Office of Tax Analysis 

U.S. Department of the Treasury 

A Dynamic Analysis of Permanent Extension 

of the President’s Tax Relief 

July 25, 2006 
i 

Executive Summary

This Report presents a detailed description of Treasury’s dynamic analysis of the President’s 

proposal to permanently extend the tax relief provisions enacted in 2001 and 2003 that are 

currently set to expire at the end of 2010. These enacted provisions include: 

• Lower tax rates on ordinary income; 

• Lower tax rates on dividends and capital gains; 

• A ten-percent individual income tax rate bracket; 

• Doubling of the child tax credit; and 

• Reducing marriage tax penalties. 

The purpose of the report is to provide a more in-depth, transparent understanding of dynamic 

analysis, while also illustrating the positive contributions the tax relief, together with spending 

reductions, can be expected to continue to make to the U.S. economy. In addition, the analysis 

shows the importance of making the tax provisions permanent for the U.S. economy’s long-term 

economic growth. 

Dynamic Analysis

Dynamic analysis goes beyond traditional analysis of tax policy by focusing on the broad 

economic effects in both the short and long term. Simply, dynamic analysis provides a more 

comprehensive and complete approach to analyzing tax policy by including its effects on the 

overall size of the economy and other major macroeconomic variables. The President’s FY 2007 

Budget proposes to create a division of dynamic analysis within the Department of Treasury’s 

Office of Tax Analysis. 

The Economic Benefits of Tax Relief

As evidenced by key economic indicators such as increased capital investment and Gross 

Domestic Product (GDP), and strong job growth, the President’s tax relief played an important 

role in strengthening the U.S. economy as it was coming out of the recent recession, and in the 

longer-term by increasing the after-tax rewards to work and saving. Lower tax rates enable 

workers to keep more of their earnings, which increases work effort and labor force 

participation. The lower tax rates also enable innovative and risk-taking entrepreneurs to keep 

more of what they earn, which further encourages their entrepreneurial activity. The lower tax 

rates on dividends and capital gains lower the cost of equity capital and reduce the tax biases 

against dividend payment, equity finance, and investment in the corporate sector. All of these 

policies increase incentives to work, save, and invest by reducing the distorting effects of taxes. 

Capital investment and labor productivity will thus be higher, which means higher output and 

living standards in the long run. 

Treasury has conducted its dynamic analysis using a model that accounts for the effects of this 

greater work effort, increase in savings and investment, and improved allocation of resources on 

the size of the economy. While this model captures many aspects of a modern economy and 

economic behavior, others are not reflected in the model. For example, the model assumes that 

resources are fully employed in the economy and that capital is only somewhat mobile 

internationally. These are areas for future development. 
ii 

Different Components of Tax Relief Have Different Effects on the Economy

Treasury’s dynamic analysis of the President’s tax relief indicates that making the tax relief 

permanent can be expected to increase the level of annual output (i.e., national income) 

ultimately by about 0.7 percent. The analysis also shows separately the effects of the President’s 

tax relief in three parts reflecting: 1) the lower tax rates on dividends and capital gains; 2) the 

lower tax rates on ordinary income (i.e., the top four rate brackets); and 3) the 10-percent tax rate 

bracket, higher child tax credit, and marriage penalty relief. This decomposition reveals that 

these tax relief components are likely to have very different effects on future economic activity. 

For example, extending just the lower tax rates on dividends and capital gains increases output in 

the long run by 0.4 percent, but when the lower tax rates for the four top income tax brackets are 

extended as well, output increases by a total of 1.1 percent in the long run. 

Financing Tax Relief – Government Spending Reductions over Increased Tax Rates

The analysis reveals that the long-run effects of these policies depend crucially on whether they 

are financed by lower spending or higher taxes in the future and are sensitive to assumptions on 

underlying parameters. The issue of how, or even if, these policies need to be financed remains a 

source of discussion among economists. The analysis presented here suggests these policies will 

result in substantially more economic activity if they are financed by a future reduction in 

government spending than if they are financed by future tax increases. If the tax relief is 

financed by future tax increases – that is, if the aggregate amount of tax relief is temporary – 

then it may result in lower output in the long run. For that reason, the Administration has 

emphasized permanence for the tax relief and spending restraint in its Budgets. 
1 

A Dynamic Analysis of Permanent Extension of the President’s Tax Relief 

1. Introduction 

This Report presents a detailed description of Treasury’s dynamic analysis of the President’s 

proposal to permanently extend the tax relief provisions enacted in 2001 and 2003 that are 

currently set to expire at the end of 2010. These provisions include the lower tax rates on 

ordinary income, the lower tax rates on dividends and capital gains, the 10-percent individual 

income tax rate bracket, a doubling of the child tax credit, and a reduction in marriage tax 

penalties. 

Tax relief can be important when the economy is performing below its full potential, and can 

increase its potential in the longer term. In 2003, real GDP was below its potential level and the 

unemployment rate was elevated. The tax relief enacted in 2001 and 2003, together with 

reductions in short-term interest rates by the Federal Reserve, helped stimulate economic growth 

and move the economy out of the 2001 recession more quickly. Previous Treasury analysis 

using the Macroeconomic Advisers macro-econometric model estimated that without the tax 

relief passed in 2001, 2002, and 2003, as many as 3 million fewer jobs would have been created 

by the end of 2004 and real GDP would have been as much as 3.5 to 4.0 percent lower. 

Beyond this short-term economic stimulus, the President’s tax relief also helps encourage 

economic growth in the longer term by increasing the after-tax reward from work, saving, and 

investment. The lower tax rates enable workers to keep more of their earnings, which increases 

work effort and labor force participation. The lower tax rates also enable innovative and risktaking entrepreneurs to keep more of what they earn, which further encourages their 

entrepreneurial activity. The lower tax rates on dividends and capital gains lower the cost of 

equity capital and reduce the tax biases against dividend payment, equity finance, and investment 

in the corporate sector. All of these policies improve incentives for work, saving, and investment 

by reducing the distorting effects of taxes. Capital investment and labor productivity will thus be 

higher, which means higher output and living standards in the long run. 

The Treasury Department’s dynamic analysis relies on a model that takes into account the effects 

of work effort, increase in savings and investment, and improved allocation of resources on the 

size of the economy. The overlapping generations (OLG) general equilibrium model used for 

this analysis (described in detail in the appendix to this report) is structured to account for the 

effects of changes in the effective tax rate on capital and labor income and the consequent effects 

on economic growth. Representative consumers and firms incorporate future prices into their 

current period decisions of how much to save, work, and produce. Output is generated by four 

production sectors, and individual level decisions of representative consumers determine the 

aggregate level of labor supply and savings in each year. 

While this model captures many aspects of the economy and economic behavior, other aspects 

are not reflected in the model. For example, the model ignores cyclical disruptions in the 

employment of capital and labor, assuming instead that all resources in the economy are always 

fully employed. The model includes a relatively simple representation of international capital 

flows in which capital is only somewhat mobile internationally. There is no uncertainty in the 
2 

model and households and firms exhibit perfect foresight regarding future prices and tax rates. 

