease 

2005 -4.0 -2.0 2.0 -4.3 -0.7 0.0 -3.5 0.0 0.7 

2006 -3.9 -1.5 2.0 -3.6 0.0 0.7 -3.5 -0.7 0.7 

2007 -3.8 -1.4 1.0 -3.6 0.0 0.7 -4.2 -0.7 0.0 

2008 -3.8 -1.0 1.0 -3.9 0.0 0.0 -3.5 -0.7 0.7 

2009 -4.1 -0.9 0.9 -4.0 -0.8 0.4 -4.4 -0.5 0.0 

2010 -4.0 -0.9 0.9 -4.0 -0.4 0.4 -3.8 0.0 0.5 

2011 -4.0 -1.6 1.6 -3.9 -0.7 0.7 -4.3 0.0 0.0 

2012 -4.0 -1.6 1.6 -3.9 -0.7 0.7 -4.3 0.0 0.0 

2013 -4.3 -1.6 1.2 -3.8 -0.7 0.7 -4.3 0.0 0.0 

2014 -3.9 -1.2 1.2 -4.2 -0.7 0.7 -4.3 0.0 0.0 
53

Table A.4. presents the baseline average effective individual marginal income tax rates 

for wages, interest, dividends, capital gains, and total income. The marginal rates are income 

weighted. As can be seen in the table, the sunsets of EGTRRA and JGTRRA increase marginal 

rates in 2011 and 2009, respectively. The marginal tax rate on dividends drops from 14 percent 

in 2007 to 12.9 percent in 2008, reflecting the introduction of the zero rate. 

Table A.4.−Baseline Marginal Tax Rates on Wages, Interest, 

Dividends, Capital Gains, and Total Income 

Average Effective Individual Marginal Rates 

Year Wages Interest Dividends Gains Total Income 

2005 0.229 0.199 0.139 0.142 0.224 

2006 0.231 0.205 0.139 0.142 0.231 

2007 0.234 0.209 0.140 0.143 0.234 

2008 0.237 0.209 0.129 0.142 0.236 

2009 0.241 0.221 0.247 0.183 0.243 

2010 0.243 0.224 0.252 0.184 0.245 

2011 0.267 0.250 0.283 0.187 0.271 

2012 0.268 0.252 0.285 0.187 0.272 

2013 0.270 0.256 0.287 0.187 0.274 

2014 0.272 0.257 0.289 0.187 0.275 

To obtain information about the effects of proposals affecting business tax liability, the 

Joint Committee staff uses its corporate tax microsimulation model, similar in structure to the 

individual microsimulation tax model. The data source for the corporate model is a sample of 

approximately 140,000 corporate tax returns provided by SOI. The staff’s individual tax 

microsimulation model is used to obtain tax rates on non-corporate business, such as partnerships 

and S Corporations. 

Depending on the requirements of the policy simulation, the corporate model can be run 

either on a full cross section of sampled tax returns (i.e., one full year) or on a panel of returns 

constructed from any combination of tax years in the 1987 through 1998 period. This panel 

feature is particularly useful in tracking net operating losses and credits that can be either carried 

back or carried forward to other tax years. The extent to which these carrybacks or 

carryforwards occur depends on how the corporate rate is being changed, and thus affects the 

size of the effective change in corporate tax rates. 

Table A.5. presents the percentage changes in marginal tax rates on business income due 

to the proposals, obtained using the Joint Committee staff’s individual microsimulation model. 

Business income includes both corporate income and pass-through income to the individuals, 

such as partnership, S Corporation, and sole proprietorship income. Therefore, not surprisingly, 

the individual tax rate reduction and the exemption increase reduce the marginal rates on 

business income. Finally, as can be seen from the table, the percentage change in the marginal 
54

tax rates on business income declines after the sunset of the EGTRRA in 2010. This is due to the 

higher rates on pass-through business income after 2010. 

