CONGRESSOFTHEUNITEDSTATES

CONGRESSIONALBUDGET OFFICE

A

P A P E R

CBO

JULY 2003

How CBO

Analyzed the

Macroeconomic

Effects of the

President's Budget
CBO
CBO

A

P A P E R

How CBO Analyzed the

Macroeconomic Effects

of the President’s Budget

July 2003

The Congress of the United States O Congressional Budget Office 
Notes

Numbers in the text and tables may not add up to totals because of rounding. 

Unless otherwise indicated, all years referred to in this paper are fiscal years.

The cover photo of the Main Treasury Building was taken by Binh Thai.
Preface

This paper describes the methods that the Congressional Budget Office (CBO) used

to estimate the macroeconomic effects of the President’s budgetary proposals. Those

estimates were presented in CBO’s March 2003 Analysis of the President’s

Budgetary Proposals for Fiscal Year 2004. 

Ben Page of CBO’s Macroeconomic Analysis Division wrote the paper under the

supervision of Robert Dennis and with the assistance of Mark Booth, Paul Burnham,

Ufuk Demoroglu, Tracy Foertsch, Mark Lasky, Shinichi Nishiyama, Larry Ozanne,

John Sturrock, and David Weiner. 

John Skeen edited the report, Christine Bogusz proofread it, and Linda Lewis Harris

assisted in its preparation. Annette Kalicki produced the electronic versions for

CBO’s Web site (www.cbo.gov).

Douglas Holtz-Eakin

Director

July 2003


Contents

Introduction 1

Inputs to the Economic Models 1

Determining Budgetary Aggregates 2

Calculating Effective Marginal Tax Rates 5

Estimating Changes in Labor Supply for Models with

No Endogenous Response to Marginal Tax Rates 12

The Proposal to Reduce Double Taxation of Corporate Income 14

Marginal Taxes on Capital 15

Cost of Capital 16

Valuation of Firms 16

Efficiency 17

Expansion of Tax-Free Savings Accounts 20

Substitution Effect 20

Income Effect 22

Extension of the Repeal of the Estate Tax 23

Translating the Models’ Outputs into Revenue and Spending Estimates 24

Description of the Models 26

The Textbook Growth Model 26

The Life-Cycle Model 28

The Infinite-Horizon Model 31

Macroeconomic Advisers’ and Global Insight’s Models 33

Appendix: Additional Results 37
Tables

1. Effects of the President’s Budgetary Proposals on 

Real Gross Domestic Product 2

2. The Budgetary Implications of the Macroeconomic

Feedbacks 4

3. The Cumulative Budgetary Impact of the President’s

 Proposals Including Macroeconomic Feedbacks 6

4. Sources of Differences Between CBO’s and the

Administration’s Estimates of the President’s Budget 8

5. Effective Tax Rates Used in the Life-Cycle and 

Infinite-Horizon Models 12

6. The Effect of Tax-Free Accounts on the After-Tax

Rate of Return 23

7. Long-Term Effects of the President’s Budget on

Three-Month Treasury Bill Rates 39

8. Effect of the President’s Budgetary Proposals on

Real Gross Domestic Product, Assuming They Are

Financed After 2023 Rather Than 2013 41

9. Long-Run Steady-State Effect of the President’s 

Budgetary Proposals on Real Gross Domestic Product 42

Box

1. Provisions Whose Effects on Effective 

Marginal Tax Rates Were Estimated Using the

Feldstein-Summers Method 10
1. See Congressional Budget Office, An Analysis of the President’s Budgetary Proposals for Fiscal Year

2004 (March 2003). 

Introduction

The Congressional Budget Office (CBO) recently published its analysis of the

potential macroeconomic effects of the proposals in the President’s 2004 budget.1

The analysis concluded that those effects would be relatively small on net, reflecting both the relative size of the proposals (costing $2.7 trillion, including interest

costs, in an economy projected to produce more than $144 trillion over the next 10

years) and the fact that the budget contains measures that would work in different

directions—some proposals would increase incentives to work and save, while

others would increase spending by government and families. 

This explains the methods and assumptions that CBO used to arrive at those results.

(See Tables 1, 2, and 3 on pages 2, 4, and 6, respectively, for the main economic

and budgetary results of CBO’s analysis; see the Appendix for additional details.)

CBO used five economic models in its analysis: two commercial macroeconometric

forecasting models that focus on the short-run dynamics of demand, by Global

Insight and Macroeconomic Advisers, and three models constructed by CBO that

focus solely on supply-side effects—a “textbook” growth model, a life-cycle model,

and an infinite-horizon model. 

First, the paper reviews how CBO translated the provisions of the President’s budget into terms that could be used in the various economic models. Second, it reviews how CBO treated several specific proposals that were particularly difficult to

analyze. Third, it describes how CBO took the basic economic results and converted them into estimates of how they might affect the estimated cost of the proposals. Finally, it reviews in detail the structure of the models. 

Inputs to the Economic Models

The President’s proposals would affect the economy in a number of ways. Some

provisions would reduce marginal tax rates on labor and capital income, which

would tend to encourage people to work and save. However, those and other provisions also would increase people’s after-tax income, which would tend to discourage work and saving. Other provisions would increase government consumption of

goods and services, which would tend to crowd out investment in productive capital. 

Finally, some provisions, such as the reduction in double taxation of corporate

income and the expansion of tax-free savings accounts, would have complex effects

that CBO calculated outside of the economic models. For example, CBO estimated

that the reduction in double taxation of corporate income would probably shift

investment from the noncorporate sectors of the economy to the corporate sector
2 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

Table 1.

Effects of the President’s Budgetary Proposals 

on Real Gross Domestic Product

(Average percentage change from CBO’s baseline)

2004-2008 2009-2013

Supply-Side Model Without Forward-Looking Behavior

Textbook Growth Model -0.2 -0.7

Supply-Side Models with Forward-Looking Behavior

Closed-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -0.3 -1.5

Higher taxes after 2013 0.5 0.3

Open-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -0.6 -0.5

Higher taxes after 2013 0.3 0.6

Infinite-Horizon Growth Model

Lower government consumption after 2013 0.2 -0.6

Higher taxes after 2013 0.9 1.4

Macroeconometric Models, Supply-Side Contribution

Macroeconomic Advisers -0.3 n.a.

Global Insight -0.2 n.a.

Macroeconometric Models, Supply-Side and Cyclical Contributions

Macroeconomic Advisers 0.2 n.a.

Global Insight 1.4 n.a.

(Continued)

and raise the value of corporate stock, among other things; the tax-free saving, CBO

estimated, would raise private saving slightly on net over the 10 years covered by

the budget. Some of those effects could be translated into variables suitable for each

model; others required modifying the initial results of the models. In making its

projections, CBO analyzed only changes in federal policies; it assumed that state

and local governments’ fiscal policies would remain at baseline levels.

Determining Budgetary Aggregates

The different economic models required different levels of detail on spending and

revenue categories. CBO’s textbook growth model required only the overall change

in the surplus or deficit each year. For the life-cycle and infinite-horizon models,
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 3

Table 1.

Continued

2004-2008 2009-2013

Memorandum: Effect on Real Gross National Product

Open-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -0.8 -2.0

Higher taxes after 2013 0.3 0

Source: Congressional Budget Office.

Notes: n.a. = not applicable.

The “textbook” growth model is an enhanced version of a model developed by Robert Solow. The lifecycle growth model, developed by CBO, is an overlapping generations general-equilibrium model. The

infinite-horizon growth model is an enhanced version of a model first developed by Frank Ramsey. The

models by Macroeconomic Advisers and Global Insight, which are available commercially, are designed to forecast short-term developments. The various models reflect a wide range of assumptions

about the extent to which people are forward-looking in their behavior: in the textbook model and those

by Macroeconomic Advisers and Global Insight, their foresight is the least, while in the infinite-horizon

model, it is perfect and extends infinitely to include a full consideration of effects on descendants.

In models with forward-looking behavior, CBO had to make assumptions about how the President’s

budget would be financed after 2013. CBO chose two alternatives—cutting government consumption or

raising taxes.

spending needed to be broken out into government consumption and transfers. With

a few exceptions, discretionary spending was classified as government consumption, while mandatory spending was classified as transfers. For the two macroeconometric models, government consumption was divided into defense and

nondefense, and transfers were divided into health and nonhealth. 

CBO started with conventional “static” estimates of the impact of the President’s

budgetary proposals on aggregate spending and revenues; those estimates assumed

baseline economic projections and excluded the budgetary implications of any

macroeconomic effects of the proposals. Because CBO and the Joint Committee on

Taxation (JCT) had not yet completed their estimates of the budgetary effects of the

President’s proposals, in its calculations of economic effects CBO relied on the

Administration’s estimates of the budgetary costs of the proposals as published in

the Fiscal Year 2004 Budget of the U.S. Government (for spending) and the General Explanations of the Administration’s Fiscal Year 2004 Revenue Proposals (for

revenues). The differences between CBO and JCT’s estimates and the Administration’s estimates were small, however—amounting to about $80 billion over five

years—and would not have meaningfully altered the estimated economic effects

(see Table 4 on page 8). 
4 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

Table 2.

The Budgetary Implications 

of the Macroeconomic Feedbacks

(Cumulative change from CBO’s conventional estimate of the President’s budget, in

billions of dollars)

2004-2008 2009-2013

Supply-Side Model Without Forward-Looking Behavior

Textbook Growth Model -45 -218

Supply-Side Models With Forward-Looking Behavior

Closed-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -44 -286

Higher taxes after 2013 57 91

Open-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -78 -105

Higher taxes after 2013 -49 148

Infinite-Horizon Growth Model

Lower government consumption after 2013 27 -81

Higher taxes after 2013 122 321

Macroeconometric Models, Supply-Side Contribution

Macroeconomic Advisers -57 n.a.

Global Insight -46 n.a.

(Continued)

The Administration estimated that (with interest costs excluded) the President’s

proposals would increase mandatory spending by $0.6 trillion and decrease revenues by $1.5 trillion over the 2004-2013 period. The Administration did not publish

year-by-year spending numbers for the 2009-2013 period, but, rather, a total

amount. CBO distributed that amount evenly over those five years.

Calculating Effective Marginal Tax Rates

In addition to their effects on the dollar amount of revenues, some of the President’s

proposals would lower the marginal tax rates on labor and capital income, thus

altering incentives to work and to save. How CBO incorporated those effects into

the models depended on the details of the models’ construction.
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 5

2. Martin Feldstein and Lawrence Summers, “Inflation and the Taxation of Capital Income in the Corporate

Sector,” National Tax Journal, vol. 32, no. 4 (December 1979), pp. 445-470.

Table 2.

Continued

2004-2008 2009-2013

Macroeconometric Models, Supply-Side and Cyclical Contributions

Macroeconomic Advisers -75 n.a.

Global Insight 231 n.a.

Source: Congressional Budget Office.

Notes: n.a. = not applicable.

