WRITTEN TESTIMONY OF THE STAFF OF THE

JOINT COMMITTEE ON TAXATION

AT A HEARING OF THE SUBCOMMITTEE ON OVERSIGHT

OF THE HOUSE COMMITTEE ON WAYS AND MEANS

CONCERNING MODELING THE ECONOMIC EFFECTS

OF CHANGES IN TAX POLICY

Presented by

Lindy L. Paull

Chief of Staff

Joint Committee on Taxation

JCX-36-02

May 6, 2002
i

CONTENTS

Page

I. INTRODUCTION ....................................................................................................................... 1

II. OVERVIEW OF THE REVENUE ESTIMATING PROCESS ................................................ 2

III. MACROECONOMIC EFFECTS OF TAX LAW CHANGES................................................ 4

A. History of Joint Committee Staff Work on Macroeconomic Modeling ............................. 4

B. Description of Macroeconomic Models Available to the Joint Committee Staff............... 6

C. Issues and Problems With the Use of Macroeconomic Analysis in Revenue Estimates.. 10

1. Sources of uncertainty....................................................................................................... 10

2. Small magnitude of macroeconomic effects of most proposals ....................................... 12

3. Baseline assumptions........................................................................................................ 13

4. Budget symmetry.............................................................................................................. 13

5. Coordination with CBO baseline and budget reconciliation analysis .............................. 14

IV. CONCLUSION....................................................................................................................... 14

I. INTRODUCTION

My name is Lindy Paull. As Chief of Staff of the Joint Committee on Taxation, it is my 

pleasure to present the testimony of the Joint Committee on Taxation (“Joint Committee”) staff 

at this hearing of the Subcommittee on Oversight concerning modeling the economic effects of 

changes in tax policy.1

Under the Congressional Budget and Impoundment Control Act of 1974, the revenue 

estimates of the Joint Committee are required to be used for purposes of all revenue legislation 

that is considered or enacted by the Congress. To satisfy this requirement, the Joint Committee 

staff prepares estimates for Members of Congress on the effects of revenue proposals on budget 

receipts. These estimates help Members determine whether specific legislation fits within targets 

set during the budget resolution process.

 

1

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

Testimony of the Staff of the Joint Committee on Taxation at a Hearing of the Subcommittee on 

Oversight of the House Committee on Ways and Means Concerning Modeling the Economic 

Effects of Changes in Tax Policy (JCX-36-02), May 6, 2002.
2

The Joint Committee staff is constantly reviewing and updating the models used to 

prepare revenue estimates. In addition, since 1995, the Joint Committee staff has been engaged 

in ongoing and extensive efforts to improve the Joint Committee’s revenue estimating 

capabilities by evaluating the feasibility of incorporating, to the extent appropriate, the 

macroeconomic effects of tax legislation.2 Three Joint Committee staff economists have devoted 

significant amounts of their time to this effort. The Joint Committee staff has utilized the 

services of economic consultants with macroeconomic expertise. Significant progress has been 

made, but significant work remains to be done.

This testimony provides a brief overview of the Joint Committee revenue estimating 

process and discusses the status of the Joint Committee staff’s investigation of the possible role 

of macroeconomic feedback analysis in revenue estimating. This discussion includes a summary 

of the Joint Committee staff’s past research efforts, a description of the macroeconomic models 

that the Joint Committee staff is currently using, a discussion of the strengths and weaknesses in 

the current state of the art of macroeconomic analysis, and a description of the Joint Committee 

staff’s plans for future work on macroeconomic analysis.

II. OVERVIEW OF THE REVENUE ESTIMATING PROCESS

In general

Revenue estimates measure the anticipated changes in Federal receipts that result from 

proposed legislative changes to the Federal tax laws (or other Federal laws). A revenue estimate 

is simply the measure of revenue projected to be collected if a particular legislative change is 

enacted compared to the revenue that is projected to be collected under present law. The starting 

point for a revenue estimate is the estimate of the receipts generated by the affected tax 

provisions under present law. Estimates of present-law receipts are based on the macroeconomic 

aggregates and growth rates projected by the Congressional Budget Office (“CBO”) as part of its 

budget forecasts. Estimates of projected revenues under a proposal are calculated based on 

assumptions about (1) the changes in tax liability intended to occur under the proposal, and (2) 

likely taxpayer responses to these tax liability changes.

Proposals for which the Joint Committee staff prepares revenue estimates range from 

those affecting broad groups of taxpayers (e.g., proposals to reduce all individual income tax 

rates or to provide a tax credit for minor children) to those affecting a narrow class of taxpayers 

(e.g., proposals to change the excise tax on bows and arrows or to exclude parsonage allowances 

from gross income). For most estimates of broad proposals, the Joint Committee staff uses large 

computerized models of the Federal income tax system and the economy. The primary data 

source for most models is samples of the tax returns filed by individuals, partnerships, 

corporations, and fiduciaries compiled by the Internal Revenue Service (“IRS”) Statistics of 

Income Division. The models combine the most recently available taxpayer information with 

forecasts of the aggregate level of national income provided by the CBO. For estimates of 

 

2

 Attachment A to this testimony provides a listing of Joint Committee publications that 

address issues relating to the revenue estimating process, including publications prior to 1995.
3

narrow proposals, the Joint Committee staff creates more targeted models based on data from a 

variety of surveys and other sources.

Efforts to improve the revenue estimating process are guided by certain principles. First, 

the revenue estimating process should consistently produce accurate estimates on which 

Members of Congress can rely in making legislative decisions. Second, the revenue estimating 

process must be viewed as fair and impartial. Third, revenue estimating methodologies should 

be improved whenever possible to enhance the accuracy of the work product.

History of revenue estimating process

Although the basic formula by which a revenue estimate is calculated has not changed 

over time, the process of preparing revenue estimates undergoes frequent changes and 

improvements. These changes and improvements have enabled the Joint Committee staff to 

produce more accurate and timely estimates of proposals for Members of Congress.