Table A.5.−Percent Changes in Marginal Tax Rates on Business 

Income Due to the Proposals 

Year Individual Tax 

Rate Reduction 

Exemption 

Increase 

Corporate Tax 

Rate Reduction 

Corporate Tax 

Rate Reduction 

with Exemption 

Decrease 

2005 -1.3 -0.2 -11.3 -11.1 

2006 -1.3 -0.2 -11.3 -11.0 

2007 -1.4 -0.2 -11.3 -11.1 

2008 -1.3 -0.2 -11.3 -11.2 

2009 -1.3 -0.1 -11.2 -11.0 

2010 -1.4 -0.2 -11.2 -11.1 

2011 -1.5 -0.3 -10.7 -10.4 

2012 -1.5 -0.2 -10.6 -10.4 

2013 -1.4 -0.2 -10.6 -10.4 

2014 -1.5 -0.1 -10.6 -10.4 

Modeling assumptions

The magnitude of the macroeconomic effects generated by these simulations depends 

upon a number of assumptions about the size of the behavioral response of taxpayers to changes 

in after tax income. The specific response parameters used in the MEG and OLG models are 

summarized in Tables A.6. and A.7., with a discussion of their significance following. 
55

Table A.6.−Key Parameter Assumptions in the MEG Model 

Labor supply elasticities in 

disaggregated labor supply Income Substitution

Low Elasticity

Substitution 

Low income primary -0.1 0.2 0.15 

Other primary -0.1 0.1 0.1 

Low income secondary -0.3 0.8 0.4 

Other secondary -0.2 0.6 0.3 

Wage-weighted population average 

with baseline rates -0.1 0.2 0.1 

 

Savings/consumption parameters underlying lifecycle consumption function 

Rate of time preference 0.015 

Intertemporal elasticity of substitution 0.25 

Derived long-run savings elasticity to 

the after tax rate of return on capital 0.29 

Table A.7.−Key Parameter Values in the OLG Model 

Description Value 

Rate of time preference 0.005 

Intertemporal elasticity of substitution 0.25 

Intratemporal elasticity of substitution 0.5 

Leisure share of time endowment 0.3 

Population growth rate 0.01 

Technological growth rate 0.01 

Capital share in non-housing production 0.27 

Capital share in housing production 0.98 

Adjustment cost parameter (quadratic adjustment cost function) 2 

Debt-to-capital ratio (average across all production sectors) 0.35 

Housing elasticity of substitution between capital and labor 0.5 

Non-housing elasticity of substitution between capital and labor 0.7 
56

Effects of tax rate reductions on labor supply

Reductions in individual tax rates have two opposing influences on labor supply 

incentives. On one hand, reductions in marginal individual income tax rates (tax rates on 

incremental amounts of income earned) create an incentive to work more because taxpayers get 

to keep more of each dollar earned, making each additional hour of work more valuable. On the 

other hand, reductions in the average tax rate create an incentive to work less, because they result 

in taxpayers having more after-tax income at their disposal for a given amount of work. 

Consistent with existing research, the simulations assume that taxpayers in different 

financial positions respond differently to these incentives. Typically, the largest response comes 

from secondary workers (individuals whose wages make a smaller contribution to household 

income than the primary earner in the household) and other underemployed individuals entering 

the labor market. Labor supply responses are modeled separately for four different groups in 

MEG: low-income primary earners, other primary earners, low-income secondary earners, and 

other secondary earners. The model simulations assume that for secondary earners, the marginal 

rate effect is larger than the average rate effect; thus reductions in wage tax rates result in 

increases in labor supplied to the economy. As the individual income tax rate reduction has 

substantial impact on average and marginal labor income tax rates, simulations are presented 

using two different sets of assumptions about the responsiveness of labor supply to changes in 

tax rates (the results obtained under assumed smaller labor responses are referred to as “low 

labor elasticity”). Since the other two proposals involve little or no changes in individual tax 

rates, the simulations on low labor elasticity are not performed. 

In the OLG model, the labor supply response to tax changes is determined by taxpayers’ 

preferences for consuming leisure versus other consumer items. To the extent that taxpayers 

prefer consumption of goods and services over leisure, they will choose to increase their work 

effort. As in the MEG model, tax policy affects these decisions through changing the average 

and marginal amount of after-tax income available to the taxpayer. Unlike the MEG model, 

these labor supply decisions are made not just with respect to current returns on labor; the 

taxpayer allocates labor across his lifetime in response to his expectations about the relative 

returns to labor in the future as well as currently. For this reason, the rate of time preference (for 

consumption) and the intertemporal elasticity of substitution (degree to which the individual is 

willing to defer leisure in order to earn more current income) also play a role in the individual’s 

labor supply decisions. 