Numbers in this table reflect the positive or negative effects on the budget of the economic impacts

shown in Table 1. They do not include the direct, or “static,” estimated cost of the proposals. The total

impact of the proposals on the budget, including both those direct costs and the secondary effects

shown above, are shown in Table 3.

The “textbook” growth model is an enhanced version of a model developed by Robert Solow. The lifecycle growth model, developed by CBO, is an overlapping generations general-equilibrium model. The

infinite-horizon growth model is an enhanced version of a model first developed by Frank Ramsey. The

models by Macroeconomic Advisers and Global Insight, which are available commercially, are designed to forecast short-term developments. The various models reflect a wide range of assumptions

about the extent to which people are forward-looking in their behavior: in the textbook model and those

by Macroeconomic Advisers and Global Insight, their foresight is the least, while in the infinite-horizon

model, it is perfect and extends infinitely to include a full consideration of effects on descendants.

The two general-equilibrium models—the life-cycle growth model and the infinitehorizon growth model—use effective marginal tax rates on labor and capital income as inputs. Those rates represent an estimate of the marginal tax on the average

dollar of additional income earned in the economy (that is, the average marginal

rate faced by all recipients of labor or capital income, weighted by the fraction of

overall income earned by each type of recipient). The effective tax rates summarize

the impact of the President’s proposals on marginal tax rates into two numbers (one

for labor income and one for capital income). 

For most provisions, CBO computed the impact on effective marginal tax rates

using a variant of a method developed by Martin Feldstein and Lawrence Summers

(see Box 1 on page 10 for a list of the provisions whose effects CBO estimated in

that way).2

 With many details set aside, the method involves four steps:
6 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

3. The population sample is based on tax return data from the Statistics of Income Sample for 2000 (based

on about 170,000 returns) supplemented with about 30,000 records from the March 2001 Current

Population Survey, to represent people not filing returns. 

Table 3.

The Cumulative Budgetary Impact of the President’s 

Proposals Including Macroeconomic Feedbacks

(Cumulative change from CBO’s baseline, in billions of dollars)

2004-2008 2009-2013

Supply-Side Model Without Forward-Looking Behavior

Textbook Growth Model -847 -2,126

Supply-Side Models With Forward-Looking Behavior

Closed-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -846 -2,194

Higher taxes after 2013 -745 -1,817

Open-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -880 -2,013

Higher taxes after 2013 -753 -1,760

Infinite-Horizon Growth Model

Lower government consumption after 2013 -775 -1,989

Higher taxes after 2013 -680 -1,587

Macroeconometric Models, Supply-Side Contribution

Macroeconomic Advisers -859 n.a.

Global Insight -848 n.a.

Macroeconometric Models, Supply-Side and Cyclical Contributions

Macroeconomic Advisers -877 n.a.

Global Insight -933 n.a.

(Continued)

# Calculate the average marginal income tax rate on each type of taxable income—wages, interest, dividends, and so on—for each year of the baseline.

CBO obtained those rates by applying a tax calculation model to a large sample of the population in 2000. CBO modified the sample over future years to

be consistent with the population projections of Social Security’s trustees and

CBO’s economic projections.3

 The model can accommodate the fact that

individuals or households face different marginal tax rates depending on their

income and family structure. When averaged across all taxpayers, those rates
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 7

Table 3.

Continued

2004-2008 2009-2013

Memorandum:

Conventional Estimate of the Budgetary 

Effect of the President’s Proposals -802 -1,908

Source: Congressional Budget Office.

Notes: n.a. = not applicable.

Numbers in this table reflect both the direct, or “static” estimated cost of the proposals (shown in the

memorandum line) and the budgetary implications of the macroeconomic feedbacks from the proposals

(shown in Table 1).

The “textbook” growth model is an enhanced version of a model developed by Robert Solow. The lifecycle growth model, developed by CBO, is an overlapping generations general-equilibrium model. The

infinite-horizon growth model is an enhanced version of a model first developed by Frank Ramsey. The

models by Macroeconomic Advisers and Global Insight, which are available commercially, are designed to forecast short-term developments. The various models reflect a wide range of assumptions

about the extent to which people are forward-looking in their behavior: in the textbook model and those

by Macroeconomic Advisers and Global Insight, their foresight is the least, while in the infinite-horizon

model, it is perfect and extends infinitely to include a full consideration of effects on descendants.

In models with forward-looking behavior, CBO had to make assumptions about how the President’s

budget would be financed after 2013. CBO chose two alternatives—cutting government consumption or

raising taxes.

vary by type of income because different types are distributed differently across

taxpayers. For example, dividends tend to be more concentrated than interest

among higher-income taxpayers, so the average marginal tax rate on dividends

tends to be higher than that on interest. For the taxes of C corporations, CBO

used an average marginal tax rate of 29 percent.

# Calculate the notional amount of taxes that would have been collected on each

type of income reported to the Internal Revenue Service (IRS) if it was all taxed

at its average marginal rate from the first step. The notional amount of tax will

exceed the actual amount because of various tax deductions and exemptions and

because of progressivity in the rate schedule.

# Determine the overall average marginal tax rate on each type of income by

dividing its notional tax by the corresponding amount of income reported in the

national income and product accounts. The overall tax rate will be substantially

lower than the rate from the first step because much income is not reported to

the IRS—partly reflecting noncompliance but mostly reflecting the fact that

some income (for instance, fringe benefits, imputed income, contributions to

tax-free accounts, and earnings of such accounts) is not taxable.
8 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

Table 4.

Sources of Differences Between CBO’s and the 

Administration’s Estimates of the President’s Budget

(Cumulative change from CBO’s baseline, in billions of dollars)

2003 2004 2005 2006 2007 2008

Total, 

2004-

2008

Administration’s Estimate

Deficit Under the President’s Budget -304 -307 -208 -201 -178 -190 -1,084

Sources of Differences Between CBO and the Administration

Revenues

Differences in baselines 24 -7 -30 7 35 55 60

Policy differences -4 -8 -5 3 * -2 -13

Total Differences 

in Revenues 20 -15 -35 10 35 52 47

Outlays

Discretionary 13 17 -1 -3 -3 -4 7

Mandatory

Differences in baselines -8 2 8 14 17 19 60

Policy differences 3 7 13 4 4 3 30

Subtotal, mandatory -5 9 21 18 21 21 90

Net interest -6 -10 6 12 12 11 31

Total Differences in Outlays 3 16 26 27 30 28 128

All Differences 18 -31 -62 -17 6 24 -80

CBO’s Estimate

Deficit Under the President’s Budget -287 -338 -270 -218 -173 -166 -1,164

Memorandum:

Economic Differences

Revenues -10 -13 2 26 46 60 121

Outlays * -1 10 23 29 31 93

Total -9 -12 -9 2 17 29 28

(Continued)
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 9

Table 4.

Continued

2003 2004 2005 2006 2007 2008

Total, 

2004-

2008

Technical Differences

Revenues 30 -2 -37 -16 -11 -8 -73

Outlays 3 17 16 4 * -2 35

Total 27 -18 -53 -20 -11 -5 -108

Sources: Congressional Budget Office; Joint Committee on Taxation.

Note: * = between -$500 million and $500 million.

# Calculate an overall average marginal tax rate on income from labor and from

capital. For labor, sum the notional income tax on labor, the marginal payroll

tax for Medicare and Social Security, and the self-employment tax—all as a

percentage of labor compensation. The calculation allows for the fact that the

income of about 7 percent of workers exceeds the cap on Social Security

taxes, meaning that those workers do not face those taxes on the margin. For

capital, take a weighted average of the separate rates for interest; dividends;

capital gains; rent; capital income of proprietors, partners, and owners of S

corporations; and income of C corporations. 

The Feldstein-Summers approach, applied to the tax rate on capital, assumes that

the marginal source of financing for firms is similar to the average. In other words,

a large proportion of financing comes from untaxed sources, such as pension funds

and individual retirement accounts. That assumption lowers the estimated effective

marginal tax rate. 

CBO’s calculations reflected a number of additional elements:

# CBO excluded interest on government debt and Federal Reserve earnings and

taxes from the measure of capital income so that the result would reflect the

marginal tax on an additional dollar invested. 

# CBO’s estimates of effective marginal tax rates assumed that workers would

pay income tax on their and their employers’ contributions to pension funds and

retirement or similar accounts, even though those contributions are actually

exempt from taxation. By contrast, CBO’s estimates assumed that withdrawals

would be untaxed, while in fact they are taxable. Those assumptions made it
10 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

Box 1.

Provisions Whose Effects on Effective Marginal Tax Rates

Were Estimated Using the Feldstein-Summers Method

The provisions whose effects on effective marginal tax rates were estimated

using the Feldstein-Summers method included these: 

# Accelerate the expansion of the 10 percent individual income tax rate bracket;

# Accelerate the reduction in individual income tax rates; 

# Accelerate the expansion of the 15 percent individual income tax rate bracket

for married taxpayers filing joint returns; 

# Accelerate the increase in the standard deduction for married taxpayers filing

joint returns; 

# Accelerate the increase in the child tax credit; 

# Provide relief to individuals from the minimum tax; and 

# Permanently extend provisions expiring in 2010 (except for the extension of

the repeal of estate and generation-skipping transfer taxes and the modification of gift taxes, which were analyzed separately). 

By the Administration’s estimates those provisions account for $788 billion of

the $1.461 trillion cost of the President’s revenue proposals over the years from

2004 to 2013. The proposal to eliminate double taxation of corporate income

(with a 10-year cost of $385 billion) would also affect the marginal tax rate on

capital, but the Congressional Budget Office (CBO) estimated that effect in a

separate calculation (described later). The proposals to expand the availability of

tax-free savings accounts (with a 10-year cost of $1 billion) would also affect the

marginal tax rate on capital, but their effect on the incentive to save would be

complex, so CBO estimated it separately from its calculation of effective tax

rates. 

practical to calculate effective rates, and if the marginal rate faced at the time of

contribution is the same as that faced at the time of withdrawal, the assumptions

do not alter the estimated effective tax rates. But people may face lower marginal tax rates when they withdraw funds in their retirement years than they did

during their working years. Because the calculation does not take that probabil

ity into account, it may understate effective rates. However, CBO used those

assumptions only to calculate effective tax rates; the estimated aggregate reve-
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 11

nues that CBO used as an input assumed that contributions would be deductible

and that withdrawals would be taxable.

# CBO’s estimate of the marginal tax rate on capital gains allows for the deferral

of taxes and the step-up in basis at death.

# CBO assumed that state and local taxes were 6 percent of individuals’ reported

income. To account for the portion of taxpayers who itemize and can claim

those taxes as a deduction, CBO deducted about 62 percent of those tax receipts

from the reported federal tax base. CBO also assumed that state and local corporate taxes applied to income of C corporations at a rate of 5.6 percent and deducted all such tax receipts from the reported federal tax base.

# CBO split the income of proprietorships and partnerships 60-40 between labor

and capital income.