These are areas for future development. 

This analysis shows the likely economic effects of making the tax relief permanent. The results 

indicate that the level of annual output (i.e., national income) may ultimately be higher by 0.7 

percent because of the combined effects of the President’s tax relief. 

The analysis also shows separately the effects of the President’s tax relief in three parts 

reflecting: 1) the lower tax rates on dividends and capital gains; 2) the lower tax rates on 

ordinary income (i.e., the top four rate brackets); and 3) the 10-percent tax rate bracket, higher 

child tax credit, and marriage penalty relief. This decomposition reveals that the tax relief 

components are likely to have very different effects on future economic activity. For example, 

extending just the lower tax rates on dividends and capital gains increases output in the long run 

by 0.4 percent, but when the lower tax rates for the four top income tax brackets are extended as 

well, output increases by a total of 1.1 percent in the long run. Extending the remainder of the 

tax relief – the 10 percent rate, the expansion of the child tax credit, and the reduction in 

marriage penalties – stimulated economic activity during and immediately after the recession and 

served other purposes, such as making the tax code more progressive. However, these elements 

of the tax relief do not have positive growth effects in the longer term in ways that this type of 

model can measure. 

The analysis reveals that the long-run effects of these policies depend crucially on how they are 

eventually financed and are sensitive to assumptions on underlying parameters. The issue of 

how, or even if, these policies need to be financed remains a source of discussion among 

economists. The analysis presented here suggests these policies will result in substantially more 

economic activity if they are financed by a future reduction in government spending than if they 

are financed by future tax increases. If the tax relief is financed by future tax increases – that is, 

if the tax relief is temporary – it may well result in lower output in the long run. In effect, the 

temporary tax relief must be paid back with interest through future tax increases, which implies 

that future tax rates increase compared to current law. For that reason, the Administration has 

emphasized permanence for the tax relief and spending restraint in its Budgets. The sensitivity 

of the results to financing and parameter assumptions is described in detail below.

The remainder of this report is organized as follows. The next section describes previous work 

done by Treasury that estimated the short-run economic effects of the President’s tax relief. 

Section 3 describes the model used in the permanence analysis in greater detail. Section 4 

outlines the methodology employed in simulating the economic effects of extending the 2001 

and 2003 tax relief and discusses some of the limitations of the model. Section 5 describes and 

explains the results and the last section concludes. 

2. Effect of the President’s Tax Relief in the Near Term 

The focus of this Report is on the future economic effects of permanently extending the 

President’s tax relief. As described in the introduction, the model used for this analysis assumes 

that the economy is always performing at its potential. This assumption simplifies the model and 

allows for a more detailed representation of household labor supply and savings behavior in both 
3 

the near term and the long run. Yet this simplification implies the model used for this report is 

not able to capture the short-run stimulus that tax relief may provide when the economy is 

operating below potential. Such a situation existed when the President’s tax relief was passed in 

2001 and 2003; real GDP was below its potential level and the unemployment rate was elevated. 

The Treasury Department previously compared how the economy would have performed if there 

had been no tax relief using a different type of model that is designed to capture the interactions 

of economic sectors as the economy fluctuates around its potential growth path. These models 

attempt to account for changes in the level and growth of GDP, employment, inflation, and 

interest rates. Short-run changes in monetary and fiscal policies are important determinants of 

accelerations and deceleration of employment and output in these models. In this earlier 

analysis, the Treasury Department used the Macroeconomic Advisers macroeconometric model 

to estimate how the economy would have performed had there been no legislated fiscal stimulus 

from 2001 through 2004. This analysis found that the tax relief increased employment and 

output substantially above what would have occurred otherwise. 

Specifically, Treasury found that, without enactment of the Economic Growth and Tax Relief 

Reconciliation Act of 2001, the Job Creation and Worker Assistance Act of 2002, and the Jobs 

and Growth Tax Relief Reconciliation Act of 2003: (1) by the second quarter of 2003, the 

economy would have created as many as 1.5 million fewer jobs and GDP would have been as 

much as 2 percent lower, and (2) by the end of 2004, the economy would have created as many 

as 3 million fewer jobs and real GDP would be as much as 3.5 to 4.0 percent lower. 

Note that the analysis described in this section estimates the economic effects that the President’s 

tax relief has already had on the economy, assuming that interest rates followed the same path as 

they did historically from 2001 forward. The remainder of the paper discusses the likely future 

economic effects of making the President’s tax relief permanent. 

3. Model description 

For the remainder of the analysis in this Report, the Treasury Department used a conventional 

neoclassical growth model with overlapping generations of taxpayers developed by Tax Policy 

Advisers, LLC.1

 In this life-cycle model, tax policy affects the incentives to work, to save and 

invest, and to allocate capital among competing uses. Representative consumers and firms 

incorporate future prices into their current period decisions of how much to save, work, and 

produce. Output is generated by four production sectors, and individual level decisions of 

representative consumers determine the aggregate level of labor supply and savings in each year. 

An overview of the model follows, with important equations and further explanation provided in 

the appendix. 

Firm Behavior

Firm behavior is modeled for each of the four production sectors – corporate, noncorporate, 

owner-occupied housing, and rental housing. In the owner-occupied housing sector, home 

owners are treated as "firms" who produce housing and rent it to themselves, taking into account 

 

1

 See http://www.taxpolicyadvisers.com. 
4 

the tax advantages of home ownership. Each production function takes the standard CobbDouglas form. 

Firm managers choose the optimal levels of labor demand and investment to maximize the value 

of the firm, or profits, in each period. Investment in each sector is determined according to the 

“q” theory of investment modified to include adjustment costs. This implies that firms will 

continue to invest as long as the increase in the value of the firm is greater than the after-tax cost 

of investment. Firm managers explicitly calculate the time path of investment in response to a 

change in the tax structure as a function of the tax-induced change in “q”, which denotes the ratio 

of the market value of capital assets to their replacement costs, taking into account convex costs 

of adjusting the level of investment from its steady state level. Differences in the level of 

depreciation allowances for tax purposes and economic depreciation are modeled explicitly, as is 

the value of the existing tax basis at any point in time. The debt-to-capital ratio is assumed to be 

fixed in each industry, and dividends in the corporate sector are assumed to be a fixed fraction of 

after-tax corporate earnings. The model assumes the traditional view of dividend taxes, which 

implies dividend taxes increase the cost of capital to firms. 