Effects of tax rate reductions on investment

Reductions in marginal tax rates on interest, dividend, or capital gains income create 

incentives for individuals to save and invest more of their income, as each additional dollar of 

investment yields more after-tax income. Conversely, reductions in the average tax rate on 

income from capital provide taxpayers with more after-tax income for the same amount of 

investment, reducing their incentive to save and invest. Changes in the statutory tax rate affect 

both marginal and average rates of tax on these sources of income, providing offsetting 

incentives. Consistent with existing research, the model simulations assume that on net, the 

marginal rate effect is slightly larger than the average rate effect, and thus decreases in tax rates 

on capital income increase savings. In addition, because both the MEG and the OLG models 
57

assume some substitutability between investment in housing and investment in business capital, 

proposals that change the relative after-tax rate of return between these two sectors are assumed 

to cause shifting in investment between the sectors. The positive effects of investment incentives 

on growth are slightly enhanced within the simulations by an assumed interaction between 

increasing capital stock and increasing technological development. Thus, increases in capital 

stock are assumed to increase labor productivity through technological progress as well as 

through capital build up. 

There is general agreement that taxation of dividend income reduces the return on 

investments financed with new share issues. However, two alternative views exist regarding the 

effect of reducing dividend taxation on corporate investment returns financed with retained 

earnings. The “traditional view” holds that reductions in dividend taxes would lower the cost of 

corporate investment financed with either new share issues or retained earnings, and thus would 

provide an incentive for corporations to increase investment. Alternatively, the “new view” 

holds that a reduction in the dividend tax rate would not lower the cost of corporate investment 

financed with retained earnings. Under this view, a decrease in the dividend tax rate would 

result in an immediate increase in the value of outstanding stock reflecting the reduction in 

dividend tax payments, thus increasing the wealth of the stockholders, and providing an 

incentive for additional consumption. The model simulations assume that half of the corporate 

sector is in accordance with the traditional view and half with the new view. 

Effects of accumulating Federal government debt and international capital flows

Increased Federal government budget deficits increase the amount of borrowing by the 

Federal government. Unless individuals increase their savings enough to finance the increased 

deficit, the increase in government borrowing will reduce the amount of domestic capital 

available to finance private investment. As government borrowing increases, the government 

and private firms compete for available funds and interest rates rise to equate the demand and 

supply of funds. This effect is often referred to as “crowding out” of private business activity by 

Federal government activity, and leads to a reduction in domestic investment and domestic 

capital formation. Crowding out is alleviated by two responses. First, individuals may increase 

their savings in response to rising interest rates; second, rising interest rates may attract 

international investors, increasing the total amount of capital available to the U.S. economy. The 

MEG simulations incorporate an assumption that there would be some inflow of foreign capital 

to the extent that the rate of return on capital is increased by the tax policy. However, the inflow 

in foreign capital is not enough to offset completely the increased Federal borrowing. The OLG 

simulations assume no inflow of foreign capital. Both models incorporate an assumption that an 

increase in the interest rate increases domestic savings. 
58

To provide an idea of the extent of crowding out in the MEG model, Table A.8. compares 

real long term interest rates from the three proposals simulated in this analysis, both with and 

without a fiscal offset. The simulations with fiscal offsets show the effects of the tax policy 

assuming virtually no increasing Federal government debt accumulation, and thus provide the 

long term interest rate for the policy with no crowding out. The difference in real interest rates 

between these simulations is about 20 to 50 basis points. These changes correspond to an 

increase ranging from 1.5 to five basis points for every one percent increase in the ratio of 

Federal debt to GDP. 