In the mid-1970s, the Joint Committee staff employed 5 economists who were 

responsible for preparing revenue estimates of all tax legislation; only 2 of these economists had 

computer training. The Joint Committee bought computer time from the Treasury Department 

and the Department of Commerce. Most of the revenue estimates prepared by the Joint 

Committee staff were done on adding machines.

In 1986, when the Congress was considering the Tax Reform Act, the Joint Committee 

staff relied on a Treasury Department mainframe computer to do large individual tax model runs. 

A model run to calculate a revenue estimate for a proposal for one year took more than one hour 

and out year effects were then calculated manually. During 1986, the Joint Committee staff 

responded to 474 revenue estimate requests.

In 2001-2002, the Joint Committee staff employs 20 professionals involved in preparing 

revenue estimates: 15 Ph.D. level economists, 3 computer specialists, and 2 statistical analysts. 

The Joint Committee staff has its own mainframe computer to do individual tax model runs 

yielding results for each year in the 10-year budget period. Each run can now be completed in 

less than 3 minutes and multiple runs take advantage of economies to shorten the average time 

per run. Each Joint Committee staff economist has a desktop computer that is more powerful 

than the large mainframe computers used in 1986. In 2001, the Joint Committee staff responded 

to 4,491 revenue estimate requests.

In addition to these tangible measures of improvements in the revenue estimating 

process, the Joint Committee staff incorporates methodological and technological advances in 

the study of economics and public finance to further improve the reliability of its revenue 

estimates. For example, the Joint Committee staff has improved its individual tax model by 

using a new extrapolation technique based on linear programming that allows for a more precise 

targeting of future levels of specific variables. This improvement gives the Joint Committee 

staff better ability to match present-law baseline projections provided by the CBO, which is 

especially useful in analyzing the out-year effects of a proposal.

Behavioral effects
4

The extent to which behavioral effects are taken into account in calculating the revenue 

effects of proposed tax legislation seems to cause the greatest confusion concerning the revenue 

estimating process. Commentators from time to time incorrectly argue that revenue estimates 

under existing methodologies are static and fail to incorporate behavioral effects. It is important 

to understand the differences between the significant behavioral effects that are taken into 

account under the current revenue estimating methodologies employed by the Joint Committee 

staff and potential macroeconomic effects.

One of the most significant elements of Joint Committee staff revenue estimates is the 

assumed effect of a proposal on taxpayer behavior. In general, a revenue estimate prepared for 

any proposal that changes the treatment of an item of expense or income, or the rate of tax on 

certain types of income or consumption, will incorporate behavioral effects. For example, some 

of the common behavioral effects include the following: excise tax increases are assumed to 

result in lower sales of the taxed items; a reduction in the taxation of sales of capital assets is 

assumed to increase capital gains realizations; temporary tax cuts are assumed to accelerate some 

affected taxable transactions; temporary tax increases are assumed to delay some affected taxable 

transactions; and changes in individual income tax rates are assumed to affect portfolio 

management decisions. The estimates may also assume that employment and investment may 

shift among sectors or industries, depending on the nature of the tax proposal. In this sense, Joint 

Committee revenue estimates are not static, but incorporate many microeconomic behavioral 

effects. However, under existing revenue estimating methodologies, revenue estimates do not 

incorporate possible effects of tax law changes on economic aggregates such as gross domestic 

product and gross national product (i.e., macroeconomic effects).

III. MACROECONOMIC EFFECTS OF TAX LAW CHANGES

It is generally agreed that certain major tax proposals, such as a proposal to eliminate the 

Federal income tax and replace it with a consumption tax, would not only affect Federal tax 

receipts, but would also affect certain macroeconomic aggregates, such as gross domestic 

product. Certain changes in tax policy may be expected, and in some cases may be designed, to 

affect the strength or growth of the national economy. For such proposals, a standard revenue 

estimate may not convey the complete picture of the long-term budgetary impacts of the 

proposal. The Joint Committee staff has been working to analyze the feasibility of incorporating 

both the long-term growth and short-term cyclical effects of such proposals so that additional 

analysis of potential macroeconomic effects can be provided along with the revenue estimates of 

these proposals.

A. History of Joint Committee Staff Work on Macroeconomic Modeling

In January 1995, the Joint Committee staff testified before a joint hearing of the House 

and Senate Budget Committees on the revenue estimating process. In that testimony,3 the Joint 

Committee staff discussed some of the issues that arise in considering whether to modify the 

revenue estimating methodology to take into account macroeconomic effects. The consensus of 

 

3

 Joint Committee on Taxation, Written Testimony of the Staff of the Joint Committee on 

Taxation Regarding the Revenue Estimating Process (JCX-1-95), January 9, 1995.
5

the expert economists who testified at the hearing was that economists had not yet developed 

models of the economy that could predict the timing and magnitude of macroeconomic effects 

with sufficient accuracy to justify including them in revenue estimates.

In 1996, the Joint Committee staff convened a group of macroeconomic modelers who 

had used forecasting or simulation models of the U.S. economy to predict the macroeconomic 

effects of major tax reform. The group was asked to work together on a modeling experiment 

that would help the Joint Committee staff to identify the sources of variation in their predictions, 

as well as the strengths of each type of model. This experiment required all of the modelers to 

start with the same present-law baseline forecast of the economy, and to estimate the same tax 

reform proposals. The results spanned a wide range of outcomes. They were made public in a 

symposium held in January 1997.4

All of the models used in the 1996 study projected that tax restructuring in the form of a 

consumption tax ultimately would produce higher economic growth. However, the models 

produced considerable variation in the magnitude and time path of the growth effects. The 

variations in the responses arose from both major structural differences in the models and from 

differences in assumptions about key behavioral parameters.