Individual Behavior

The model has a conventional overlapping generations structure. All individuals in a given 

cohort are identical, with each living for 55 years, the last 10 of which are spent in retirement.2 

Each individual has perfect foresight and chooses consumption (and thus saving) to maximize 

lifetime utility – an aggregation of utility in each of the 55 periods of the lifecycle, discounted at 

a fixed rate of time preference that is common to all individuals – subject to a lifetime budget 

constraint that takes into account a hump-shaped age-wage profile, inheritances and a target 

bequest. Utility in each period is a CES function of leisure and an aggregate consumption good 

which is in turn an aggregation of four goods – a composite good produced by the corporate 

sector, a composite good produced by the non-corporate sector, owner-occupied housing, and 

rental housing. The intertemporal elasticity of substitution is assumed to be 0.35 and the 

intratemporal substitution elasticity between goods and leisure is assumed to be 0.8.3 Sensitivity 

to these and other parameters is considered in more detail below.

Government Behavior

The model includes a simple characterization of the Social Security program. Government 

services are separable in the individual utility function and government debt is a constant fraction 

of Gross National Product (GNP) in the initial steady state. 

 

2

 This formulation, in effect, excludes an individual’s life prior to joining the labor force, but does include both 

individuals’ working years plus their retirement. An alternative approach to modeling the retirement decision would 

be to allow the retirement age to be endogenous so that individuals could come out of retirement and rejoin the work 

force in response to reform-induced changes in the after-tax wage. This potential labor supply response is precluded 

by assuming a fixed retirement age. 

3

 See Elmendorf (1996), Engen, Gravelle, and Smetters (1997) and Altig et al. (2001) for discussion on the plausible 

range of values for these parameters. These parameter values yield a Frisch elasticity of labor supply, which 

measures the labor supply elasticity holding the marginal utility constant, equal to 0.4. This value is consistent with 

the range of estimates reported in Browning, Hansen, and Heckman (1999). 
5 

The government finances government expenditures by collecting taxes, and issuing government 

debt. The tax instruments available to the government in the initial equilibrium include the 

following: (1) a corporate income tax; (2) an individual income tax with a progressive wage 

income tax structure and a tax base that is adjusted for various exclusions, exemptions, 

deductions and credits; and (3) constant rate capital income taxes applied at different average 

rates to non-corporate business income, interest income, dividends and capital gains. 

An important feature of this type of model is that a permanent reduction in taxes, as compared to 

the baseline, would lead to an unsustainable accumulation of government debt relative to GNP 

and the model will not converge without an offsetting change to stabilize the debt-to-GNP ratio. 

In this type of model, the tax relief is typically financed by an offsetting change in taxes or 

spending, that can occur in the future or contemporaneously with the initial policy change and 

can take a multitude of forms. In this analysis it is assumed that the government’s financing 

requirement is satisfied by either cutting future government spending or raising future taxes, in 

part to illustrate the sensitivity of the results to the financing assumption. 

International Capital Flows

Although the focus of the model is on the U.S. domestic economy, it includes a simple 

representation of international capital flows, which are assumed to respond to differences in 

after-tax rates of return in the U.S. and the “rest of the world” through a constant elasticity 

expression.4 This approach represents a compromise between the standard closed economy 

approach and the alternative of a completely open economy in which capital is perfectly mobile 

and the international return to capital is fixed. A more sophisticated modeling of the 

international flows of goods and capital would be a marked improvement over the current 

version of the model. 

4. Methodology 

In the steady state, per-capita growth in the model is equal to a constant rate of technological 

change. In the initial steady state, the model’s tax parameters are calibrated to match current law 

average marginal effective tax rates by income source over the budget window. Simplifying 

assumptions were made in order to meld the data into the stylized model. First, given the 

requirement of constant tax rates in the steady state, the initial tax rates were set equal to the 

average of current law rates over the period 2011-2016, when statutory rates are unchanging. 

Second, the initial steady state assumes that current law polices are fiscally sustainable. That is, 

tax revenues in each period are just large enough to pay for government spending and transfer 

payments, including interest on the government debt, so that the government debt-to-GNP ratio 

is constant.5

 The initial share of tax revenues as a percentage of GNP is set to match current law 

averaged over the years 2011-2016. 

 

4

 This elasticity is set equal to 0.2 in the base case, which implies that international capital flows are not very 

sensitive to differences in the after-tax rate of return in the U.S. compared to the rest of the world. 5

 Note that this approach ignores the structural fiscal imbalance of the Social Security and Medicare systems, but 

this assumption seems appropriate in generating the likely independent effect of a tax change and is commonly used 

in this type of analysis. For example, see Auerbach (2002). 
6 

The tax relief is decomposed into three parts to show the economic effects of each: 

1. Extend the lower rates on dividends and capital gains. (Dividends and capital gains are 

taxed at a top rate of 15 percent, as compared to a top rate on dividends of 39.6 percent 

and for long-term gains of 20 percent in the absence of tax relief); 

2. Extend the reduction in the top four ordinary individual rates. (These rates are 

maintained at 25, 28, 33 and 35 percent, as compared to the rates of 28, 31, 36 and 39.6 

percent that would apply beginning in 2011 under current law. The repeal of the phaseout of personal exemptions and itemized deductions [PEP and Pease provisions] is also 

extended); and, 

3. Extend the higher child tax credit ($1,000 per child), reduction in marriage tax penalties 

(by increasing the standard deduction and increasing the size of the 15 percent bracket for 

joint filers), and the 10-percent tax rate bracket.6

 

The percentage decline in average marginal tax rates by income source compared to current law 

for the years 2011-2016 is shown in Table 1.7 Extending the lower tax rates on dividends leads 

to more than a 50 percent decline in the average marginal dividend tax rate compared to current 

law for the years 2011 through 2016. Extending the relief on capital gains leads to more than a 

20 percent decline in the average marginal tax rate on capital gains for the same period. 

Lowering ordinary rates leads to a decline in the average marginal tax rate on labor income of 

5.6 percent, while the average marginal rate on small business income (income from sole 

proprietorships, partnerships, and S-corporations) falls by 11.4 percent. Extending the reminder 

of the tax relief has only small effects on the change in marginal tax rates.8 

Financing the Tax Relief

As discussed above, an important feature of this type of model is that tax relief must be financed 

by an offsetting change in government revenues or spending to stabilize the ratio of government 

debt to GNP. There are numerous possibilities for satisfying the government’s intertemporal 

budget constraint and two are examined in this analysis: (1) the tax relief is permanent and 

future government spending is reduced, and (2) future taxes are increased. Specifically, in this 

analysis, the tax relief is assumed to remain in place through the end of the 10-year budget 

window (i.e., 2016), holding government spending equal to the baseline amount during this 

period, and issuing additional government debt relative to the baseline to account for the decline 

in tax revenues over the budget window. The tax relief is then financed by either: (1) adjusting 

government consumption spending in each year after the 10-year budget window to hold the 

ratio of government debt-to-GNP at the ratio that exists in the first year after the budget window 

(2017), or (2) adjusting all income tax rates proportionally in each period after the budget 

window to hold the government debt-to-GNP ratio equal to the value it takes in the first year 

 

6

 The economic effects of the repeal of the estate tax are not included in this analysis. There is considerable 

uncertainty regarding the likely behavioral responses to repealing the estate tax, and the target bequest motive used 

in this model is not very flexible in capturing the range of likely responses. 