The provision in the budget that temporarily would allow firms to expense 30 percent of investment in equipment through 2004 would lead to shifts in the timing of

tax payments and profits. Those shifts, unless adjusted for in some way, would

distort the calculation of effective rates: 30 percent expensing reduces taxable income (and therefore tax payments) in the year of investment but raises it in following years because only the remaining 70 percent of investment can be depreciated

over the normal tax life (seven years at most for nearly all equipment). Calculations

based on those tax payments and profits would falsely suggest a disincentive to save

in the years after 2004. In addition, profits in the initial years of the projection are

unusually low because of cyclical factors, which could also distort the estimated

effective rates. To avoid those problems, CBO calculated effective tax rates assuming that the shares of income from wages, dividends, interest, and other components

for 2003 to 2012 matched those projected for 2013, when those shares are assumed

to have settled to their long-term values. (Because of that adjustment, in calculating

effective tax rates, CBO assumed, for example, that profits as a share of gross domestic product (GDP) would be 8.4 percent in 2003, the share projected for 2013,

rather than 7.4 percent, the share that CBO actually projects for 2003.) 

CBO estimates that by 2013, the President’s proposals would reduce the effective

tax on labor income by about 1.3 percentage points and the effective tax on capital

income by about 1.5 percentage points (see Table 5). CBO incorporated those estimated changes into the two general-equilibrium models, with no attempt to model

changes in the shape of the rate schedule (for example, changes in progressivity). 

The levels of effective tax rates estimated for the two models differ because those

used in the life-cycle model do not include payroll and state and local taxes; those

taxes are included in the model separately from federal income taxes. Despite the

different levels of effective tax rates, though, the year-by-year changes from the

rates in CBO’s baseline are very close. (They differ only because of interactions
12 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

Table 5.

Effective Tax Rates Used in the Life-Cycle and InfiniteHorizon Models 

(In percentage points by calendar year)

Labor Capital

Year

Current

Law

President’s

Proposals Change

Current

Law

President’s

Proposals Change

Life-Cycle Model

2002 19.9 19.9 0 13.8 13.8 0

2003 19.9 18.1 -1.8 13.8 12.6 -1.2

2004 19.5 18.3 -1.3 13.7 12.6 -1.1

2005 19.5 18.4 -1.1 13.7 12.6 -1.1

2006 19.1 19.0 -0.1 13.5 12.5 -0.9

2007 19.4 19.4 0 13.5 12.5 -0.9

2008 19.6 19.6 0 13.5 12.5 -1.0

2009 19.6 19.6 0 13.5 12.5 -1.0

2010 20.1 20.1 0 13.5 12.5 -1.0

2011 21.8 20.4 -1.5 14.1 12.6 -1.5

2012 21.8 20.4 -1.5 14.1 12.6 -1.5

2013 22.2 20.9 -1.3 14.1 12.6 -1.5

Infinite-Horizon Model

2002 34.0 34.0 0 16.7 16.7 0

2003 34.0 32.3 -1.7 16.7 15.5 -1.2

2004 33.7 32.5 -1.2 16.6 15.5 -1.1

2005 33.7 32.6 -1.1 16.6 15.5 -1.1

2006 33.3 33.2 -0.1 16.4 15.5 -0.9

2007 33.5 33.5 0 16.4 15.5 -0.9

2008 33.8 33.8 0 16.4 15.4 -1.0

2009 33.8 33.8 0 16.4 15.4 -1.0

2010 34.2 34.2 0 16.4 15.4 -1.0

2011 35.9 34.5 -1.4 17.0 15.5 -1.4

2012 35.9 34.5 -1.4 17.0 15.5 -1.4

2013 36.3 35.0 -1.3 17.0 15.5 -1.5

Source: Congressional Budget Office.

Note: For the effective rates calculated for the life-cycle model, the tax on labor income includes only the

federal income tax. The tax on capital income includes the federal corporate and personal income

taxes. For the infinite-horizon model, the tax on labor income includes federal, state and local income

taxes and federal Social Security and Medicare payroll taxes. The tax on capital income includes

federal, state, and local income taxes on personal and corporate income. State and payroll taxes are

not included in the estimates for the life-cycle model because that model treats those taxes separately.
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 13

4. Global Insight’s model incorporates responses of labor supply to changes in after-tax wages. However,

those responses are much smaller than CBO’s estimates, and CBO overrode them for the purposes of its

analysis.

5. Congressional Budget Office, Labor Supply and Taxes (January 1996). 

between federal taxes and state and local taxes—for example, some state and local

taxes can be deducted from the reported federal tax base by households that itemize.) 

Estimating Changes in Labor Supply for Models

with No Endogenous Response to Marginal Tax Rates

The general-equilibrium models predict changes in labor supply on the basis of

changes in marginal tax rates on labor and changes in current and future income.

However, in the three remaining models that CBO used—the textbook growth

model and the two macroeconometric models—there is little or no mechanism for

marginal tax rates to affect labor supply.4

 Therefore, for those models CBO separately estimated the effect of marginal rates on labor supply and then imposed the

results on the models.

In particular, to calculate the response of labor supply, CBO used the same model

as it used to calculate effective tax rates. For each tax return in the model, it calculated marginal tax rates on labor as well as after-tax income both under current law

and under the President’s proposals. It then combined the changes in marginal tax

rates and income with assumed substitution and income elasticities to predict the

change in labor supply. 

CBO’s calculations allowed for different effects for primary and secondary earners

in a household and for effects that vary by income. For primary earners, the

population-weighted uncompensated labor supply elasticity with respect to after-tax

wages averaged 0.07 (the sum of an income elasticity of -0.07 and a compensated

substitution elasticity of 0.14). Within that average, primary earners in the first

decile of earnings were assumed to have a net elasticity of 0.17, while earners in the

top 40 percent, a net elasticity of 0.028. Secondary earners were assumed to have a

compensated substitution elasticity of 0.75 and an elasticity with respect to after-tax

household income of -0.25. Those elasticities were based on a review of empirical

estimates.5

CBO then directly adjusted labor supply in the textbook growth model and the

macroeconometric models by the estimated percentage change derived from that

method. 

In estimating the economic effects of marginal tax rates on labor income, CBO

concentrated on the effect on hours of work supplied. Analysis of many other effects, such as shifts between taxable and nontaxable forms of income or changes in
14 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

6. See George R. Zodrow, “On the ‘Traditional’ and ‘New’ Views of Dividend Taxation,” National Tax

Journal, vol. 44, no. 4, pt. 2 (December 1991), pp. 497-509.

the portion of taxable income that is reported to the IRS, should already be included

in the static revenue estimates of the Joint Committee on Taxation. There could be

additional effects, however, on the intensity of work, but CBO did not include any

such effects because of a lack of empirical evidence on which to base estimates.

The Proposal to Reduce Double

Taxation of Corporate Income

The President’s budget includes one proposal—to reduce double taxation of corporate income—that would have particularly complex economic effects. The proposal

would eliminate taxation of dividend income paid out of profits that were already

taxed at the corporate level. In addition, it would eliminate taxation of capital gains

attributable to retained earnings that were already taxed at the corporate level. 

The proposal would have three important economic effects. First, it would reduce

marginal tax rates on capital income and lower firms’ cost of capital investment.

Second, it would increase the market value of corporations. Third, reducing double

taxation of corporate income would, over time, make the allocation of capital

among different sectors of the economy more efficient. 

Economists have not agreed on how the taxation of dividends affects the economy.

Two views are prevalent.6 Under the first (or “traditional”) view, the tax on dividends raises the cost of capital and reduces investment. Under the second (or

“new”) view, the tax on dividends permanently reduces the value of a firm but

leaves unaffected both the cost of capital and investment by the firm. 

CBO’s calculations reflect an average of the implications of those two views. That

average was created in different ways in the different models. For the

macroeconometric models, CBO made economic projections under two sets of

assumptions for model inputs such as the cost of capital and the valuation of firms,

with one set reflecting the traditional view and one set reflecting the new view.

CBO then took the average of the economic variables from the two projections as

its estimate. For the remaining models, the only variable for which the traditional

view and the new view had different implications was the efficiency effects of the

provision. CBO estimated those effects on the basis of prior research, adjusted its

estimate to reflect an average of the two views, and then added it back into the

model results.

Corporate behavior probably more closely matches the assumptions of the first

view—indeed, that is what is generally taught to business school students. However, in an open economy, results are likely to lean toward the second view as long

as capital is reasonably available in the world market at a price that is unaffected by
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 15

7. Clemens Fuest and Bernd Huber, The Optimal Taxation of Dividends in a Small Open Economy, Working

Paper No. 348 (Munich: CESifo, 2000).

U.S. tax policy.7 Firm evidence of the actual effects of dividend-taxation policy in

the United States is scarce. Given the difficulty of determining precisely how investment would respond to the President’s proposal, CBO simply split the difference between the two views.

Marginal Taxes on Capital

The estimated effective tax rates on capital used in the life-cycle and infinite-horizon models (shown in Table 5) incorporate the effects of the proposal to reduce

double taxation of corporate income. CBO calculated those effects outside the tax

simulation model used to estimate the effects of most other provisions. Those effects do not differ under the traditional and new views of dividends.

CBO assumed that the proposal to reduce double taxation of corporate income

would allow corporations to shelter only about 80 percent of their dividends in 2003

but that that proportion would rise to 90 percent over the next five years and then

remain at that level. That rise has to do with the timing of tax payments. 

The amount of dividends and capital gains that a firm could shelter would be limited to the amount of its fully taxed profits. That amount would be measured as:

fully taxed profits = corporate taxes * ( 1/0.35 -1)

where 0.35 is the top corporate tax rate and corporate taxes include foreign tax

credits. The factor in parentheses indicates that a firm could shelter income equal to

1.86 times the amount of taxes it paid. CBO assumed that firms would probably

shelter all of the dividends they could before sheltering their retained earnings

(which would eventually show up as capital gains) because dividend income tends

to be taxed at higher rates. Firms that, for whatever reason, incurred low corporate

taxes in the first few years after the proposal became effective might not be able to

shelter all of their dividends. However, over time, most firms will experience years

when they pay more than enough taxes to shelter all of that year’s dividends. Some

of the extra increment can be carried over to shelter dividends in future years with

lower tax payments, implying that the overall average share of dividends that can be

sheltered rises over time. 

Once firms have sheltered all possible dividends, they can use any remaining

amount of the extra increment to shelter retained earnings. CBO concluded that

about 40 percent of the portion of capital gains that reflect retained earnings could

be sheltered in that way.
16 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

Of course, some of the sheltering would be redundant—much corporate income

accrues to firms or entities that are already untaxed. Under current law, the effective

overall marginal tax on dividends is about 19 percent, much lower than the effective statutory rate that applies to taxable shareholders. Tax rate changes and a 90

percent dividend exclusion under the President’s plan would reduce the effective

overall rate to about 5 percent. Likewise, the proposal would reduce the overall

effective rate on capital gains from about 5 percent to roughly 3 percent.