Some significant factors that explained the differences in modeling results were 

attributable to assumptions about the strength of behavioral responses to tax incentives, the 

operations of international financial markets, and the actions of the Federal Reserve Board. Each 

of these factors significantly influenced the outcomes predicted by the different models. Several 

less obvious, but equally important factors, also contributed to the differences in model 

predictions. Because the present-law tax Code is quite complex, the modeling of the present-law 

tax system was quite different among the models. As a result, the estimation of the magnitude of 

tax-induced changes in after-tax investment returns and after-tax wage rates, which are the major 

factors that influence taxpayer behavior, varied significantly among the models. In addition, 

certain structural features of the different models that were chosen to facilitate the mathematical 

solutions of the models significantly affected the predicted outcomes of certain types of tax 

policy. Finally, each variation in the tax reform proposal being analyzed required weeks of new 

modeling effort to accommodate a reasonably accurate representation of that change.

Since the 1997 symposium, the Joint Committee staff (1) has worked to develop a model 

that could be used in conjunction with detailed tax return data to provide accurate estimates of 

the effects of specific tax proposals on different groups of taxpayers (the model is discussed in 

more detail below); (2) has conducted a review of existing empirical studies that have estimated 

the size of behavioral responses to tax policy changes; and (3) is in the process of testing the 

basic structure and performance of the Joint Committee staff model.

The significant challenge in developing a macroeconomic model is to keep the solution 

mechanisms of the basic macroeconomic model flexible enough to allow for the analysis of 

 

4

 The models, the proposals, and the results are summarized in Joint Committee on 

Taxation, Joint Committee on Taxation Tax Modeling Project and 1997 Tax Symposium Papers 

(JCS-21-97), November 20, 1997.
6

several versions of a tax proposal without major recalibration of the model. In addition, the 

model must be capable of utilizing input from the Joint Committee microsimulation tax models 

to provide the necessary detail to simulate tax policy proposals within the macroeconomic 

models. As explained below, the Joint Committee staff has devoted much effort to creating 

analytic links between Joint Committee microsimulation tax models and the Joint Committee 

macroeconomic model.

The Joint Committee staff review of existing empirical studies has focused in particular

on studies that provide behavioral information about specific types of taxpayers, so that 

appropriate behavioral assumptions can be applied to each group. The two main growth-related 

responses that have been estimated by multiple studies, and that are explicitly built into the Joint 

Committee macroeconomic model, are the decisions by individuals to work more or less, and the 

decisions by businesses to invest more or less in response to changes in tax policy. In addition, 

the decision to consume or save, which affects both short-run demand fluctuations and long-term 

capital growth, is an important behavioral parameter that has been the subject of much study. 

The Joint Committee staff has attempted to identify near-consensus assumptions and to use those 

in its modeling efforts.

Finally, the Joint Committee staff has been testing the basic structure and performance of 

the Joint Committee macroeconomic model by simulating different large tax policy changes, 

varying key underlying solution equations and behavioral assumptions, and analyzing the results 

for internal inconsistencies and sensitivity to different assumptions. Several important issues 

remain to be addressed including the appropriate modeling of the policy of the Federal Reserve 

Board and international capital flows. These two issues can cause large swings in short-run 

economic activity and, therefore, the uncertainties surrounding their appropriate treatment lead to 

a high level of uncertainty in short-run forecasts.

B. Description of Macroeconomic Models Available to the Joint Committee Staff

The Joint Committee staff is developing an in-house model for use in analyzing the 

macroeconomic effects of tax proposals. This model, the macroeconomic equilibrium growth 

(“MEG”) model, is a computational equilibrium model with neoclassical foundations that can be 

used to analyze both long-run growth effects and short-run disequilibrium adjustments resulting 

from proposed tax changes. The Joint Committee staff also subscribes to two commercially 

marketed econometric models and has access to an intertemporal general equilibrium model with 

overlapping generations and forward looking agents.5

It is important to note that each of the models described below is well designed to 

examine a set of the issues that are critical to understanding the effects of tax policy changes, but 

none of the models is designed to address all of the issues that arise in the macroeconomic 

analysis of tax policy changes. For this reason, the Joint Committee staff employs a variety of 

 

5

 These models are the Washington University Macroeconomic Model (“WUMM”), 

provided by Macroeconomic Advisers, Inc, and the DRI econometric model, formerly provided 

by Standard and Poors, Inc., but now provided by Global Insight Inc.
7

models to gain an understanding of the contributions and limits of current state of the art 

macroeconomic modeling in tax policy analysis.

Macroeconomic Equilibrium Growth (“MEG”) Model

The MEG model has been developed with the help of an outside contractor. The MEG 

model has the following features: (1) a neoclassical growth foundation in which long-run 

economic growth is determined by labor supply, investment and savings, and total factor 

productivity growth; (2) a tax sector calibrated to the Joint Committee staff’s microsimulation 

models of the Federal tax system; and (3) a flexible structure that facilitates running simulations 

in several different equilibrium modes and to allow short-run disequilibrium adjustments in 

response to changes in fiscal policy. 

Labor supply is determined by taxpayer responses to changes in the average and marginal 

after-tax wage rates, and by general demographic trends. Capital resources are determined by 

the stock of undepreciated capital from previous periods plus investment in the current period. 

Total investment is determined by the responses of domestic savings and international capital 

flows to tax changes. The amount of domestic investment in the current period is responsive to 

proposed tax changes through the effect of the changes on the after-tax rate of return on 

investment. The amount of international investment is responsive to changes in demand for 

imports. The Joint Committee staff uses its microsimulation individual and corporate income tax 

models to determine the effects of a tax proposal on changes in effective and marginal tax rates 

on the following sources of income: wages, dividends, interest, rent, and capital gains. This 

information is used as input into the behavioral equations in the MEG model. Behavioral 

parameters in these equations are drawn from empirical economic literature.