7

 The average marginal rates are weighted by income from that source. 8

 The decline in the marginal tax rate on wages actually becomes smaller (5.1 percent decrease) when the full tax 

relief is extended. This appears to be the result of more taxpayers being affected by the AMT and the longer phaseout of the child tax credit. 
7 

after the 10-year budget window (2017).9 The first financing option is consistent with the 

Administration’s policy of spending restraint. The second financing option, in effect, models the 

tax relief as temporary, which requires that future taxes increase enough to pay for the temporary 

decline in taxes with interest. 

Sensitivity to Underlying Parameter Assumptions

The results also depend on how responsive households and firms are to changes in after-tax 

prices, such as the wage rate and the interest rate. The behavioral parameters used for the base 

case simulations are shown in Table 2. There are three primary parameters that affect the 

responsiveness of household labor supply and savings to tax changes: the intertemporal 

elasticity of substitution, the intratemporal elasticity of substitution between the composite 

consumption good and leisure, and the initial share of leisure in the time endowment. The base 

case simulations use values for these parameters that approximate “central tendency” estimates. 

However, there is uncertainty about the exact value of these parameters and results are also 

presented that consider “low” and “high” values for these parameters.10 In addition, the degree 

to which housing and non-housing goods are substitutable is adjusted. The approach taken for 

this Report is to adjust the parameters as a group, rather than individually, mostly to facilitate 

ease in presentation.11 This approach provides only limited information on the importance that 

any given parameter would have on the results, but it provides an overall sense of the robustness 

of the results and highlights the uncertainty that remains in the economics literature on the likely 

responsiveness of taxpayers to changes in tax rates. 

Limitations of the Model

The model used for this analysis captures many of the likely economic effects that would result 

from extending the President’s tax relief, including incentive effects on household labor supply 

and savings, the intersectoral reallocation of capital that would result from reducing the double 

taxation of corporate profits, and the crowding out of private investment that would occur by 

financing the tax relief through issuing government debt. Like all economic models, this model 

employs important simplifying assumptions, and other economic models, which employ different 

simplifying assumptions, could yield different economic results from extending the President’s 

tax relief. The model used in this analysis departs from economic reality in the following ways. 

 

9

 Auerbach (2002) and Auerbach and Kotlikoff (1987) employ a similar approach when examining the effects of a 

temporary tax decrease financed with future tax increases. The Congressional Budget Office (2004, 2006) also 

makes similar financing assumptions, but the reduction in government spending (or the increase in income taxes) is 

phased in over a 10-year period after the end of the 10-year budget window which allows the debt-to-GNP ratio to 

rise somewhat more in the long-run. 

10 The Frisch labor supply elasticity equals 0.18 under the low response parameters and 0.75 under the high response 

parameters. This is consistent with the results surveyed by Browning, Hansen and Heckman (1999), and recent 

papers by Ziliak and Kniesner (1999, 2005) and Lee (2001), which estimate the Frisch labor supply elasticity for 

men ranges between 0.0 and 0.5. The econometric literature has generally found larger labor supply responses for 

women compared to men, but there are few studies that measure the Frisch labor supply elasticity for women. 

Aaronson and French (2002) suggest this value is believed to be around 1. This Report assumes the Frisch labor 

supply elasticity for women ranges between 0.55 and 1.25, and that women account for one-third of labor earnings. 

11 A similar approach is taken by Rogers (1997). For each simulation, this Report also adjusts the rate of time 

preference in order to maintain the initial capital-output ratio. 
8 

First, this model does not account for short-term deviations in output from potential GNP. This 

implies that the model does not capture some of the short-run benefits of tax relief when it occurs 

at a time when the economy is below its potential, which occurred with the 2001 and 2003 tax 

relief. Section 2 of this Report describes a separate Treasury analysis of the effect of the 

President’s tax relief that includes these cyclical effects. 

Second, the treatment of international capital flows is quite simple. A broader model would 

employ a more sophisticated representation of these flows and would also include international 

trade in goods. The limited role of international capital flows allowed in this model has only a 

minor impact on the economic results in this analysis. It is unclear whether a broader model of 

international trade and capital flows would lead to results that are smaller or larger in magnitude 

than the results presented in this paper. 

Third, as mentioned above, the model assumes that the “traditional” view of dividend taxation 

holds, which implies that taxes on dividends increase the cost of investing in the corporate 

sector. An alternative approach that is termed the “new” view of dividend taxation suggests that 

dividend taxes are capitalized into the value of the firm, but do not affect marginal investment 

decisions.12 The degree to which each view represents an accurate portrayal of the economy 

remains an unsettled issue. Recent research suggests a segmented market, with some firms 

behaving in a manner consistent with the traditional view and other firms behaving in a manner 

consistent with the new view.13 

To the extent that the new view holds, the output gains resulting from extending the lower tax 

rates on dividends found in this analysis are likely to be overstated. However, this model also 

does not include a measure of other efficiency gains that would likely result from lowering the 

tax rate on dividends due to reducing the distortions between debt and equity financing. 

Moreover, the model assumes that the level of dividends and corporate payout decisions are held 

fixed.14 It is not clear whether a fuller model that accounts for both new view firms and these 

other financial distortions would show larger or smaller effects overall. 

Fourth, this model assumes perfect certainty and perfect competition. Of course, as suggested by 

empirical research, some individuals save as a precaution against unforeseen events and at least a 

portion of savings is not very sensitive to changes in the interest rate. Thus, the implied 

elasticity of savings with respect to the after-tax interest rate in the certainty model is likely to be 

higher than in a model that incorporates risk. To partially offset the lack of risk in the model, 

households have a simple target bequest motive that tends to mitigate the savings response.15 On 

the other hand, some models with imperfect competition find that the distortionary effects of 

capital income taxation are larger than models that assume perfect competition.16 

 

12 For an excellent overview of these issues, see Zodrow (1991). 

13 For example, see Auerbach and Hasset (2003). 14 The importance of these distortions is also diminished to the extent the new view holds. 

15 It is worth noting, however, that Hurst, et al., (2005) recently estimated that precautionary savings account for less 

than 10 percent of total wealth. 

16 For example, see Judd (2002). 
9 

Fifth, this model likely overstates the economic cost of deficit finance of temporary tax relief as 

the rate of return to government bonds in the model is greater than the rate of growth in GNP.17 

Historically, the average return on government debt is below the average growth rate of the 

economy, which implies it might not be necessary to increase taxes in the future in order to 

stabilize the government debt ratio. Some research suggests that the need to raise future tax rates 

to pay for temporary tax relief only occurs with a small probability.18 

Finally, the financing assumptions used in this model are conventional for this type of analysis 

and are not meant to be predictions of what policies actually would be set by this Administration 

or by a future Administration or Congress. Numerous other policy prescriptions also could be 

employed. If the revenue cost of the tax relief is financed through reductions in government 

spending, then the sooner those reductions begin, the smaller would be the crowding out effect 

on private investment and the larger would be the increase in long-run output. If the revenue 

cost of the tax relief is financed through future tax increases, then the way future taxes are 

increased would greatly affect the long-run results; the more the future tax increases affect 

marginal rates, the more future economic output will suffer as a consequence. 