Cost of Capital

The macroeconometric models require as an input an estimate of the effect of the

proposal to reduce double taxation of corporate income on the cost of capital to

firms. That effect differs under the traditional and new views of how dividend taxes

affect economic behavior. Under the first view, reductions in both the effective tax

rate on dividends and that on capital gains reduce the cost of capital. Under the

second view, only the reduction of the effective tax rate on capital gains reduces the

cost of capital. The reduction of the tax on dividends does nothing more than permanently raise the value of the shares of C corporations. (S corporations do not pay

corporate tax, and, thus, their income would not qualify for an exclusion.) To represent the second view, CBO calculated the change in the marginal tax on capital as if

the proposal would shelter about 40 percent of the retained earnings of C corporations but none of their dividends. CBO generated two economic projections with

the two macroeconometric models, one using inputs consistent with the traditional

view and one with the new view, and then took the average of the economic results.

As with the estimate of the effective marginal tax rates on capital, described earlier,

CBO calculated the proposal’s impact on the cost of capital assuming that the shares of output coming from corporate profits, dividends, and retained earnings in

2013 would apply to all years between 2003 and 2013. The shares in 2013 represent

historically typical shares, while shares in earlier years are affected by the availability of extra expensing and cyclical factors.

Valuation of Firms

Changes in the valuation of firms are important to the macroeconomic results,

because they help determine what will happen to consumer wealth and consumer

spending. In CBO’s two forward-looking models (the life-cycle model and the

infinite-horizon model), the simulated people in the models automatically calculate

the wealth effect of the tax change with perfect foresight. However, the two

macroeconometric models require an exogenous estimate of the increase in firms’

valuation because those models contain no mechanism to automatically convert the

present value of the expected change in stockholders’ after-tax income into a change in equity prices. The estimated effect on the valuation of firms differs under the

traditional view and new view of dividends. 

The structure of both models allows a reduction in taxation of dividends to affect

consumption in two ways: through a reduction in tax payments, which increases
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 17

disposable income, and through an increase in the value of firms, which increases

wealth (and therefore affects consumption). However, both effects are reflections of

the same thing—the expectation of lower tax payments on dividends—so including

both would overstate the effect of the policy change on consumption. To avoid that

double-counting, CBO adjusted the models to eliminate the direct effects on consumption of the increase in disposable income stemming from lower taxes on dividends. 

Under the traditional view, reducing double taxation of corporate income reduces

the cost of capital and increases investment. In the short run, stock prices rise because expected after-tax returns to investors increase. In the long run, however,

additional investment will drive down the pretax return to capital. Thus, current

shareholders initially benefit from the lower taxes on dividends, but eventually the

higher investment raises the capital/labor ratio, increasing real wages and transferring the benefit of the lower taxes to workers. CBO estimated that under the traditional view of dividends, the President’s proposal to reduce double taxation of

corporate income would initially increase the market value of shares by 3 percent.

That estimate reflected both the additional returns that investors would expect and

their belief that the returns would be temporary. That estimate assumed that asset

prices would respond immediately to increased expected future returns but that

workers would not spend the extra income from higher wages (due to the larger

capital stock from increased investment) until they received it. 

Under the new view, by contrast, cutting taxes on dividends permanently increases

the value of firms but leaves unchanged the cost of capital and, therefore, investment. CBO estimated that under the new view, the President’s proposal would

permanently raise the value of the shares of corporations by some 10 percent, reflecting the present value of the expected decline in taxes under the assumption that

the tax benefit would be permanent. CBO’s estimate assumed, as discussed earlier,

that the fraction of a marginal additional dollar of dividend income that was taxable

would be the same as the fraction of average dividend income that was taxable.

Other commentators have arrived at substantially higher estimates by assuming that

all of a marginal change in dividend income would be taxable.

CBO generated two economic projections with the two macroeconometric models,

one using inputs consistent with the traditional view and one with the new view,

and then took the average of the economic results. 

Efficiency

Double taxation of corporate income causes deadweight loss principally because it

shifts economic activity from the corporate to the noncorporate sector. In addition,

it distorts the choice between equity and debt financing. The deadweight loss from

those effects generates welfare costs that are partially reflected in a lower level of

GDP because resources are not employed optimally. However, some of the efficiency losses—such as the effect of the choice between debt and equity financing
18 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

8. See Arnold C. Harberger, “Efficiency Effects of Taxes on Income from Capital,” in Marian Krzyzaniak,

ed., Effects of the Corporation Tax (Detroit: Wayne State University Press, 1966); and Charles L. Ballard

and others, A General Equilibrium Model for Tax Policy Evaluation (Chicago: University of Chicago

Press, 1985). The ratio of corporate taxes to GDP was significantly higher at the time of earlier studies, but

if the deadweight loss was proportional to the level of taxes, using today’s ratio to convert to a share of

GDP would be appropriate. 

9. See Roger H. Gordon and Jeffrey MacKie-Mason, “Effects of the Tax Reform Act of 1986 on Corporate

Financial Policy and Organizational Form,” in Joel Slemrod, ed., Do Taxes Matter? (Cambridge, Mass.:

MIT Press, 1990); Gordon and MacKie-Mason, “Taxes and the Choice of Organizational Form,” Journal

of Finance, vol. 50, no. 2 (June 1997); and Austan Goolsbee, “Taxes, Organizational Form, and the

Deadweight Loss of the Corporate Income Tax,” Journal of Public Economics, vol. 69, no. 1 (July 1998),

pp. 143-152.

10. See Jane G. Gravelle and Laurence Kotlikoff, Does the Harberger Model Greatly Understate the Excess

Burden of the Corporate Income Tax? Working Paper No. 2742 (Cambridge, Mass.: National Bureau of

Economic Research, October 1988); Gravelle and Kotlikoff, “The Incidence and Efficiency Costs of

Corporate Taxation When Corporate and Non-Corporate Firms Produce the Same Good,” Journal of

Political Economy, vol. 97, no. 4 (1989), pp. 749-780; and Gravelle and Kotlikoff, “Corporate Tax

Incidence and Inefficiency When Corporate and Noncorporate Goods Are Close Substitutes,” Economic

Inquiry, vol. 97 (1993), pp. 501-516.

11. See Austan Goolsbee, The Impact and Inefficiency of the Corporate Income Tax: Evidence from State

Organizational Form Data, Working Paper No. 9141 (Cambridge, Mass.: National Bureau of Economic

Research, September 2002). 

on individuals’ asset portfolios, or changes in marginal incentives that are offset by

income effects—may not show up in output measures.

To gauge the effect on output, CBO reviewed various of estimates of the impact of

corporate taxation. Efforts to quantify the deadweight loss from corporate taxes

have produced a wide range of estimates that are typically reported as welfare losses

(including such items as the value of leisure) and not the effect on GDP. Translating

the disparate conclusions of studies into an expected change in GDP from the President’s proposal involves a large amount of judgment.

The standard Harberger model, in which industries are either corporate or

noncorporate, suggests efficiency costs of less than 20 percent of corporate tax

revenues, or about 0.4 percent of GDP at today’s ratio of corporate taxes to GDP.8

Using time-series data, several studies estimate smaller effects of around 5 percent

to 10 percent of corporate taxes, or about 0.1 percent to 0.2 percent of GDP.9

Gravelle and Kotlikoff employ a different (“mutual-production”) model that measures the deadweight loss in an economy in which corporate and noncorporate

production occurs within the same industry. Their work indicates a much higher

deadweight loss, possibly exceeding 100 percent of the tax, or 2 percent of GDP.10

That loss results from the greater substitution between corporate and noncorporate

activities that exists when both occur in the same sector. Goolsbee concludes from

work based on the mutual-production model that the estimates based on time-series

data are low, although the deadweight loss is still “modest.”11
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 19

12. John B. Shoven, “The Incidence and Efficiency Effects of Taxes on Income from Capital,” Journal of

Political Economy, vol. 84, no. 6 (December 1976), pp. 1261-1283; and Don Fullerton and others,

“Corporate Tax Integration in the United States: A General Equilibrium Approach,” The American

Economic Review, vol. 71, no. 4 (1981), pp. 677-691. 

13. See Department of the Treasury, Report of the Department of the Treasury on Integration of the Individual

and Corporate Tax Systems (January 1992), p. 140.

14. Ibid.

Estimates by Shoven and by Fullerton indicate losses of about 0.75 percent to 1.5

percent of consumption, or about 0.5 percent to 1.0 percent of GDP.12 But those

estimates are based on average, rather than marginal, effective tax rates. Studies

using average rates tend to estimate larger effects than those using theoretically

preferable marginal rates.13

Finally, models incorporating the new view of dividends show very small losses, on

the order of 0.014 percent of consumption. That is to be expected. Under the new

view, after-tax returns to corporate and noncorporate activity are equilibrated by a

fall in the price of corporate equity rather than by a differential in before-tax rates of

return, substantially decreasing the distortion caused by the taxes.

In 1992, Treasury estimated the effects of several different proposals to integrate

the individual and corporate tax systems (none exactly like the current one) using

both the Harberger model and the mutual-production model.14 The Harberger model

estimated welfare gains ranging from 0.29 percent to 0.35 percent of consumption,

or about 0.19 percent to 0.23 percent of GDP. The mutual-production model estimated gains ranging from 0.53 percent to 0.74 percent of consumption, or about

0.35 percent to 0.49 percent of GDP. (In those proposals, the revenue loss was

made up with a lump-sum tax, which is the appropriate assumption for CBO’s

current modeling strategy.)

Relying on that evidence and taking the average of effects under the traditional and

new views of dividends, CBO concluded that the impact of the President’s proposal

on the allocation of capital would raise GDP by about 0.14 percent (about $15

billion in 2003) once the capital stock was fully adjusted. That estimate resulted

from averaging an effect of 0.28 percent under the traditional view of dividends

with an effect of about zero under the new view. CBO assumed that fully adjusting

the capital stock would take 10 years, with the addition to GDP increasing linearly

over that period. CBO added that increment to the predictions of the textbook, the

life-cycle, and the infinite-horizon growth models. 

A slightly different procedure was appropriate for the two macroeconometric models, because those models incorporate multiple sectors and thus can reflect endogenously some of the efficiency effects of the President’s proposal. In both models,
20 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

changes in the cost of capital for business investment will automatically shift investment from the housing sector to the business sector. In practice, CBO ran the

models twice, with assumptions corresponding to the traditional view and the new

view of the effects of dividend taxation. Under the traditional view, CBO assumed

that 75 percent of the efficiency effects of the proposal were captured within the

models (the effects were not fully captured because the models cannot reflect efficiency gains from shifting capital into C corporations from other businesses). Under

the new view, as before, there were no efficiency effects. 

For two reasons, CBO’s estimate of efficiency effects did not include any gains

from reducing the distortion in the decision of whether to finance investment by

debt or by equity. First, most of those gains would show up in utility rather than

GDP. Second, a large part of the efficiency gains might not be realized because of

the President’s proposal to expand tax-free savings accounts (to the extent that

interest was untaxed, a new differential would arise between the tax treatment of

dividends and interest).