The MEG model is designed to simulate the transition path to the long run equilibrium in 

the economy using several different solution methods. Equilibrium solution methods require that 

all markets clear during each period in the transition from the initial steady state to the new long 

run steady state. Equilibrium solutions for simulations of changes in tax policy require 

mechanisms to negate any changes in aggregate demand that the tax change could be expected to 

stimulate. One such mechanism is to model an “omniscient” Federal Reserve monetary policy, 

which changes interest rates each period to offset changes in demand. Another such mechanism 

is to balance any net change in tax revenues with an offsetting lump sum change in government 

expenditure (set at levels designed to neutralize the “balanced budget” multiplier effect). These 

two equilibrium approaches yield different implications for the interim growth effects of a given 

tax proposal. A third approach requires the model to use “potential” output rather than actual 

output in deriving investment responses to tax changes, which mitigates the short-run 

disequilibrium movements of variables in the model, and thus can be used to isolate supply side 

growth effects.

The MEG model can also simulate the transition path to the new long run equilibrium 

using a short run disequilibrium system that converges to a long run equilibrium that is 

consistent with neoclassical growth theory. A lag structure is in place for most of the behavioral 

decisions so that movements toward desired levels of investment, labor supply, and output take 

place over periods of several quarters. Several different Federal Reserve monetary reaction 

functions can be incorporated into these disequilibrium simulations. In addition to providing 
8

information on the range of short run responses the economy may have to specific tax proposals, 

this analytic framework is useful for comparing MEG results to results from commercial 

econometric models.

As part of the Joint Committee’s ongoing work to refine the MEG model, the Joint 

Committee staff has used the model to simulate the effects of various tax proposals to analyze 

the model’s performance. These simulations have revealed areas in which the model has needed 

substantial alteration. As a result, the MEG model is still in development in a number of areas. 

The Joint Committee staff is in the process of expanding the number of labor supply and 

investment income equations in the MEG model in order to improve the linkages between this 

model and the detailed microsimulation models used by the Joint Committee staff. Measures of 

taxpayer response to tax changes within the MEG model continue to be the subject of substantial 

scrutiny and ongoing research. There is also substantial uncertainty as to the appropriate 

modeling of monetary policy of the Federal Reserve Board and the likely responsiveness of 

international capital markets to U.S. tax changes.

Intertemporal model

The Joint Committee staff has access to an intertemporal general equilibrium model with 

forward looking agents (that is, consumers and firm managers who make decisions based on 

their expectations about the future). Individual behavior is modeled using an overlapping 

generations framework that consists of fifty-five cohorts, denoted by ages that range from zero to 

54, as the model’s individual life span is known (with certainty) to be 55 years. Each generation 

is represented by a single individual, who has an economic life span of fifty-five years, works for 

the first forty-five of those years, and is retired for the last ten. Consistent with the life-cycle 

theory, the model assumes that individuals borrow money in the early years of life, pay back 

their debts and save for retirement in their prime working years, and draw down their savings 

during retirement. Under this theory, an individual’s lifetime consumption path is flatter than his 

lifetime earnings pattern. In addition, the model includes the following features: tax deferred 

savings, a simple bequest motive, a model of the Social Security system, payroll taxes, and 

progressive tax rates on wages. The income tax is modeled as a progressive tax on labor income 

coupled with flat rate taxes on capital income. Capital income is taxed at flat rates on dividends, 

on interest, and on capital gains. The tax rate on capital gains is an effective annual accrual rate, 

taking into account the benefits of deferral of tax until gains are realized and tax exemption of 

gains transferred at death.

On the production side, the model assumes that firm managers act to maximize the value 

of the firm in a perfectly competitive environment in the absence of uncertainty. The approach 

utilized is based on Tobin's “q” theory of investment, as extended to include adjustment costs.6 

It is similar to the firm modeling approaches used by several others.7 The economy has a single 

 

6

 Hayashi, F., “Tobin’s Marginal q and Average q: A Neoclassical Interpretation,” 

Econometrica 50 (1982), pp. 213-224.

7

 See, for example, Auerbach, A. and Kotlikoff, L. (1987). Dynamic Fiscal Policy, 

Cambridge, MA: Harvard University Press; and Goulder, L. and Summers, L., “Tax Policy, 

Asset Prices, and Growth,” 39 Journal of Public Economics (1989), pp. 265-296.
9

production sector in which firm values are calculated explicitly. Firms finance new investment 

through retained earnings, issuing debt and issuing new shares of equity. Firms pay dividends 

equal to constant fraction of after-tax profits net of economic depreciation, and new debt issues 

are a constant fraction of net investment. For tax purposes firms are allowed to depreciate 

capital more rapidly than the economic rate of depreciation. The model distinguishes between 

the present value of depreciation deductions on existing and future capital. In addition, the 

model includes a quadratic adjustment cost function that increases the cost of investing in and 

installing new capital goods.

The model assumes that the resources in the economy are fully employed in each year 

and therefore does not account for short-run disequilibria (i.e., cyclical movements in the 

economy) in the markets for labor, capital, or other goods that would occur during transition 

periods.

Other models

The Joint Committee staff subscribes to two commercially available macroeconomic 

models (WUMM and DRI) to provide a range of possible transition scenarios in analyzing the 

effects of proposed tax changes. The models simulate the effects of proposals assuming different 

Federal Reserve Board and international responses. Because of the uncertainty inherent in 

making such assumptions, these types of simulations are best used to provide information about 

the possible range of outcomes and the degree of sensitivity of the estimated ranges to the 

assumptions used. A general description of the WUMM model is provided in the following 

paragraphs. The DRI model is similar to the WUMM model.