5. Description of results 

As described above, results are presented assuming that the tax relief is financed either through a 

future decrease in government spending or a future increase in taxes. The first year in the model 

is set to be 2007. Households and firms in the tax relief simulations anticipate the future 

continuation of lower tax rates after 2010 and the offsetting fiscal policy of reducing government 

consumption or increasing tax rates beyond the budget window. However, the macroeconomic 

effects for the first four years of the budget window (2007-2010) are generally small as tax rates 

do not change between the different simulations for those years. Results are presented in Tables 

3 and 4, and discussed below for only the last six years of the budget window (2011-2016) and 

for the long run. 

Tax Relief Financed with Future Decrease in Government Spending

For this set of results, the model assumes that government consumption purchases (i.e., 

government spending) adjust after 10 years to stabilize the government debt-to-GNP ratio. In the 

model, government consumption purchases do not enter household utility functions and only 

indirectly affect household decisions through market prices.19 Prior to 2017, the debt-to-GNP 

ratio is allowed to rise, but, beginning in 2017, government purchases decline in each year to 

hold the government debt ratio fixed. 

Most of the economic effects of the tax relief can be explained by examining households’ 

budgets and prices. The tax relief leads to offsetting substitution and income effects for both 

 

17 The model assumes that the after-tax rates of return to government bonds, private bonds and corporate equity are 

equal. 

18 See Ball, Elmendorf, and Mankiw (1998). 

19 That is, government spending is not valued by households. An alternative assumption is that valued government 

spending decreases, such as government transfer payments to individuals. This would mostly eliminate the income 

effects of the tax relief and lead to larger output effects. A more detailed modeling of the government sector would 

also be an improvement in the model. 
10 

household leisure and consumption choices. The reduction in the marginal tax rates on labor and 

capital income increases the price of current leisure and consumption, and households respond 

by supplying more labor and savings through the substitution effect.20 The reduction in tax 

liabilities increases household after-tax wealth, and households’ desire to consume more leisure 

and consumption through an income effect. There is an additional income effect (termed the 

human wealth effect) which supports an initial increase in labor supply and savings. This effect 

arises from the increase in the after-tax interest rate that results from the lower tax on capital, but 

this effect becomes less important over time as the interest rate declines as capital accumulates. 

However, other effects also are at work. The lower tax rate on dividends lowers the effective tax 

rate on investment in the corporate sector relative to the other sectors. The reduction in the 

double tax on corporate profits results in a more even taxation of investments across production 

sectors, a more efficient allocation of capital, and an increase in output. 

In addition, when lower taxes on capital income are financed initially by issuing government 

debt, private investment is crowded out by an increase in government borrowing. Private saving 

may increase as a result of the tax relief (and may be augmented by capital inflows from abroad), 

but private investment will generally not increase by the same amount because a portion of the 

increase in private saving funds the increase in government debt. When the majority of the tax 

relief is on labor income, the crowding-out effect is even larger and private investment could 

even decline in the short run. When government purchases decline after the budget window to 

stabilize the government debt ratio, more private saving is released to fund private investment, 

although some crowding out of private investment does persist in the long run. 

The short-run and long-run effects for all three steps of the permanence proposals under the base 

case parameters are shown in Table 3 for the two financing assumptions. The results from 

lowering the dividends and capital gains rates are shown in column (1). Substitution effects 

dominate when capital gains and dividends rates fall in 2011, and private savings and investment 

increase in both the short run and long run. The capital stock increases by an average of 0.2 

percent from 2011-2016 compared to the baseline and GNP increases by 0.1 percent.21 The 

increase in output is helped by a more efficient allocation of capital that comes from reducing the 

double taxation of corporate investment. In the long run, the capital stock increases by 1.2 

percent, and output increases by 0.4 percent, with a small decline in labor supply of 0.1 percent. 

When reductions to the top four ordinary income tax rates are extended as well, crowding out 

during the budget window is more pronounced and the average increase in the capital stock is 

just 0.1 percent for the years 2011 through 2016. Domestically funded investment actually 

declines during this period, but capital inflows from abroad lead to an overall increase in the 

 

20 The reduction in the wage tax rate leads to a shifting from leisure towards labor within a period, while the 

reduction in the effective capital tax rate leads households to shift leisure and consumption into the future. 21 Real gross national product (GNP) is used as the measure of national output. Investment in the domestic economy 

financed by foreigners would lead to an increase in gross domestic product (GDP), but some of this increase must be 

returned to the foreign owners of the capital. GNP, which nets out the return to foreign-owned capital more 

accurately reflects the resources available to U.S. citizens. 
11 

capital stock.22 Column (2) of Table 3 also indicates that labor supply increases by 0.7 percent 

on average from 2011-16 leading to an increase in output of 0.7 percent during the same time 

period. Domestically funded private investment increases after the budget window as the 

government debt ratio is stabilized over time by reducing government spending, and in the long 

run the capital stock increases by 2.3 percent, labor supply increases by 0.2 percent, and output 

increases by 1.1 percent.23 

In contrast, column (3) shows that when adding the remaining tax relief that increases the deficit 

with only a small variation in marginal tax rates, then financing government debt more than 

offsets for the increase in private savings and capital inflows from abroad so that the capital 

stock declines on average by 0.3 percent from 2011-2016 compared to the initial steady-state, 

and GNP is only 0.5 percent larger (due to the increase in labor supply of 0.5 percent). Once 

government spending is reduced to stabilize the government debt ratio, private investment 

increases so that in the long-run, the capital stock increases by 2.3 percent and output increases 

by 0.7 percent. 

Extending the increase in the child tax credit, the 10-percent marginal tax bracket, and the 

reduction in marriage tax penalties primarily increase individual after-tax income, but result in 

very little change in marginal tax rates. Households respond to this rise in income by increasing 

their consumption of goods and services. Households also consume more leisure, which leads to 

a long-run decline in labor supply of 0.3 percent through the income effect.24 This decline in 

labor supply is the primary reason why the long-run increase in GNP is smaller than in the 

previous simulation. To a lesser extent, the greater crowding out of private investment that 

results from a higher government debt burden also contributes to this relative decline, as 

indicated by the decline in domestically financed investment from 2.6 to 2.3 percent. The overall 

capital stock shows no change between the two simulations due to an offsetting increase in 

foreign capital flows. 

Tax Relief Financed with Future Increase in Taxes

Under this financing assumption, all average and marginal tax rates on labor and capital income 

are changed by the same proportion in each year after the 10-year budget window in order to 

maintain the baseline amount of government services and to maintain the government debt-toGNP ratio at the value it takes at the end of the budget window. In effect, the tax relief is 

modeled as temporary, as it is more than reversed in the future by across-the-board, proportional 

tax increases. 