Expansion of Tax-Free Savings Accounts

The President’s budget includes a proposal to form two new tax-free accounts,

lifetime savings accounts (LSAs) and retirement saving accounts (RSAs). LSAs

would be designed to facilitate everyday saving, and withdrawals could be made

from them at any time without penalty. RSAs would be designed as a vehicle for

retirement saving and would carry a penalty for early withdrawals. The new accounts would increase the amount that people could save tax-free. The effects of the

accounts on saving are not easily analyzed within the models used by CBO, so the

agency estimated those effects in a side calculation. (The proposals for savings

accounts were therefore not included in CBO’s calculation of the effective tax rates

on capital.) 

The proposals would both raise the after-tax return to saving, generating a substitution effect that would tend to increase saving, and increase after-tax income, generating an income effect that would tend to increase consumption and reduce national

saving. CBO estimated those two effects separately.

Substitution Effect

The substitution effect applies only to people on the margin, that is, those who

currently contribute the maximum tax-free amounts but who might save more if

those amounts were increased. Those not on the margin are people who do not

currently contribute the maximum tax-free amounts and people who do but who

have enough taxable assets to shift so that they would not have to save more to take

full advantage of additional opportunities for tax-free saving. To estimate the substitution effect, CBO estimated the saving of people on the margin and the change
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 21

in the after-tax rate of return associated with LSAs and RSAs and applied an estimated elasticity to that change, adjusting saving accordingly.

Who Is on the Margin? Tax advantages comparable to those offered by LSAs

(specifically, the ability to withdraw funds at any time without penalty) do not

currently exist. Hence, CBO needed to identify who would not be affected by the

accounts on the margin—those who have sufficient assets to shift into the accounts

without saving any more. To accomplish that, CBO tabulated taxable assets in the

1998 Survey of Consumer Finances (SCF) and classified households by the number

of years that they could fund an LSA for every person in the family (assuming a

baseline of 2.6 percent net growth in assets per year). Beginning in the second year,

the households had to be able to fund an RSA in the previous year for every worker

in the family as well. Households that lacked enough existing assets to contribute

the maximum to an account even in the first year were assumed to be on the margin

in 2003 and all subsequent years; those who could fund the maximum contribution

in the first but not the second year were assumed to be on the margin in 2004 and

all subsequent years, and so forth. Those with enough assets to fund the maximum

contribution through 2013 were assumed not to be on the margin at any time during

the budgetary projection period.

By contrast, the tax advantage offered by RSAs is comparable to that of Roth individual retirement accounts (IRAs)—if one ignores the reduction in the age for

penalty-free withdrawals from 59 and a half to 58. For simplicity, CBO assumed

that traditional IRAs and 401(k)s also had the same tax advantages, although that

would be true only if a person’s preretirement and postretirement tax rates were the

same. By that reasoning, households that were not currently contributing the maximum to either their IRA or 401(k) were not on the margin. So CBO reclassified

SCF assets by the number of years that they could fund both LSAs for all family

members and RSAs for all workers but then scaled those assets by the percentage of

workers receiving the maximum tax benefit from their IRA or 401(k) (ranging from

3 percent for lower-income workers to 36 percent for the highest-income workers).

Having identified households on the margin, CBO assigned a baseline level of

saving to them. CBO estimated the overall level of saving to be 2.8 percent of

personal income (based on the average over the past five years) and distributed

saving in proportion to assets.

Change in the After-Tax Rate of Return. CBO used a case study model to calculate the after-tax rate of return for regular savings versus a Roth IRA using a 6

percent before-tax rate of return. CBO assumed that the President’s proposals to

accelerate the decrease in marginal tax rates and to reduce double taxation of corporate income were in place for regular savings (effectively exempting 40 percent of

investment income from tax). CBO estimated the after-tax rate of return for five

different marginal rates (15 percent, 25 percent, 28 percent, 33 percent, and 35

percent). For LSAs, the after-tax rate of return was the same as the before-tax
22 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

15. The elasticity of 0.5 was based on evidence reviewed in Douglas W. Elmendorf, “The Effect of InterestRate Changes on Household Saving and Consumption: A Survey,” Finance and Economics Discussion

Series No. 1996-44 (Board of Governors of the Federal Reserve System, 1996).

rate—6 percent. For RSAs, CBO assumed that 30 percent would be subject to a

penalty upon withdrawal, reducing the after-tax rate of return to 5.892 percent. For

taxable accounts, the after-tax rate of return depended on the tax bracket. (See Table

6 for a summary of the results.)

Results. CBO partitioned the SCF tabulations into the five income classes shown in

Table 6, assumed to correspond to the five marginal tax rates. CBO then calculated

the percentage change in the after-tax rate of return, applied an elasticity of 0.5, and

multiplied the result by the savings deemed to be on the margin.15

Income Effect

An income effect applies to people who experience a reduction in taxes on the

return to saving, whether or not they are on the margin. The reduction in taxes

increases the value of a tax-free account relative to the value of a regular account.

People can then save less and still receive the same after-tax income over their

lifetime.

Because the reduction would apply to the amounts that people were expected to

contribute to LSAs and RSAs, CBO estimated those amounts using SCF data. CBO

determined the maximum possible contribution by people on the margin in each

year and added the maximum contribution for all those not on the margin because

they could shift enough assets to fully fund the accounts.

CBO attempted to reconcile its estimates of contributions with estimates of the

revenue effects of the LSAs from the Department of the Treasury. CBO’s estimates

most closely approximated the pattern of Treasury’s estimates assuming a withdrawal rate of 18 percent per year. To match the level of revenue losses as well as

the pattern over time, however, CBO had to assume a relatively low rate of return of

2.5 percent within LSAs. That low rate of return would be consistent with participants’ converting interest-bearing checking accounts, savings accounts, and money

market accounts to LSAs.

To estimate the percentage reduction in saving due to the income effect, CBO used

the case study model, assuming a 4.5-year holding period and 2.5 percent rate of

return for LSAs and a 21-year holding period and 6.0 percent rate of return for

RSAs.

CBO also scaled the estimated RSA contributions to eliminate households not

currently contributing the maximum tax-free amount; they presumably would not

increase their contributions and therefore would experience no income effect.
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 23

Table 6.

The Effect of Tax-Free Accounts on the 

After-Tax Rate of Return

After-Tax Rate of Return (In percent) 

by Type of Account 

Marginal Tax Rate

(In percent)

Income Class 

(In dollars)

Taxable 

Account LSA RSA

15 Under 50,000 5.460 6.000 5.892

25 50,000-99,999 5.100 6.000 5.892

28 100,000-199,999 4.992 6.000 5.892

33 200,000-499,999 4.812 6.000 5.892

35 500,000 and Over 4.740 6.000 5.892

Source: Congressional Budget Office.

Notes: LSA = lifetime savings account; RSA = retirement savings account.

The table assumes that all accounts earn a pretax rate of return of 6 percent. The LSA would earn the

full 6 percent. The RSA would earn slightly less, because CBO assumed that 30 percent of withdrawals

would be subject to a penalty for early withdrawal. Ordinary taxable accounts would earn an after-tax

return on each extra dollar invested that depended on the marginal tax rate faced by the owner. 

The substitution and income effects together imply a small negative effect on saving in the early years of the projection period, moving gradually to a small positive

effect in later years. CBO added those calculated changes in saving to the

macroeconometric models: the substitution effect as a change in consumption, and

the income effect as if income had changed. In the other models, the estimated

changes in saving had virtually no effect on average GDP over the 10-year period.

Extension of the Repeal of the Estate Tax

The President’s proposal to make permanent the repeal of the estate and gift taxes

after 2010 was particularly difficult to analyze. To begin with, there is no clear

consensus on people’s motives for leaving bequests or even on whether bequests

are typically the result of a deliberate saving plan. If bequests are accidental rather

than deliberate, repealing the estate tax would not encourage saving. Moreover,

analysts who believe that estate taxes affect consumption and saving disagree about

the direction of the effect: a lower estate tax makes it cheaper for people to leave

money to their heirs, which could encourage them to save more in order to leave

larger bequests; in contrast, with a lower estate tax, people can leave the same aftertax bequest with less saving, which might induce them to save less. Also, all other

things being equal, a lower estate tax increases the after-tax size of bequests, which

could lead potential recipients to increase their consumption and reduce their saving. Finally, although a great deal of attention has been focused on the effects of
24 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

estate taxes on sectors such as agriculture or activities such as entrepreneurial ventures, there remains little agreement on those effects or their implications for the

economy as a whole.

Because so little is understood about how repealing the estate tax would affect

consumption, CBO’s estimates from all but the infinite-horizon model assumed that

in their consumption and saving, people would respond in the same way as they

have, on average, to past spending or tax changes that affected the budget deficit.

That assumption implies that people would spend about 60 percent of their

increased after-tax income, boosting aggregate consumption. In the infinite-horizon

model, however, CBO assumed that people would respond in the same way that

they would to a change in lump-sum taxes. In that model, the assumption implies

that people would save all of the increase in after-tax income from lower estate

taxes and that consumption would not rise.

Translating the Models’ Outputs 

into Spending and Revenue Estimates

Calculating the implications of the models’ results for spending and revenues required estimates of the effects of the proposals on a number of income variables

and on prices and interest rates. Those variables are a part of the normal output of

the macroeconomic models by Global Insight and Macroeconomic Advisers. The

textbook, life-cycle, and infinite-horizon growth models have very simple income

categories, however. Because each of those models assumes that production follows

a Cobb-Douglas function, the models predict that the change in GDP due to the

President’s proposals would be split into a change in total capital income of about

30 percent of the change in GDP, and a change in total labor compensation that

accounts for the remaining 70 percent of the change in GDP. However, revenue

estimates require additional details for domestic book profits; wages and salaries;

dividends; personal monetary interest income, excluding that earned in publicly

administered government employee retirement plans; both farm and nonfarm proprietors’ income; and rental income.

CBO assumed that wages and salaries would change in proportion to GDP. Because

the models also assume that total labor compensation changes with GDP, the implication is that other labor income also changes in proportion to GDP. Since most of

proprietors’ income is payment for their work, CBO assumed that that income

would change in the same way. 

CBO assumed that changes in personal interest income reflected changes in interest

payments by businesses and by government and changes in interest payments to and

from foreigners. CBO used its budget calculations to derive government interest

payments. Under CBO’s assumptions, business interest payments depended on both

GDP and on interest rates: higher interest rates imply that a higher share of GDP is
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 25

accounted for by business interest payments. CBO assumed that every increase of

100 basis points in interest rates would raise business interest payments as a share

of GDP by 0.4 percentage points. That relationship is consistent both with the output from the macroeconometric models and with a historical regression of the share

on a weighted average of interest rates.

The two open-economy simulations of the life-cycle model imply changes in the

flows of capital income across the nation’s borders. In those simulations, a part of

the additional borrowing from the President’s proposals is financed by higher borrowing from abroad. Consequently, the simulations also predict higher payments of

capital income to foreigners that are reflected in weaker projections for gross national product than for GDP. The portion of those capital payments that are made in

the form of interest—which CBO estimated to be about 75 percent—must be subtracted from total interest payments in calculating taxable personal interest income

because foreigners do not pay U.S. taxes on their interest income. 