WUMM is a large-scale structural macroeconometric model. In the long run, the 

equilibrium is determined by equations that are derived from neoclassical microeconomic 

foundations. The long-run level of output depends on prevailing tax rates since long-run output 

is determined by the stock of capital and labor supply and households and firms decisions 

depend explicitly on after-tax prices and rates of return. In the short run, the resources in the 

economy are less than fully employed as prices and wages adjust slowly to their equilibrium 

values. Model parameters and behavioral responses are estimated using post-war quarterly data.

WUMM’s consumption function is based on the life-cycle theory of consumption. 

Consumer spending depends on the average age of the consuming population, labor income, 

asset income, transfer payments and net worth. Business fixed investment in equipment and 

structures is derived using the neoclassical theory developed by Jorgenson. The demand for 

capital is derived from a production function with a unitary elasticity of substitution between 

labor and capital. Housing demand depends on demographics, disposable income, and the user 

cost of housing. The real exchange rate and the relative price of domestic and foreign goods 

determine net exports. Government spending is exogenous except for interest payments on the 

national debt.

In general, the price level is modeled as a markup over smoothed labor costs. In the short 

run, the markup equation and the relationship between unemployment and inflation determine 

prices. In the short run, the real interest rate is determined by the supply and demand for money 
10

or by a function that describes the Federal Reserve Board’s monetary policy. In the long run, the 

real interest rate is equal to the value that equates savings and investment.

C. Issues and Problems With the Use of Macroeconomic Analysis in Revenue Estimates

While substantial progress has been made to develop a model that will assess the 

potential macroeconomic effects of tax law changes, difficult problems remain to be solved. In 

theory, the incorporation of macroeconomic feedback effects in revenue estimates would provide 

year-by-year estimates of changes in revenues resulting from the influence of tax policy on 

national economic aggregates like business profits, wages and interest rates. However, to 

achieve this goal would require the modeling of the effects of tax policy changes to decide on a 

single set of assumptions with respect to (1) the effects of short-run, or business cycle, 

fluctuations in the economy, (2) changes in Federal Reserve Board policies, (3) the reactions of 

international capital markets, and (4) budgetary scoring conventions on the expenditure side. As 

detailed below, these issues present significant challenges that remain to be resolved.

1. Sources of uncertainty

Effects of business cycle fluctuations

Business cycle fluctuations lend uncertainty to any attempt to measure the 

macroeconomic effects of a tax change. A net cut in taxes should stimulate consumption and 

investment in the short-run, resulting in an increase in aggregate demand. The ultimate effect of 

this increase in demand on the economy will depend on facts such as whether resources in the 

economy would otherwise be in full use at the time of the tax reduction, on the response of the 

Federal Reserve Board to the policy, and on the responses of international capital flows. Shortrun fluctuations are also critical to accurate assessment of the effects of tax proposals on longterm growth, because of the interactions of these cyclical effects and the rate of business 

investment, which can affect the growth capacity of the economy for a period of years.

When the economy is doing very well, at a “peak” stage of the business cycle, virtually 

everyone who wants to be employed is already employed, and productive buildings and 

equipment are operating near capacity. Under these circumstances, domestic businesses would 

be unable to increase production significantly in response to a sudden increase in demand such as 

would be created by a large net tax cut. When demand for goods and services increases more 

rapidly than the supply of goods and services, a potentially inflationary situation exists. Any 

apparent growth in output of the economy (as measured by the dollars spent on goods and 

services or dollars received as income) is likely to be primarily from a growth in prices, rather 

than in real production. In contrast, if the economy is slowing down, nearing the “trough” of a 

business cycle, unemployed people and under-used productive capacity will be available to 

respond to increases in demand with increases in supply. In this situation, less inflationary 

pressure exists, and growth in output is likely to reflect an actual increase in economic activity. 

Although in both cases the increase in demand would be likely to result in a temporary increase 

in tax receipts for the Federal government, this distinction between inflationary and real growth 

is important from a budgetary “scoring” standpoint. In the first case, the costs faced by the 

government to provide the same level of services will also increase due to inflation, resulting in 

possibly no net improvement of the Federal government’s fiscal situation. In the second case, a 
11

temporary increase in real economic activity could generate additional revenues without 

generating additional costs, thus improving the net fiscal position of the Federal government.

Assessing whether or not the economy will be operating near a peak in the business cycle 

at the time a proposed tax cut is actually enacted and the tax savings in the hands of the 

taxpayers is a notoriously uncertain task. Because economic forecasting models generally rely 

most heavily on the more recent characteristics of the economy, they are not well suited to 

predicting the exact timing of a change in the direction of the economy.

Actions of the Federal Reserve Board and international capital flows

Another major source of uncertainty is the reaction of the Federal Reserve Board to fiscal 

policy changes. If the Federal Reserve Board believes there is a significant risk of inflation 

associated with an expansionary fiscal policy, then it may raise interest rates to reduce the risk of 

inflation. An increase in interest rates reduces consumer purchases of durable goods and 

business investment, and thus would slow the growth of the economy. In addition, since the 

exchange rate and the U.S. interest rate are positively related, an increase in the interest rate 

would reduce net exports. This occurs because an increase in the exchange rate makes U.S. 

goods relatively more expensive to foreigners and imports relatively cheaper to consumers in the 

United States. These reductions counter-act the growth effects of an expansionary fiscal policy 

and thus could render dynamic revenue estimates less reliable if the Federal Reserve Board’s 

actions are not predicted accurately. Existing macroeconomic models use an array of monetary 

policy rules to describe the actions of the Federal Reserve Board; however, there is no way to be 

certain of how the Federal Reserve Board will act in the future. Furthermore, there is an 

unknown lag associated with monetary or fiscal policy that contributes to the uncertainty of 

determining how the Federal Reserve Board actions would affect the path of the economy.