 

22 The rows labeled “Investment” in Table 3 and Table 4 reflect domestically funded gross investment, while the 

rows labeled “Capital Stock” in Table 3 and Table 4 represent changes in the domestic capital stock regardless of 

whether the new investment is funded by domestic savings or foreigners. 

23 The long-run change in labor supply for the simulations in this section is small as the substitution effect resulting 

from higher after-tax wages is offset by an income effect from the household’s increase in lifetime wealth due to the 

decline in tax payments. 

24 As indicated in Table 1, the decline in the average marginal tax rate on labor income is also slightly smaller under 

the full extension of the tax cuts, compared to when just the top four ordinary rates are decreased. This also 

contributes to the relative decline in labor supply through the substitution effect. 
12 

Again, much of the results can be explained in terms of income and substitution effects. But in 

this case, as tax rates increase after the budget window, the substitution and income effects 

discussed above work in opposite directions. Households are forward looking and many of the 

transitional generations make choices that are influenced by both the tax decreases and the 

following tax increases. This implies that income effects are less important determinants of 

behavior during the budget window, and households respond by supplying more labor and 

savings during this period relative to the simulations discussed above in which future 

government consumption decreases. 

The second set of results reported under column (1) in Table 3 shows the effects of financing the 

lower dividends and capital gains tax rates with future increases in all income taxes. On net, in 

the long run this combination of tax relief and tax increases reduces the burden of taxation on 

corporate investment in favor of greater taxation of labor income and, to a lesser extent, capital 

income in other sectors. This implies some increase in output resulting from a more efficient 

allocation of capital across production sectors. These gains are offset to a certain extent in the 

long run by the crowding out of investment due to a higher government debt ratio and the higher 

tax rates needed to pay for higher interest payments on the government debt. In the long run, the 

capital stock increases by 0.7 percent and GNP increases by 0.3 percent (compared to increases 

of 1.2 percent and 0.4 percent, respectively, when government consumption declines). 

The results in column (2) show a similar pattern. Over the budget window, households work 

more and save more compared to the same tax relief with a government spending offset. Labor 

supply increases on average by 0.9 percent during 2011-16, rather than 0.7 percent; the capital 

stock increases by 0.6 percent, rather than 0.1 percent; and GNP increases by 0.9 percent, rather 

than 0.7 percent. In the long run, the increase in tax rates needed to stabilize the government 

debt ratio leads to no change in labor supply compared to an increase of 0.2 percent when 

government spending declines, and the capital stock increases by 0.3 percent compared to 2.3 

percent when government spending declines. GNP increases in the long-run by only 0.3 percent, 

compared to the 1.1 percent increase described above. 

Extending all of the tax relief and then financing with an increase in taxes after the budget 

window leads to short-run effects that are again slightly larger than if a reduction in government 

consumption is used to finance the revenue cost of the tax decrease. The capital stock increases 

by 0.6 percent during 2011-16 and GNP increases by 0.8 percent. However, in the long run, the 

combined effects of increasing marginal tax rates and crowding out lead to a decline in labor 

supply (0.8 percent), capital (1.8 percent) and GNP (0.9 percent). 

Sensitivity Analysis

This section reports the macroeconomic results of the same tax changes and financing 

assumptions described above with different values for certain parameters that represent “low” 

and “high” levels of responsiveness. 

Lowering the intertemporal elasticity of substitution reduces the degree to which households are 

willing to substitute consumption and leisure across time, which leads to a lower savings supply 

response to a decrease in capital taxes. If only dividends and capital gains tax rates are lowered 
13 

and financed by future reductions in government spending, the capital stock increases by 0.9 

percent in the long-run using the lower parameter values, compared to a 1.2 percent increase 

using the base case parameters. In the long run, if lower tax rates on dividends and capital gains 

are extended and financed by reductions in future government spending, GNP increases by 0.3 

percent using low parameter values, and by 0.5 percent using the high parameter values. 

The choice of parameter values has little influence on the long-run increase in GNP when using 

future income tax increases to finance extensions of the lower rates on dividends and capital 

gains. For the low parameter values, GNP increases by 0.2 percent in the long run and for the 

high parameter values, GNP increases by 0.3 percent, as seen in column (1) of Table 4. The 

small difference is primarily the result of the parameters having offsetting effects. Lowering the 

intertemporal elasticity of substitution lowers the savings response, but lowering the 

intratemporal elasticity of substitution and the initial leisure share of the time endowment 

dampens the labor supply response and labor supply does not decline as much when future tax 

rates are increased. 

The choice of parameter values has a greater influence when extensions of the lower ordinary tax 

rates for the top four individual brackets are added to the lower tax rates on dividends and capital 

gains. The long-run increase in GNP when the tax relief is financed by reducing future 

government spending ranges from 0.4 percent using the low responsiveness parameters to 1.6 

percent using the high responsiveness parameters. When the tax relief is financed by increases in 

future tax rates, then GNP in the long-run falls by 0.1 percent under the low response parameters 

and increases by 0.6 percent under the high response parameters. 

Similarly, when all of the tax relief is extended and financed by the reduction in future 

government spending, then long-run GNP increases by only 0.1 percent in the low response case 

and by 1.2 percent in the high response case. However, when using future income tax increases 

to pay for the tax relief, then, in both the low response and the high response case, GNP falls by 

0.9 percent in the long run. Again, this is the result of lower behavioral response parameters 

working in offsetting ways when income taxes are raised. Lower intertemporal and 

intratemporal elasticity of substitutions imply a smaller labor supply response during the budget 

window and a higher debt-to-GNP ratio at the end of the window which results in larger 

crowding out effects. This leads to a large decrease in the capital stock (3.6 percent) in the long 

run. However, the lower labor supply response results in a reduction in labor supply of only 0.4 

percent in the long run as future income taxes are increased. In contrast, under the higher 

response parameter values, the capital stock falls by only 1.3 percent, but labor supply falls by 

1.1 percent as labor supply is more sensitive to the long-run increase in marginal tax rates on 

labor. 

6. Conclusion 

The analysis presented in the paper suggests that permanently extending the President’s tax relief 

enacted in 2001 and 2003 likely would lead to a long-run increase in the capital stock and an 

increase in national output in both the short run and the long run. If the revenue cost of that tax 

relief is offset by reducing future government spending, the increase in output is likely be about 

0.7 percent under plausible assumptions. If, instead, the tax relief is extended only through the 
14 

end of the budget window (i.e., it is temporary), the tax relief would increase national output in 

the short run, but long-run output would decline as future tax rates increase. 