The model, however, calculates capital payments to foreigners on the basis of an

interest rate equal to the marginal product of capital, or roughly double the government’s interest rate. That assumption overstates the interest payments made to

foreigners and understates the share of total interest payments that goes to domestic

investors and is therefore taxable. CBO therefore reduced its estimate of taxable

interest income only by half of the model’s estimate of interest payments to foreigners in the open-economy simulations.

CBO assumed that the sum of the shares of GDP constituted by economic profits

and business interest payments remained constant; hence, any change in the interest

share of GDP was reflected with the opposite sign in profits. That calculation implied that the share of depreciation in GDP was unchanged. Two factors would

affect depreciation. First, the lower national saving would mean lower overall investment, which would tend to reduce depreciation. Second, because the President’s

proposals would tend to reduce the taxes on corporate investments relative to housing, more of each year’s investment would go to business and less to housing.

CBO’s models do not currently distinguish between business and housing investment, so the agency was unable to determine the relative magnitude of those two

effects and hence the sign of the impact on business investment and depreciation.

For that reason, CBO kept the share of GDP devoted to depreciation unchanged.

Under CBO’s assumptions, dividends remained the same share of domestic economic profits as in the agency’s baseline, and rental income changed by the same

percentage as GDP. 

Once CBO translated the economic output from the models into the proper variables, the agency estimated the spending and revenue implications using its usual

methods. The impact on revenues depended mostly on the level and distribution of

different types of income, which in turn depended largely on overall output, interest
26 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

16. For a more detailed description of the textbook growth model, see Congressional Budget Office, CBO’s

Method for Estimating Potential Output: An Update (August 2001). 

rates, and price levels (as described above). The impact on spending depended

largely on interest rates, price levels, and wages. It is important to note that CBO

held discretionary spending at its baseline level in nominal dollars under any economic assumptions because the President’s budget proposals specified dollar

amounts. Consequently, in CBO’s estimates, higher inflation, which tends to raise

nominal revenues, does not affect discretionary spending and therefore tends to

improve the budget balance. 

Description of the Models

This section provides a summary description of the models that CBO used in its

analysis: the textbook growth model, the life-cycle model, the infinite-horizon

model, and the two macroeconometric models. 

The Textbook Growth Model

The textbook growth model is the model CBO uses to compute historical values of

potential output and to estimate potential output in its 10-year baseline projections.

It is an enhanced version of the Solow growth model.16 Real GDP in the nonfarm

business sector (which accounts for roughly three-quarters of GDP) is determined

by a Cobb-Douglas production function of a capital aggregate, labor hours, and

exogenous total factor productivity. The coefficient on capital in the production

function equals 0.30 and that on labor equals 0.70. Specifically:

# Labor input is the number of hours worked.

# Capital input is an index of capital services that aggregates such services for

four types of equipment (computers, software, communications equipment, and

other equipment), as well as nonresidential structures, inventories, and land.

# Total factor productivity is calculated as a residual over history and projected on

the basis of historical trends, adjusted for business cycles and changes in the

measurement of prices.

The model includes four additional sectors: government, farm, households and

nonprofit institutions, and residential housing. Projected output in most of those

sectors is based on their historical share of the labor force and historical productivity in the sectors. Output in the housing sector is a constant ratio to the stock of

housing.

The policies in the President’s budget would affect output in the growth model

primarily through the impact of higher deficits on investment and lower marginal
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 27

tax rates on labor supply. The effect of changes in deficits on investment is the

same whether it stems from changes in taxes, transfers, or government consumption. Therefore, the two key inputs that determine the estimated effects of the President’s budgetary proposals are the overall change in the surplus and the estimated

change in the labor supply.

In the growth model, capital accumulation is determined by the rate of national

saving and net capital inflows. Changes in the federal surplus affect national saving

and, therefore, private investment and the capital stock. The President’s budget

implies lower surpluses than those in CBO’s baseline, which would tend to result in

a lower projected capital stock, less output, and higher interest rates.

The impact of changes in the federal surplus on investment is partially offset by

changes in private saving and capital inflows. Those offsets are determined by

simple rules of thumb based on historical averages and the behavior of a variety of

economic models. The private-saving offset equals 40 percent of the initial change

in the federal surplus (for example, if the surplus falls by $1, private saving increases by 40 cents); the net-foreign-investment offset equals 40 percent of the

change in national saving (for example, if the change in national saving equals 60

cents, as in the previous example, the change in net foreign investment equals 24

cents, or 40 percent of 60 cents, and domestic investment falls by 36 cents). Therefore, a decrease in the surplus not only causes domestic investment to fall but also

causes capital inflows to rise, which implies higher net payments to foreigners in

the future. Those higher payments subtract from domestic income, so when the

surplus declines, gross national product (which is based on income) tends to fall by

more than gross domestic product (which is based on domestic output). 

The textbook growth model does not automatically incorporate any effect of marginal tax rates on labor supply. Therefore, CBO estimated the effect on labor supply

of the lower marginal tax rates under the President’s budget in a side calculation,

described previously, and added the estimated effect to the projected number of

labor hours in the model. The growth model incorporates no direct effect of aftertax interest rates on consumption and saving, but private saving would rise under

the President’s budget because of the private-saving offset described above. 

The textbook growth model also has no internal method of taking account of how

the President’s proposal to reduce double taxation of dividends would affect the

allocation of capital. That proposal would shift some investment from the housing

and noncorporate business sectors to the corporate sector, which would tend to

increase output. CBO estimated the magnitude of the effect on output in a side

calculation, also described previously, and added it to the estimated changes in

income derived from the growth model’s projections. 

Finally, the textbook growth model also does not incorporate any demand-side

effects; it assumes that output is always at its potential level. With output always at
28 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

17. For a more detailed description of the life-cycle model, see Shinichi Nishiyama and Kent Smetters,

“Consumption Taxes and Economic Efficiency in a Stochastic OLG Economy,” Technical Paper 2002-6

(December 2002), available from CBO’s Macroeconomic Analysis Division or at www.cbo.gov/tech.cfm.

In addition, a forthcoming CBO technical paper will describe the life-cycle model’s estimates of the effects

of simple tax experiments (such as a proportional change in all marginal tax rates). 

its potential, prices remain at their baseline levels—there is no estimated effect of

policy on inflation. The model also does not incorporate any explicit forwardlooking response to future policy changes. 

The Life-Cycle Model

The life-cycle model is a general-equilibrium growth model. It incorporates simulated households that make decisions about how much to work and save in order to

make themselves as well off as possible over their lifetime.17 Those simulated

households differ in their ages, working ability (measured by hourly wages), accumulated savings, and earnings histories (which determine their Social Security

benefits). A household is assumed to consist of a married couple with some children. A household enters the economy when it is 20 years old. 

Every year, each household below age 80 may shift from its current working ability

to another one (technically speaking, working ability follows a Markov process).

That means future income, on an individual level, is uncertain in the model. However, the individual shocks to earnings cancel one another out in the aggregate, so

aggregate earnings and output are not uncertain. There are eight distinct workingability levels for each age below 80. 

At the end of each year, a fraction of the households die, according to current U.S.

mortality rates. Households can live at most 110 years; that is, the mortality rate at

the end of age 109 is one.

Each household chooses its optimal consumption, labor supply (working hours),

and savings, taking a series of current and future factor prices (such as the interest

rate and wage rate) and policy variables (such as marginal income tax rates) as

givens. Households in the model can foresee those future factor prices and policy

variables because they are assumed to know all future government policies as well

as the current distribution of households does and because there are no aggregate

shocks in the model.

The utility function of a household is a constant relative risk aversion function of a

Cobb-Douglas aggregate of consumption and leisure. The share parameter of consumption is 0.47, the elasticity of intratemporal substitution of consumption for

leisure is 1.0, and the elasticity of intertemporal substitution is 0.5. The rate of time

preference is chosen so that the capital stock is 2.7 times output, and the share

parameter on consumption is chosen so that the average household supplies a total
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 29

of 3,360 hours of labor in the baseline steady state (the estimated values in the U.S.

economy).

The model has a representative (but perfectly competitive) firm with Cobb-Douglas

production technology. The share parameter of capital is assumed to be 0.30 and

that of labor 0.70, just as in the textbook growth model.

The model assumes two polar cases for the degree of openness of the economy—a

closed economy and a small open economy. In a closed economy, no international

capital flow is assumed, and the trade surplus is assumed to be zero. The interest

rate and the wage rate are determined by the domestic capital stock (which is equal

to the sum of total private wealth and net government wealth) and labor supply. In

a small open economy, a perfectly flexible international capital flow is assumed.

The interest rate and the wage rate are fixed at their international levels. The domestic capital stock is determined by the labor supply of the economy, and the

difference between domestic capital and national wealth (the sum of private wealth

and net government wealth) is made up by international capital inflows (or outflows). Therefore, in a small open economy, the percentage change in GDP is equal

to the percentage change in labor supply. 

The model includes a progressive federal income tax that is modeled on the current

rate structure, a flat state income tax, and a Social Security system calibrated to the

existing one. For federal income taxes, the statutory marginal rates are modified by

two adjustment factors so that the effective tax rates on labor income and capital

income are roughly the same as those in the U.S. economy. State and local taxes are

assumed to be 4 percent after standard deductions and exemptions similar to the

federal ones. For the Social Security system, the payroll taxes for both the Old-Age,

Survivors, and Disability Insurance (OASDI) and the Hospital Insurance portions of

Medicare are included, as are OASDI benefits, at levels consistent with statutory

formulas. To solve a dynamic model for equilibrium, the model economy has to be

on a balanced growth path with a constant per capita real growth rate and population growth rate in the long run. To make the economy return to a balanced growth

path, CBO needed to make some financing assumption to stabilize the debt-to-GDP

ratio at some time in the future, because the tax cuts and spending increases in the

President’s proposals would otherwise result in an unsustainable increase in the

debt/GDP ratio relative to the baseline. 

CBO assumed that the debt/GDP ratio was stabilized either by a permanent lumpsum tax increase or a cut in government consumption in the 11th year, that is, in the

first year after the 10 years covered by the fiscal policy specified in the budget. In

subsequent years, the tax increase or spending cut remains a constant share of economic output. Most of the policy change in the 11th year offsets the tax cuts and

spending increases included in the budget, which are assumed to continue permanently. Increased interest costs and budgetary losses or gains due to the economic

impacts of the budget also affect the size of the policy change that is required. 
30 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

18. Beyond 2013, the relative effects on output under the three assumptions about financing are very different.

Assuming that the President’s proposals are ultimately financed by an increase in marginal tax rates implies

the most negative effect on output in the long run, while assuming that they are financed by a lump-sum

increase in taxes (or a cut in government consumption that is valued as highly as personal consumption)

implies the most positive effect on output. (Assuming a cut in government spending that is not valued leads

to an intermediate effect on long-run output.)

In order to stabilize the ratio of debt to GDP, government consumption has to be cut

by between 2.8 percent and 3.0 percent of GDP between 2013 and 2014, from about

0.6 percent of GDP above its baseline level in 2013 to about 2.2 percent to 2.4

percent below its baseline level in 2014. Lump-sum taxes must be raised by about

2.3 percent of GDP between 2013 and 2014, from about 0.8 percent of GDP below

their baseline level in 2013 to about 1.5 percent above their baseline level in 2014.