It is also unclear how international capital markets will react to either a change in tax 

policy or a change in Federal Reserve Board policy. Some macroeconomic models assume that 

an increase in the returns on business investment will induce increased international as well as 

domestic investment, and some do not. The amount of international investment induced by a tax 

change can affect the amount of total investment, the size of the capital stock and net economic 

growth it induces. The independent actions of the Federal Reserve Board and foreign banks 

introduce a high degree of uncertainty in macroeconomic forecasting. It is unclear at this time 

that there is any way to reduce these sources of uncertainty through modeling improvements and, 

therefore, to make accurate year-by-year macroeconomic predictions.

Effects of changes in the Federal budget deficit on the interest rate

Conventional economic theory suggests that a relationship exists between interest rates 

and the size of the Federal deficit, through its potential effect on the supply of loanable funds. 

Specifically, conventional economic theory predicts that an increase (decrease) in the Federal 

budget deficit would decrease (increase) the supply of loanable funds, causing an increase 

(decrease) in interest rates, and thus, decrease (increase) consumer purchases of durable goods 

and business investment. This relationship between the size of the Federal deficit and the 

interest rate implies that larger budget deficits would be associated with a smaller stock of capital 

and a lower rate of growth in the economy. Changes in the pattern of business capital 
12

accumulation can affect the economy’s growth capacity for a sustained period of time. This 

effect would tend to offset positive economic growth induced by the positive behavioral 

incentives in some tax cuts.

However, even though this view is considered the conventional theory in the economic 

literature, a less widely held, but nonetheless important, view of the economy questions the 

validity of the conventional theory. The empirical literature on this subject fails to provide 

conclusive evidence supporting either view.8 The relationship between changing Federal 

government deficits and the interest rate is commonly included in structural macroeconometric 

models that focus on short run forecasting. It is usually not included in general equilibrium 

simulation models, which typically assume “balanced budget” tax changes to simplify model

solutions. This inconsistency between classes of models makes efforts to isolate “supply side” 

effects from general macroeconomic effects an important component of dynamic analysis.

Sensitivity of results to behavioral assumptions and model structure

The effects of tax policy changes on the long-term growth of the economy depend on 

how the tax policy affects after-tax returns to labor and capital, and on how the suppliers of this 

labor and capital respond to these changes. The way a model treats costs of labor and capital 

varies significantly across different types of models. Some models incorporate these effects 

through simple elasticities incorporated in labor supply, savings, and investment equations. In 

other models, these responses are embedded within more complex sets of equations that attempt 

to capture multiple feedback interactions between labor, capital, consumers, and financial 

markets. In either case, the results generated can vary significantly depending on the parameters 

selected and the functional forms and solution criteria for the equations used. While empirical 

studies provide some information about reasonable ranges and assumptions for some of these 

assumptions, there are many different views as to which approach is the “most correct.”

2. Small magnitude of macroeconomic effects of most proposals

Most revenue proposals are likely to have little or no macroeconomic consequences since 

many of these proposals are of limited scope or represent changes that are subject to modest or 

offsetting influences from a macroeconomic perspective. For example, a proposal to encourage 

investment in a targeted area may simply shift investment away from alternative areas in the 

economy. Such a shift may achieve the desired effect within the targeted area, but may not have 

a net effect on the economy as a whole.

Revenue proposals also may be subject to opposing incentive effects. For example, a 

reduction in marginal tax rates will increase the after-tax return on additional labor and saving 

and thereby encourage additional work and savings effort. However, a reduction in marginal tax 

rates is typically accompanied by an increase in after-tax income as well. This “income effect” 

tends to work in the opposite direction from the positive incentive effects, lessening the need to 

work or save to achieve a desired level of consumption. The net effect depends upon the relative 

 

8

 For more on this issue see Elmendorf, D. and Mankiw, N. Gregory, “Government 

Debt,” National Bureau of Economic Research Working Paper 6470 (1998).
13

importance of these two potentially offsetting factors and the relative sensitivity to the two 

factors among affected taxpayers.

Other proposals, such as cuts in capital gains taxes and accelerated depreciation, that 

increase the after-tax profitability of business investment, may be expected to affect the long-run 

growth of the economy through a build up in the amount of productive plant and equipment. 

However, it is likely that this capital build up will develop gradually, with most of the budgetary 

consequences occurring outside the near-term budget horizon. Even a ten-year forecasting 

period may not be long enough for the full effects of increased productivity resulting from 

increased capital to be fully manifested.

3. Baseline assumptions

The reference point for Joint Committee revenue estimates is the CBO ten-year 

projection of Federal receipts, referred to as the revenue baseline.9 The revenue baseline serves 

as the benchmark for measuring the effects of proposed law changes. The baseline assumes that 

present law remains unchanged during the ten-year budget period. Thus, the revenue baseline is 

an estimate of the Federal revenues that will be collected over the next ten years in the absence 

of statutory changes.

The revenue baseline is based upon CBO forecasts of macroeconomic variables such as 

the annual rate of growth of nominal gross domestic product, inflation rates, interest rates, and 

employment levels.10 For modeling purposes, a number of elements of the CBO forecast are 

disaggregated to match specific tax-related variables. For example, the aggregate forecast of 

wages and salaries paid is statistically matched to various types of taxpayers by income class.

Some argue against using the present-law revenue and expenditure baselines as the 

benchmark for measuring the effects of proposed law changes on the grounds that changes in 

revenues may have an induced effect on government spending behavior. They suggest that the 

effects of a proposed tax cut should be measured relative to the effects of an offsetting 

expenditure change, rather than relative to present law. However, the public availability of the 

present-law baseline is an important feature of the current revenue estimating process that may 

be more difficult to achieve if some other reference point were adopted; it serves as an objective 

and observable reference point for measuring all budget proposals, including spending proposals.

4. Budget symmetry

The argument in favor of providing macroeconomic analysis for certain revenue 

proposals is essentially an argument in favor of expanding the scope and accuracy of the 

information used in the budget process. This argument, however, is not limited either to the 

 

9

 The revenue baseline is a component of the budget baseline prepared by the CBO, 

which includes expenditures as well as receipts.