Table A.8.−Annual Real Long-Run Interest Rates 

Individual Tax 

Rate 

Reduction 

Personal 

Exemption 

Increase 

Corporate Tax 

Rate 

Reduction 

 

No fiscal offset 

 MEG aggressive Fed 0.046 0.047 0.046 

 MEG neutral Fed 0.044 0.044 0.044 

Fiscal Offset: decrease in Government spending

 MEG aggressive Fed, 0.042 0.042 0.042 

 MEG neutral Fed 0.042 0.042 0.042 
59

APPENDIX B: ALTERNATE FEEDBACK MEASURE 

For proposals that include a revenue-neutral change in tax policy, such as a reduction in 

the corporate income tax rate and an offsetting decrease in the personal exemption, the 

traditional “revenue feedback” measure is undefined. The conventional revenue feedback 

measure divides the change in receipts due to macroeconomic effects by the amount of the 

conventional revenue estimate; for revenue neutral proposals, the conventional revenue estimate 

is near zero, and thus cannot be put in the denominator. An alternate way to illustrate the 

relationship between macroeconomic effects of tax policy and their impacts on revenues is to 

present a measure of the change in proposed-law revenues that owes to macroeconomic effects, 

as a percent of present-law baseline receipts: revenues are computed under proposed law with 

and without macroeconomic effects, and the difference between these measures is divided by 

present-law baseline receipts. This methodology provides an indication of the long-run impact 

of the growth effects of the proposals on revenues. 

Tables B.1., B.2., and B.3. below, show a comparison of feedback as computed under this 

alternative measure for the individual tax rate reduction, the increase in the personal exemption, 

and the corporate tax rate reduction, respectively. Inside the budget horizon, the results are 

broadly comparable to our standard measure of revenue feedback; in the long run, the measure is 

consistent with the macroeconomic effects presented in figures and discussed above. Growthinduced changes in revenues are likely to be greater within the budget window in response to a 

cut in individual income tax rates than in response to the other proposals. In the long run, the 

corporate tax cut produces a greater growth induced change in revenues. 

Table B.1.−Macroeconomic Effect of Individual Tax Rate Reduction on Real Revenues 

Percent Changes in Total Real Revenues Owing to Macroeconomic Effects 

Calendar Year Period 2005-2009 2010-2014 2005-2014 

 

No fiscal offset 

 MEG aggressive Fed 0.1 0.2 0.2 

 MEG aggressive Fed - low labor elasticity 0.1 0.2 0.1 

 MEG neutral Fed 0.3 0.5 0.4 

 MEG neutral Fed - low labor elasticity 0.3 0.5 0.4 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed 0.1 0.3 0.2 

 MEG aggressive Fed - low labor elasticity 0.1 0.3 0.2 

 MEG neutral Fed 0.1 0.2 0.1 

 MEG neutral Fed - low labor elasticity 0.0 0.2 0.1 

 OLG 0.7 0.9 0.8 
60

Table B.2.−Macroeconomic Effect of Personal Exemption Increase on Real Revenues 

Percent Change in Total Real Revenues Owing to Macroeconomic Effects 

Calendar Year Period 2005-2009 2010-2014 2005-2014 

 

No fiscal offset 

 MEG aggressive Fed 0.0 -0.0 0.0 

 MEG neutral Fed 0.2 0.3 0.2 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed 0.0 0.1 0.1 

 MEG neutral Fed -0.0 0.0 0.0 

 OLG 0.3 0.3 0.3 

Table B.3.−Macroeconomic Effect of Corporate Tax Rate Reduction on Real Revenues 

Percent Change in Total Real Revenues Owing to Macroeconomic Effects 

Calendar Year Period 2005-2009 2010-2014 2005-2014 

 

No fiscal offset 

 MEG aggressive Fed 0.1 0.3 0.2 

 MEG neutral Fed 0.3 0.5 0.4 

 OLG n.a. n.a. n.a. 

Fiscal offset: decrease in personal exemption 

 MEG aggressive Fed 0.1 0.3 0.2 

 MEG neutral Fed 0.1 0.2 0.1 

 OLG 0.2 0.4 0.3 

Fiscal offset: decrease in Government spending 

 MEG aggressive Fed 0.2 0.4 0.3 

 MEG neutral Fed 0.1 0.2 0.1 

 OLG 0.3 0.5 0.4