Those policy changes beyond the 10-year budget window are foreseen by households and can affect their behavior during the first 10 years. For instance, if taxes

are going to be raised in 2014, people in the model will tend to work and save more

in preparation. That additional work and saving tends to improve the budget balance, which is why the adjustment to lump-sum taxes required to stabilize the

debt/GDP ratio is smaller than the required adjustment to government consumption.

There is no similar impact of cuts in government consumption on work and saving

because the model assumes that government consumption does not provide value to

people. (Estimates assuming a future increase in marginal tax rates, not shown for

brevity, fall between those assuming a future cut in government consumption and

those assuming a future lump-sum increase in taxes.)18

The model assumes no intergenerational altruism—that is, the utility of children

does not enter the utility function of parents. All of the bequests in the model are

accidental, due to uncertain life span. For simplicity, the wealth left by the deceased

households is collected and distributed to the working-age households (ages 20 to

64) in a lump-sum manner. (Each working-age household rationally expects to

receive the future accidental inheritances when it makes decisions about consumption, labor supply, and saving.) 

The President’s budgetary policies affect output in the life-cycle model mainly

through reductions in marginal tax rates on labor and capital income, increases in

after-tax income (from both reduced taxes and increased transfers), increases in

government consumption, and changes in expected budgetary policies outside the

10-year projection period. CBO’s method for calculating changes in the effective

marginal tax rate on labor and capital income were described previously. CBO used

the Administration’s spending and revenue projections to estimate changes in aftertax income and government consumption. (Most discretionary spending was classified as government consumption, and most mandatory spending was classified as

transfers.) The reductions in marginal tax rates under the President’s budget reduce

projected tax revenues in the model somewhat; CBO made additional adjustments
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 31

19. For a detailed discussion of this type of model, see Robert J. Barro and Xavier-I-Martin, Economic Growth

(New York: McGraw-Hill, 1995). 

through lump-sum taxes to match the Administration’s revenue estimates. In the

models, changes in transfers are also distributed on a lump-sum basis.

Reductions in marginal tax rates on labor income affect labor supply by raising

after-tax wages. That change induces households to increase their labor supply by

raising the price of leisure relative to consumption. The response of labor supply to

after-tax wages in the model depends on how the lost revenue is assumed to be

financed outside the 10-year projection period. In a closed economy, the effective

long-run wage elasticity of labor supply with respect to after-tax wages is 0.21

when the tax cut is financed by a cut in government consumption and 0.36 when it

is financed by a lump-sum tax increase; in an open economy, the elasticities are

0.16 and 0.35, respectively. Those elasticities were calculated on the basis of the

change in the steady-state quantity of labor supplied relative to the change in aftertax wages from an across-the-board 10 percent tax cut.

Reductions in taxes and increases in transfers that do not affect after-tax wages

(such as child tax credits or a prescription drug benefit) tend to reduce households’

labor supply through an income effect—people tend to work less because they can

maintain the same standard of living with less work.

Reductions in the marginal tax rate on capital income tend to reduce current consumption and increase saving because they make future consumption relatively less

expensive than current consumption. Once again, the effect on consumption depends on how the tax cut is assumed to be financed. In a closed economy, the longrun elasticity of savings with respect to the after-tax interest rate is 1.40 when the

tax cut is financed by a cut in government consumption and 1.60 when it is financed by a lump-sum tax increase. In an open economy, the elasticities are 0.95

and 1.10, respectively. 

Government consumption affects behavior in the model by reducing the share of

output available for private consumption and investment. Government consumption

is not included in the utility function, so it is assumed to be pure waste. Alternatively, one could assume that government consumption is a perfect substitute for

private consumption. In that case, the effect of a change in government consumption is the same as that of an equal change in transfers or lump-sum taxes.

The Infinite-Horizon Model

The infinite-horizon growth model is a Ramsey-type model similar in many ways to

the life-cycle model.19 A simulated household chooses how much to work and

consume in order to maximize its well-being over its lifetime. The basic forms of

the utility function and production function are the same as in the life-cycle model,
32 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

and government consumption is assumed to have no value. Like the life-cycle

model, the infinite-horizon model requires an offsetting policy change to stabilize

the debt-to-GDP ratio beyond the 10-year projection period. That policy change is

fully foreseen and affects behavior over those 10 years.

Rather than including a set of overlapping households of different ages and earnings

ability, the infinite-horizon model includes just one representative household. (That

type of model is often called a “representative agent” model.) Also, unlike the lifecycle model, there is no uncertainty about mortality or individual earnings ability;

the household is assumed to know all future developments with certainty.

The most important difference between the models is that the household in the

infinite-horizon model behaves as if it expects to live forever, whereas the households in the life-cycle model expect to live only for a fixed period of time. That

assumption of an infinite horizon is equivalent to an assumption that the household

values its descendants’ consumption as much as its own.

CBO calibrated the share parameters on the Cobb-Douglas production function to

match the capital and labor shares of income in the agency’s forecast for 2003 and

adjusted the discount rate to match the projected capital/output ratio.

As with the life-cycle model, solving the infinite-horizon model requires that the

tax cuts and spending increases in the President’s budget be financed at some point

in order to stabilize the debt/GDP ratio and return the economy to a balanced

growth path. CBO assumed that that financing occurred through either a lump-sum

tax increase or a cut in government spending in the 11th year of the projection.

In order to stabilize the ratio of debt to GDP in the model, government consumption

has to be cut by about 3.9 percent of GDP between 2013 and 2014, from about 0.6

percent of GDP above its baseline level in 2013 to about 3.3 percent below its

baseline level in 2014. Alternatively, lump-sum taxes must be raised by about 3.5

percent of GDP between 2013 and 2014, from about 0.6 percent of GDP below

their baseline level in 2013 to about 2.9 percent above their baseline level in 2014.

The adjustments to stabilize the debt/GDP ratio are larger than in the life-cycle

model because in the infinite-horizon model, the changes in marginal tax rates

under the President’s proposals, which are continued permanently after the 10th

year of the projection, result in larger projected revenue losses than in the life-cycle

model. 

The response of the labor supply to after-tax wages in the model depends on how

the lost revenue is assumed to be financed outside the 10-year projection period.

The effective long-run wage elasticity of labor supply is 0.15 when the tax cut is

financed by a cut in government consumption and 0.35 when it is financed by a

lump-sum tax increase. Those elasticities are based on the change in the steady-
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 33

state quantity of labor supplied relative to the change in after-tax wages from an

across-the-board 10 percent tax cut. 

There is no external sector in the infinite-horizon model; all of its projections assume a closed economy.

As in the life-cycle model, in the infinite-horizon model the President’s budgetary

policies affect output mainly through reductions in marginal tax rates, increases in

after-tax income, increases in government consumption, and changes in expected

budgetary policies outside the 10-year projection period. The decreases in marginal

tax rates tend to encourage the household to work and save more, which increases

output and the capital stock, while the increases in after-tax income and government

consumption tend to reduce saving and the capital stock. The infinite-horizon

model uses the same values for changes in marginal tax rates, transfers, and government consumption as does the life-cycle model. After the new marginal tax rates are

imposed, adjustments in lump-sum taxes are used to align the total change in revenues with the Administration’s estimates.

Macroeconomic Advisers’ and Global Insight’s Models

The models by Macroeconomic Advisers and Global Insight are econometrically

estimated models of the U.S. economy that combine demand-side (Keynesian) and

supply-side features. The demand-side features of those macroeconometric models

are more obvious, especially in the short run: in both models, total output is always

determined by demand for the components of output. Utilization of the factors of

production adjusts to achieve that level of output.

Supply-side features of the models affect output insofar as they affect demand. The

full effects do not occur immediately but only gradually, through the unemployment

rate, prices, and interest rates. Suppose, for example, that a policy raises aggregate

supply more than it does aggregate demand. In Macroeconomic Advisers’ and

Global Insight’s models, that change will push the unemployment rate higher than

what it would otherwise have been. All else being equal, that scenario puts downward pressure on inflation. Higher unemployment rates and lower inflation may

lead the Federal Reserve to lower interest rates. Lower interest rates then increase

demand for interest-sensitive items like consumer durables, business fixed investment, residential investment, and net exports (through a weaker dollar).

To isolate the supply-side impacts of policies in the macroeconometric models,

CBO eliminated the Keynesian demand effects by changing interest rates so that the

unemployment rate was brought back to baseline levels. Given that the models

achieve supply-side effects through changes in interest rates, that approach seemed

reasonable. However, when CBO divided the estimated budgetary effects from the

macroeconomic impacts of the President’s proposals into supply-side and demandside portions, the interest rates in the supply-side estimates changed only enough to

reflect the impact of changes in the ratio of capital to output on the rate of return to
34 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

capital, rather than at the high levels necessary to maintain baseline unemployment.

Those high interest rates reflected demand-side pressures, so it made little sense to

ascribe their budgetary effects to supply-side effects.

Another difference between the macroeconometric models and the life-cycle and

infinite-horizon models is their treatment of expectations. While the life-cycle and

infinite-horizon models are forward-looking, the macroeconometric models assume

that people respond to economic changes in the same way as they have in the past,

regardless of the source of those changes. So, for example, long-term interest rates

are set according to the current state of the economy and do not take account of

expected changes in the budget that will alter the state of the economy in the future.

Thus, the financing assumption crucial to results from the life-cycle and infinitehorizon models is irrelevant in the macroeconometric models. CBO made no adjustments for that feature of the macroeconometric models. To the extent that expectations about future financing decisions play a role in economic outcomes, that

may or may not have been a bad assumption.

In the models by Macroeconomic Advisers and Global Insight, aggregate supply at

full employment is determined by labor and capital in much the same way as in the

textbook growth model. To estimate the labor supply response, CBO used the same

calculation as in the textbook growth model. CBO then used that estimate in place

of a smaller response built into Global Insight’s model and no response in Macroeconomic Advisers’ model. Capital responds through changes in investment. The

supply-side portion of changes in investment comes from changes in the cost of

capital. Higher interest rates boost the cost of capital, reducing investment, while

the tax provisions for dividends reduce the cost of capital, increasing investment.

While budget policy can affect international capital flows in the macroeconometric

models, those effects are probably incomplete. In both models, reduced national

saving leads to higher interest rates, causing the dollar to appreciate, thus raising the

trade deficit. Capital inflows rise to finance the higher deficit. Reduced national

saving thus ultimately leads to capital inflows, just as in the textbook growth model. However, the models do not capture the fact that foreign taxpayers do not benefit

from the proposal to reduce double taxation of corporate income and would therefore probably reduce their holdings of U.S. equities.