10 For a detailed discussion of the methodologies employed by the CBO to forecast 

Federal revenues, see Congressional Budget Office, Description of CBO’s Models and Methods 

for Projecting Federal Revenues, May 2001.
14

revenue effects of a tax proposal, or to proposals affecting revenues. The most direct example of 

the desirability of including some outlay analysis is the relationship between net changes in tax 

revenues and Federal debt service expenses. A proposed tax increase that would result in a net 

reduction in the deficit would also result in a net reduction in public debt. The decrease in public 

debt would result in a reduction in Federal outlays to service the debt.

Many argue that direct changes in some Federal spending programs should be subjected 

to macroeconomic feedback analysis. A proposal that would expand the nation’s infrastructure, 

or improve education, can have similar macroeconomic effects to revenue proposals. Providing

macroeconomic analysis on the revenue side of the budget, but not developing similar analysis 

on the outlay side of the budget, raises the possibility of biasing the consideration of competing 

revenue and outlay proposals.

The capacity of macroeconomic analysis to expand the scope and accuracy of revenue 

analysis has been debated over a period of years and remains a subject of controversy. This 

controversy also applies to the feedback effects of outlay proposals. Although the general 

implications of certain improvements to public infrastructure on national production are clear in 

theory, efforts to quantify these implications are problematic.

5. Coordination with CBO baseline and budget reconciliation analysis

To the extent that macroeconomic feedback effects would eventually be incorporated into 

revenue estimates for budget scoring purposes, issues of consistency and coordination may arise. 

For example, the effects of a tax cut on changes in Federal debt service expenses may be 

incorporated in the reconciliation process itself, through the budget projections provided by the 

CBO. These net budget effects can extend beyond the mechanical change in debt service to 

underlying effects on national savings, interest rates, and private capital formation. This was the 

case, for example, in the 1997 Deficit Reduction Act, for which CBO estimated an explicit net 

budget effect attributed to moving the budget onto balanced budget path. The fact that the 

scoring of tax legislation may differ from proposal to proposal depending on the manner in 

which policy initiatives are considered raises possibility of including inconsistent, or doublecounted general fiscal effects. In addition, it would be problematic for the scoring of revenue 

proposals to incorporate these short-run macroeconomic feedback effects if scoring of 

expenditure proposals does not include them as well. An important component of the 

development of Joint Committee’s macroeconomic analysis of revenue proposals is coordination 

with CBO’s budget scoring. Coordination between the Joint Committee staff and the CBO staff 

would be necessary.

IV. CONCLUSION

Summary of significant issues

The Joint Committee staff has made substantial progress since 1995 in the development 

of a macroeconomic model that would analyze the potential effects on the economy of a major 

change in tax policy. The Joint Committee staff has also obtained several other types of 

macroeconomic models to insure that a wide variety of tools would be available to analyze 

changes in tax policy.
15

An important point to keep in mind is that the vast majority of the revenue estimates 

produced by the Joint Committee staff each year relate to relatively narrow or modest changes in 

Federal tax laws. Such changes would not be expected to have any measurable effect on the 

economy. In addition, some major tax legislation may have proposals with opposing incentive 

effects so that the net effect of the legislation on the economy may be quite small. Thus, for the 

vast majority of Joint Committee revenue estimates, no measurable macroeconomic effects 

would be identified.

Revenue estimates are provided, under the existing budget rules, for a relatively short 

time period (at most 10 years). Forecasting the timing and magnitude of the effects of a change 

in tax policy on the economy is the aspect of macroeconomic modeling that is associated with 

the greatest amount of uncertainty. There are a variety of issues giving rise to this uncertainty 

and each issue raises serious problems with respect to the reliability of estimates of the timing 

and magnitude of any potential macroeconomic effect. The validity and utility of any estimates 

of macroeconomic effects remain subject to question until these issues are addressed.

The major issues that remain to be resolved can be summarized as follows:

(1) Predicting the effects of business cycle fluctuations.--One of the most difficult 

aspects of economic modeling is the prediction of when the economy is likely to 

change direction, either to slow down during a period of growth, or to begin 

recovering during a period of recession. The effect of a tax change on real, nearterm economic growth depends on the state of the economy at the time of the 

change. If the economy is near capacity, inflationary pressures may reduce the 

net positive effect of tax changes on the economy.

(2) Predicting the potential response of the Federal Reserve Board to fiscal policy 

changes.--The Federal Reserve Board’s policies on interest rates affect the rate of 

growth of the economy and, thus, affect the potential macroeconomic effects of a 

major tax policy change. Absent some definitive information, such as a statement 

from the Federal Reserve Board with respect to its expected policies, it is 

impossible to predict with any precision how the Federal Reserve Board will react 

to a change in tax policy. It could be assumed that there would be no change in 

Federal Reserve Board policies, but such an assumption would undoubtedly be 

incorrect. Within the budget forecasting period, such effects can overwhelm any 

impacts on long-term growth that might result from a particular policy change.

(3) Predicting how the macroeconomic effects of tax policy changes would influence 

different types of individual and corporate income and international capital 

flows.--The predicted size of the effects of any given proposal on individual and 

corporate income and international capital flows can vary significantly depending 

on the structure of the model and various assumptions about the strength of 

behavioral responses built into the model. Ultimately, the importance of these 

types of responses would have to be determined from existing empirical economic 

evidence. The Joint Committee staff is continuing to enhance these components of 

the MEG model, and to experiment with other modeling approaches.
16

(4) Sensitivity of results to behavioral assumptions and model structure.--The effects 

of tax policy changes on the long-term growth of the economy depend on how the 

tax policy affects after-tax returns to labor and capital, and on how the suppliers 

of this labor and capital respond to these changes. The way a model treats costs 

of labor and capital varies significantly across different types of models and can 

result in significant disparities in the results.