The analysis also suggests that if only the portions of the President’s tax relief that primarily 

reduce marginal tax rates are extended (i.e., the lower rates on dividends, capital gains and the 

top four ordinary income brackets), it is likely that output would increase regardless of whether 

the revenue cost of the relief is financed through a future reduction in government spending or a 

future increase in tax rates, although the increase would be considerably larger if government 

consumption is reduced. 
15 

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18

(1) (2) (3)

Lower Dividends and 

Capital Gains Tax Rates

(1) Plus Lower Top 4 

Ordinary Rates

(2) Plus Remaining Tax 

Cut Extensions

Wages 0.0% -5.6% -5.1%

Dividends -52.8% -52.9% -54.1%

Capital Gains -21.0% -23.3% -23.7%

Interest 0.0% -7.1% -8.2%

Business Income* 0.0% -11.4% -12.1%

Department of the Treasury

 Office of Tax Analysis

* Includes income from IRS Form 1040 Schedules C, E and F

Table 1

Average Percentage Change in Average Marginal Tax Rates by Income Source Compared to Current 

Law for Years 2011-2016
19

Baseline Low High

Intertemporal substitution elasticity 0.35 0.20 0.50

Intratemporal substitution elasticity (between leisure and goods) 0.80 0.50 1.00

Leisure share of time endowment 0.40 0.30 0.50

Rate of time preference* 0.001 -0.055 0.024

Elasticity of substitution between housing and non-housing good 1.00 0.50 1.50

International capital flow elasticity 0.20 0.20 0.20

Population growth rate 0.01 0.01 0.01

Technological growth rate 0.01 0.01 0.01

Adjustment cost parameter 5.00 5.00 5.00

Capital income share 0.34 0.34 0.34

Capital/output ratio 2.29 2.29 2.29

Department of the Treasury

 Office of Tax Analysis

*The rate of time preference was adjusted to maintain the initial capital-output ratio

Table 2

Model Parameters
20

 

2011-2016 Long-run 2011-2016 Long-run 2011-2016 Long-run

Financed by Decreasing Future Government Consumption

Real GNP 0.1% 0.4% 0.7% 1.1% 0.5% 0.7%

Capital Stock 0.2% 1.2% 0.1% 2.3% -0.3% 2.3%

Labor Supply 0.0% -0.1% 0.7% 0.2% 0.5% -0.3%

Consumption 0.1% 0.6% 1.1% 2.5% 1.3% 3.5%

Investment 0.5% 1.6% -0.5% 2.6% -3.0% 2.3%

Financed by Increasing Future Income Taxes

Real GNP 0.2% 0.3% 0.9% 0.3% 0.8% -0.9%

Capital Stock 0.3% 0.7% 0.6% 0.3% 0.6% -1.8%

Labor Supply 0.1% -0.1% 0.9% 0.0% 0.7% -0.8%

Consumption 0.0% 0.1% 0.7% 0.4% 0.5% -0.7%

Investment 1.1% 1.1% 2.1% 0.5% 1.8% -2.0%

Department of the Treasury

 Office of Tax Analysis

* Assumes the U.S. is a large open economy with a simple representation of limited international capital flows

Table 3

 Macroeconomic Effects of Extending The 2001 and 2003 Tax Cuts with Base Case Parameter Values: 

Percentage Change from Initial Steady-State Values

(1) (2) (3)

Lower Dividends and 

Capital Gains Tax 

Rates

(1) Plus Lower Top 4 

Ordinary Rates

(2) Plus Remaining 

Tax Cut Extensions

Base Simulation*
21

2011-2016 Long-run 2011-2016 Long-run 2011-2016 Long-run

Financed by Decreasing Future Government Consumption

Real GNP 0.1% 0.3% 0.3% 0.4% 0.1% 0.1%

Capital Stock 0.0% 0.9% -0.4% 0.8% -1.1% 0.6%

Labor Supply 0.0% -0.1% 0.1% -0.3% -0.1% -0.7%

Consumption 0.3% 0.7% 1.5% 2.9% 1.9% 4.0%

Investment -0.3% 1.1% -4.4% 0.2% -7.8% -0.5%

Financed by Increasing Future Income Taxes

Real GNP 0.1% 0.2% 0.5% -0.1% 0.4% -0.9%

Capital Stock 0.2% 0.4% 0.3% -1.6% 0.3% -3.6%

Labor Supply 0.0% -0.1% 0.4% -0.1% 0.2% -0.4%

Consumption 0.0% 0.2% 0.6% 0.5% 0.5% 0.0%

Investment 0.7% 0.6% 0.4% -2.4% 0.0% -5.3%

Financed by Decreasing Future Government Consumption

Real GNP 0.2% 0.5% 1.1% 1.6% 0.9% 1.2%

Capital Stock 0.2% 1.3% 0.5% 3.1% 0.2% 3.1%

Labor Supply 0.1% 0.0% 1.3% 0.7% 1.1% 0.1%

Consumption 0.0% 0.6% 1.2% 2.7% 1.3% 3.4%

Investment 1.0% 1.8% 1.4% 3.6% -0.2% 3.4%

Financed by Increasing Future Income Taxes

Real GNP 0.2% 0.3% 1.3% 0.6% 1.1% -0.9%

Capital Stock 0.3% 0.8% 0.8% 0.9% 0.8% -1.3%

Labor Supply 0.1% -0.1% 1.4% 0.2% 1.1% -1.1%

Consumption 0.0% 0.1% 0.9% 0.5% 0.7% -1.1%

Investment 1.3% 1.3% 3.1% 1.4% 2.9% -1.1%

Department of the Treasury

 Office of Tax Analysis

* Assumes the U.S. is a large open economy with a simple representation of limited international capital flows

Table 4

 Macroeconomic Effects of Extending The 2001 and 2003 Tax Cuts with Low and High Degree of 

Responsiveness: Percentage Change from Initial Steady-State Values*

(1) (2) (3)

High Responsiveness 

Lower Dividends and 

Capital Gains Tax 

Rates

(1) Plus Lower Top 4 

Ordinary Rates

(2) Plus Remaining 

Tax Cut Extensions

Low Responsiveness
22

Appendix: Description of the Tax Policy Advisers OLG Model 

The model has four production sectors – owner-occupied housing, rental housing, non-corporate 

non-housing goods and services, and a corporate non-housing goods and services sector. The 

time path of investment demands in all three sectors is modeled explicitly, taking into account 

capital stock adjustment costs. On the consumption side, the current tax advantage of owneroccupied housing relative to other assets is taken into account in modeling the demands for the 

four goods. This section outlines the basic structure of the model, which combines various 

features from similar and well-known models constructed by Auerbach and Kotlikoff (1987), 

Goulder and Summers (1989), Goulder (1989), Keuschnigg (1990) and Fullerton and Rogers 

(1993), with the time path of investment in each production sector calculated to maximize firm 

value in the presence of convex (quadratic) adjustment costs, following Hayashi (1982). The full 

details of the model are provided in Diamond and Zodrow (2005). 