CBO made two other changes to Global Insight’s model. In the version of the

model that was the starting point for CBO’s estimates (the one that Global Insight

used to produce its February forecast), growth in wages did not depend on the level

of the unemployment rate, but only on its change. Thus, a permanent reduction in

the unemployment rate produced only a temporary rise in wage inflation. Supplyside effects on output were minimal. Therefore, CBO substituted a wage equation

very close to the one included in the version of the model that Global Insight used

to produce its March forecast, one in which wage growth depends on both the level

of and change in the unemployment rate. A permanent reduction in the unemploy-
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 35

ment rate produces a continuous acceleration in wage and price inflation, restoring

the importance of supply-side effects.

Also, in Global Insight’s model, capital gains taxes depend on changes in stock

prices. However, the model assumes that people treat higher capital gains taxes

from a one-time rise in stock prices as if they will be permanent, and not as onetime events, and so reduce their consumption. Instead, CBO assumed that changes

in receipts from capital gains taxes affect consumption only 10 percent as much as

changes in receipts from other personal taxes.

CBO constructed baselines for both models in which levels for GDP, aggregate

price indexes, unemployment and interest rates, stock market appreciation, and the

sunset provisions of tax legislation closely matched CBO’s January 2003 forecast.

In the baseline in Global Insight’s model, CBO also aligned most incomes, taxes,

and spending with CBO’s forecast levels.

To implement the President’s proposals in the models, CBO changed tax rates and

spending levels in line with the cost estimate from the Fiscal Year 2004 Budget of

the U.S. Government and the General Explanations of the Administration’s Fiscal

Year 2004 Revenue Proposals, because CBO had not yet completed its Analysis of

the President’s Budgetary Proposals. Within the simulation, CBO changed tax

rates by the same amount in every quarter of the year since income taxes are paid by

calendar year, and it implemented higher spending by raising the appropriate categories of spending in each model.

In both models, the extension of the research and experimentation credit reduces

corporate income taxes. In Global Insight’s model, that change boosts research and

development spending, which raises productivity with a lag.

CBO assumed that the proposals for lifetime savings accounts and retirement savings accounts would induce changes in consumption according to their estimated

income and substitution effects. CBO spread the large income effect in 2003 evenly

over the 10-year projection period.

Appendix A: Additional Results

This section provides some results that go beyond those shown in Tables 1, 2,

and 3.

 

One of the important variables for estimating the budgetary effects of the President’s proposals was the estimated effect on interest rates. Those rates affect both

interest payments on the national debt, and, through their effect on the relative

amounts of different types of income, tax revenues as well. Table 7 shows the

effects of the President’s proposals on interest rates, as estimated by various models.

For the life-cycle and infinite-horizon models, the Congressional Budget Office

(CBO) had to make an assumption about how the revenue losses and spending

increases under the President’s budget would ultimately be financed in order to

stabilize the debt/gross domestic product (GDP) ratio. In CBO’s main estimates,

those financing changes—a permanent (as a percentage of output) cut in government consumption or increase in lump-sum taxes—were assumed to be made in

2014, the year after the end of the period covered by the budget. However, that

choice of year is essentially arbitrary. Table 8 shows the estimated effects on real

GDP assuming that the financing changes were instead made after 2023. 

Those estimates differ from the ones assuming financing in 2014 (shown in Table

1) for several reasons. In the life-cycle model, delaying the increase in lump-sum

taxes results in a lower (or more negative) estimated impact on output, because

current workers and retirees would not have to face the tax for as long before their

death. That means they have less incentive to work harder and save more. By

contrast, the timing of lump-sum taxes makes no difference in the infinite-horizon

model, because the representative agent in that model (or children whose welfare he

values as highly as his own) will eventually face taxes of an equivalent present

value.

The direction of the effect of changes in the timing of financing through government consumption depends on the specific model. The infinite-horizon model and

the life-cycle model assuming a closed economy estimate that delaying the cut in

government consumption results in a more positive or less negative impact on

output. That is in part because of the timing of changes in the wage rate. When the

financing is delayed, there is increasing crowding out of the capital stock between

2014 and 2023, which greatly depresses the wage rate. The wage rate between

2004 and 2013 is therefore high by comparison, resulting in a shifting of more labor

into that period, and therefore a higher level of output relative to that when financing occurs earlier. By contrast, in the life-cycle model assuming a small open economy the wage rate is fixed by the world economy, so there is no similar effect, and

delaying financing results in a slightly lower GDP over the first 10 years. 

The economic effects outside the budget window can differ substantially from those

within the budget window. For the models without forward-looking behavior, the

increase in the deficit under the President’s budget would, if not offset, lead to
38 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

rising crowding out of investment as the budgetary imbalance continued to increase,

due to rising interest payments. In the forward-looking models, a more concrete

answer can be given. In those models, the economy eventually reaches a steady

state, in which the economic effects are constant as a share of output. Table 9 shows

the economic effects in the life-cycle and infinite-horizon models once the economy

has reached a steady state. 

The steady-state effects of the President’s proposals with financing through an

increase in lump-sum taxes tend to be more positive than those within the first 10

years for two reasons. First, in the life-cycle model within the first 10 years there

are some people who will not be affected by the increased taxes because they will

die before the increases occur, and therefore do not have to increase labor supply

and reduce consumption in response. Second, in both models it takes time for the

capital stock to grow to fully reflect the reduction in consumption and increase in

labor supply that stems from the increased taxes. Note the key point that the taxes

being raised are lump-sum taxes, which do not affect marginal incentives to work

and save. The steady-state effects on output of finance through an increase in marginal tax rates would tend to be negative. 

The steady-state effects of the President’s proposals with financing through a cut in

government consumption differ from the effects within the first 10 years, but the

sign of the difference is uncertain. On the one hand, a cut in government consumption allows greater private consumption for any given level of work, which tends to

reduce labor supply. On the other hand, more resources are available for investment for any given level of private consumption, which tends to lead to increases in

the capital stock. In the life-cycle model’s results, the former effect dominates, and

the steady-state effects on output (GDP in the closed-economy case and GNP in the

open-economy case) are more negative than those within the 10-year window. In

the infinite-horizon model results, the latter effect dominates, and the steady-state

effects on output are more positive than those within the 2004-2013 period.
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 39

Table 7.

Long-Term Effects of the President’s Budget 

on Three-Month Treasury Bill Rates

(Average percentage-point difference from CBO’s baseline)

2004-2008 2009-2013 

Supply-Side Model Without Forward-Looking Behavior

Textbook Growth Model 0.1 0.4

Supply-Side Models with Forward-Looking Behavior

Closed-Economy Life-Cycle Growth Model

 Lower government consumption after 2013 0 0.2

 Higher taxes after 2013 0 0.1

Open-Economy Life-Cycle Growth Model

 Lower government consumption after 2013 0 0

 Higher taxes after 2013 0 0

Infinite-Horizon Growth Model

 Lower government consumption after 2013 0 0.1

 Higher taxes after 2013 0 0

(Continued)
40 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

Table 7.

Continued

2004-2008 2009-2013 

Macroeconometric Models, Supply-Side Contribution

Macroeconomic Advisers 0.2 n.a.

Global Insight 0.3 n.a.

Macroeconometric Models, Supply-Side and Cyclical Contributions

Macroeconomic Advisers 1.5 n.a.

Global Insight 0.9 n.a.

Source: Congressional Budget Office.

Notes: n.a. = not applicable.

The “textbook” growth model is an enhanced version of a model developed by Robert Solow. The lifecycle growth model, developed by CBO, is an overlapping generations general-equilibrium model. The

infinite-horizon growth model is an enhanced version of a model first developed by Frank Ramsey.

The models by Macroeconomic Advisers and Global Insight, which are available commercially, are

designed to forecast short-term developments. The various models reflect a wide range of assumptions

about the extent to which people are forward-looking in their behavior: in the textbook model and

those by Macroeconomic Advisers and Global Insight, their foresight is the least, while in the infinitehorizon model, it is perfect and extends infinitely to include a full consideration of effects on descendants.

In models with forward-looking behavior, CBO had to make assumptions about how the President’s

budget would be financed after 2013. CBO chose two alternatives—cutting government consumption

or raising taxes.

For the models by Macroeconomic Advisers and Global Insight, the supply-side contribution to interest rate changes shown in the table reflects only the effect of changes in the ratio of capital to output on

the rate of return to capital. In fact, the interest rates in the “supply-side” projections had to be increased by much more to keep the unemployment rate at its baseline level. Those large increases stem

from demand-side pressures, so categorizing them as supply-side effects would make little sense. The

numbers shown are the ones that were used in generating the budgetary effects shown in Table 1.
HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET 41

Table 8.

Effect of the President’s Budgetary Proposals on Real

Gross Domestic Product, Assuming They are Financed

After 2023 Rather Than 2013

(Average percentage change from CBO’s baseline)

2004-2008 2009-2013

Supply-Side Models with Forward-Looking Behavior

Closed-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -0.2 -1.0

Higher taxes after 2013 0.1 -0.4

Open-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -0.7 -0.6

Higher taxes after 2013 -0.3 -0.1

Infinite-Horizon Growth Model

Lower government consumption after 2013 0.8 0.9

Higher taxes after 2013 0.9 1.4

Memorandum: Effect on Real Gross National Product

Open-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -0.9 -2.2

Higher taxes after 2013 -0.4 -1.3

Source: Congressional Budget Office.

Notes: In models with forward-looking behavior, CBO had to make assumptions about how the President’s

budget would be financed beyond the period covered by the budget. These results show the estimated

economic effects of the President’s proposals if they were financed by cutting government consumption or raising taxes after 2023, rather than after 2013 as in most of CBO’s other published results.

Results are shown only for the life-cycle and infinite-horizon models, because only in those models

does the timing of financing affect the results.

The life-cycle growth model, developed by CBO, is an overlapping generations general-equilibrium

model. The infinite-horizon growth model is an enhanced version of a model first developed by Frank

Ramsey.
42 HOW CBO ANALYZED THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET

Table 9.

Long-Run Steady-State Effect of the President’s 

Budgetary Proposals on Real Gross Domestic Product 

(Average percentage change from CBO’s baseline)

Effect on Real GDP

Supply-Side Models with Forward-Looking Behavior

Closed-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -1.8

Higher taxes after 2013 0.7

Open-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -0.2

Higher taxes after 2013 1.6

Infinite-Horizon Growth Model

Lower government consumption after 2013 0.6

Higher taxes after 2013 2.5

Memorandum: Effect on Real Gross National Product

Open-Economy Life-Cycle Growth Model

Lower government consumption after 2013 -2.4

Higher taxes after 2013 0.3

Source: Congressional Budget Office.

Notes: The life-cycle growth model, developed by CBO, is an overlapping generations general-equilibrium

model. The infinite-horizon growth model is an enhanced version of a model first developed by Frank

Ramsey. In those models, the effect of the President’s proposals on the economy eventually (after

several decades) stabilizes at a permanent level as a percentage of GDP. This table shows those longrun, permanent effects, which can differ substantially from the effects within the 10-year period covered by the budget.

In models with forward-looking behavior, CBO had to make assumptions about how the President’s

budget would be financed after 2013. CBO chose two alternatives—cutting government consumption

or raising taxes.
CBO
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