(5) Consistency of treatment between revenue and spending proposals.--If 

macroeconomic effects are accounted for with respect to revenue proposals, it can 

be argued that a similar approach is necessary with respect to spending proposals. 

If the issues of consistency of treatment for Federal budget scorekeeping purposes 

are not addressed, then two equivalent policies would have different projected 

effects on the economy depending upon whether the policies were achieved 

through the tax system or through Federal spending. It would be necessary to 

coordinate with the CBO staff to address these possible issues of consistency.

Future plans

The goal of the Joint Committee staff efforts is to improve the quality and accuracy of the 

revenue estimating process. Because of the sources of uncertainty and differences in modeling 

outlook with respect to the issues that have been identified, Ways and Means Chairman Bill 

Thomas and the Joint Committee staff have invited a “blue ribbon” panel of macroeconomic 

modeling experts to review the Joint Committee’s work and make suggestions both for modeling 

improvements and for the type of information that should be included in these analyses.

In the near term, the objective of the Joint Committee macroeconomic modeling project 

is to provide background information about the range of likely economic feedback effects of 

major tax proposals, including an explanation of the areas of greater and lesser uncertainty. The 

Joint Committee staff has identified several areas for improving modeling capacity, particularly 

in improving the links between the Joint Committee microeconomic tax simulation models and 

macroeconomic models. Work is underway on several specific enhancements to labor supply 

and consumption modeling within the MEG model to improve this linkage.

In addition, the Joint Committee staff is in the process of soliciting input from other 

macroeconomic modeling groups on the MEG model and suggestions for future directions for 

modeling improvement. This process would include discussions with the CBO on baseline 

assumptions and appropriate expenditure interactions. Another component of this process will 

involve producing a series of working papers describing key technical features of the MEG 

model and using the model to estimate the longer-run macroeconomic growth effects of several 

types of tax proposals. The papers will be circulated to other tax and macroeconomists for 

purposes of stimulating discussion on the validity of the Joint Committee analysis, which will be 

used to inform further refinements to the model.

In the near future, the Joint Committee staff expect to be able to produce comparative 

analyses of the long-term growth and associated revenue feedback effects of major tax proposals, 

and to attach “macroeconomic feedback notes” containing this analysis to revenue estimates of 

those proposals for which such a note is clearly indicated. This analysis would include a 
17

description of the major assumptions used to produce the analysis, as well as a discussion of the 

degree of certainty associated with the results.

Conclusion

It is important to reiterate a point that was made at the beginning of this testimony. The 

revenue estimating process should provide Members with consistently accurate estimates of their 

proposals. The difficult issues presented in developing the ability to incorporate macroeconomic 

effects in revenue estimates should not be minimized. While the Joint Committee staff remains 

committed to improving the revenue estimating process by assessing the potential 

macroeconomic effects of major tax legislation, these issues must be addressed in a manner that 

is accepted by expert economists. To do otherwise would undermine the integrity of the revenue 

estimating process and could reduce, rather than enhance, the accuracy of the Joint Committee 

staff revenue estimates.
18

Attachment A -- Selected List of Revenue Estimating Methodological Publications

of the Joint Committee on Taxation (1990-2001)

Joint Committee on Taxation, Explanation of Methodology Used to Estimate Proposals 

Affecting The Taxation of Income From Capital Gains (JCS-12-90), March 27, 1990.

Joint Committee on Taxation, Tax Policy and the Macroeconomy: Stabilization, Growth, and 

Income Distribution Scheduled for Hearings Before the House Committee on Ways and Means 

on December 17-18, 1991 (JCS-18-91), December 12, 1991.

Joint Committee on Taxation, Discussion of Revenue Estimation Methodology and Process 

(JCS-14-92), August 13, 1992.

Joint Committee on Taxation, Discussion of Revenue Estimation Methodology and Process

(JCX-31-92), August 4, 1992.

Joint Committee on Taxation, Methodology and Issues in Measuring Changes in the Distribution 

of Tax Burdens (JCS-7-93), June 14, 1993.

Joint Committee on Taxation, Written Testimony of the Staff of The Joint Committee on Taxation 

Regarding the Revenue Estimating Process for the Joint Hearing of the House and Senate 

Budget Committees of the 104th Congress on January 10, 1995 (JCX-1-95), January 9, 1995.

Joint Committee on Taxation, Methodology and Issues in the Revenue Estimating Process 

Scheduled for a Hearing Before the Senate Committee on Finance on January 24, 1995 (JCX-2-

95), January 23, 1995.

Joint Committee on Taxation, Membership of the Joint Committee on Taxation Revenue 

Estimating Advisory Board (JCX-29-95), June 29, 1995.

Joint Committee on Taxation, Description and Analysis of Tax Proposals Relating to Savings 

and Investment (Capital Gains, IRAs, and Estate and Gift Tax) Scheduled for a Public Hearing 

Before the House Committee on Ways and Means on March 19, 1997 (JCX-5-97), March 18, 

1997.

Joint Committee on Taxation, Joint Committee on Taxation Tax Modeling Project and 1997 Tax 

Symposium Papers (JCS-21-97), November 20, 1997.

Joint Committee on Taxation, Background Information Relating to the Joint Committee on 

Taxation (JCX-4-99), February 3, 1999.

Joint Committee on Taxation, Testimony of The Staff of The Joint Committee on Taxation Before 

the Committee on Ways and Means (JCX-82-99), November 10, 1999.
19

Joint Committee on Taxation, Appendix I to JCX-82-99: NIPA and Federal Income Tax Receipts 

Data (JCX-83-99), November 10, 1999.

Joint Committee on Taxation, Background Information Relating to the Joint Committee on 

Taxation (JCX-1-00), January 12, 2000.

Joint Committee on Taxation, Background Information Relating to the Joint Committee on 

Taxation (JCX-24-01), April 10, 2001.