The Corporate and Non-Corporate Non-Housing Production Sector 

In each period s, firms in the corporate and non-corporate production sectors produce output 

( Xs ), which includes all non-housing goods and services, using capital X Ks and labor X Ls using 

a CES production function with an elasticity of substitution in production σ X and a capital share 

parameter X a . Firms are assumed to choose the time path of investment to maximize the present 

value of firm profits or, equivalently, maximize firm value VX , net of all taxes. Total taxes in 

the corporate and non-corporate production sectors in period s, are 

(1 ) X X X X X XX X X X X X X T p X wL f I I f iB f K K s bs s s s s FT s s s IT s s IT s bs ps s τ τ = − − −Φ − − + − τ δ ττ ⎡ ⎤ ⎣ ⎦ , 

where X

bs τ is the tax rate on business income in sector X, X

s p is the price of the good in sector X, 

ws is the wage rate, X

s I is gross investment, X Φs are (deductible) adjustment costs per unit of 

investment, i

s is the before-tax interest rate, X Bs is total indebtedness, X

τ s δ is depreciation for tax 

purposes, X Kτ s is the remaining tax basis of the capital stock, X

ps τ is the property tax rate in sector 

X, with property taxes assumed to be fully deductible against the business income tax, and IT f

( FT f ) is one under the income tax (consumption tax) and zero otherwise.25 Following Goulder 

and Summers (1989) and Cummins, Hassett and Hubbard (1994), the adjustment cost function 

per unit of investment is assumed to be a quadratic function of gross investment per unit of 

capital 

2 ( / 2)( / )

/

X XX X X X

s s ss

s X XX

s ss

I p IK

K IK

⎛ ⎞ β μ − Φ = ⎜ ⎟ ⎝ ⎠

 

25 That is, depreciation and interest expense are deductible under an income tax, while expensing is allowed under a 

consumption tax with no interest deductions. The property tax on businesses is treated as a tax on capital rather than 

a benefit tax (Muthitacharoen and Zodrow, forthcoming).
23

where X β is the parameter that determines the level of adjustment costs and X μ is set so that 

adjustment costs are zero in the steady state. 

Assuming firms do not make any financial investments, total net cash receipts, including net new 

bonds issued, X BNs , and net new shares issued (new equity investment in the non-corporate 

sector) X VNs , must either be used to finance new investments (including adjustment costs) or 

distributed to shareholders 

[] 1( ) X X X X X XX X X

s s ss ss s s s s s s p X w L i B T BN VN I DIV − − − + + = +Φ + , 

where X DIVs is the dividend payout in sector X. Each firm is assumed to maintain a fixed 

debt/asset ratio X b and pay out a constant fraction of earnings after taxes and depreciation (the 

non-corporate firm distributes all net income) in each period. This implies that new investments 

in the corporate sector are financed with debt and new share issues if retained earnings do not 

supply enough equity to finance the desired level of investment. New investments in the noncorporate sector are financed with debt and new equity investments since there are no retained 

earnings in this sector. 

The model assumes individual level arbitrage, which implies that the after-tax return to bonds 

must equal the after-tax return received by the owners of the firm, or 

( ) ( ) 1 1( )( 1 ) 1

X XX X

X ds s gs s s s

bs s X

s

DIV V V VN

i

V

τ τ

τ

− +− − − +

− = , 

where τ is is the average marginal personal income tax rate on interest income, τ ds is the average 

marginal tax rate on dividends, τ gs is the average effective annual accrual tax rate on capital 

gains ( ) 1

XX X V V VN ss s + − − . Solving this expression for X Vs , subject to the transversality condition 

requiring a finite value of the firm, yields 

( )( ) 1 1 ,

1 (1 ) (1 )

X X

du gu u u X

s u

u s

iu u gu

v s

DIV VN

V

i

τ τ

τ τ

∞

=

=

⎡ ⎤ −− − ⎣ ⎦ =

⎡ ⎤ +− − ⎣ ⎦

∑

∏

That is, the value of the firm in the composite good sector equals the present value of all future 

net distributions to the owners of the firm. The time path of investment that maximizes this 

expression in the presence of adjustment costs is 

( )

1 1

s

1 , p 1

XX X X X

s s FT s bs IT s

X X X

s bs s

I q b f fZ

K

τ

β τ

+ + −+ + Ω + = − Ω
24

where 1

X

s q + is shadow price of additional capital (commonly referred to as ‘marginal q’ which 

equals the ratio of the market value of a marginal unit of capital to its replacement cost), X Ωs is a 

weighted average of the dividend and capital gains tax rates divided by one minus the capital 

gains tax rate, and 1

X Zs+ is the tax savings from accelerated depreciation allowances on future 

investments. 

 

The relationship between ‘marginal q’ and ‘average q’ (denoted as X Qs ) is 

XX X

X X s s s

s s X X

s s

VX X q Q K K− = =−

where X Xs is the value of future depreciation deductions on the existing stock of capital 

used in the production of thee good in sector X. 

The Owner-Occupied and Rental Housing Production Sectors 

 

Housing is produced in the owner-occupied and rental housing production sectors where, 

following Goulder and Summers (1989) and Goulder (1989), rental housing is produced by noncorporate landlords and owner-occupied housing is produced by the owners. The technology 

used in the production of rental housing ( Rs ) and owner-occupied housing (Os ) is assumed to be 

identical – capital and labor combined in a CES production function with an elasticity of 

substitution in production of σ H and a capital share parameter of H a .

26 Landlords and owneroccupiers are also are assumed to choose time paths of investment to maximize the equivalent of 

firm value, net of total taxes. 

 

In the case of the rental housing sector, the firm is modeled as a non-corporate firm. This 

implies that landlords are taxed at the individual level, so total taxes paid are 

(1 ) , R R R R R RR R R R R R R

s bs s s s FT s s s IT s s IT s bs ps s

R

s s T p w L f I I f i B mK f K K R τ τ = − − −Φ − − − + − τ δ ττ ⎡ ⎤ ⎣ ⎦

where R

bs τ is the average marginal tax rate applied to rental housing income,27

m is annual 

maintenance expenditures per unit of rental housing capital, and the definitions of all other 

variables are analogous to those in the composite good production sector. Solving the cash flow 

equation in the rental housing sector for after-tax rents received by landlords R

s S yields 

 

26 Thus, the producer prices of rental and owner-occupied housing services are identical. However, rental and 

owner-occupied housing services are not perfect substitutes, so that the mix of rental and owner-occupied housing 

services changes along the transition path to a new equilibrium. 

27 The tax rate on rental housing income is a weighted average of the non-corporate tax rate on landlord profits and 

the corporate tax rate. The weight is determined by the share of rental housing produced in the corporate sector, 

which is equal to 10 percent. 
25

( ) (1 ) R RR R R R R R R R R

s s s ss ss s s s s s s S p F w L i B mK T BN E I = ⋅ − − − − + + − +Φ , 

where R Es is net new equity invested by landlords in the rental housing sector. Individual 

arbitrage in this case implies 

( ) ( )( ) 1 1

1

R R RR

s gs s s s

is s R

s

S VVE

i

V

τ

τ

+− − − +

− =

which can be solved for the value of the rental housing firm 

1 1( )

1 (1 ) (1 )

R R

gu s s R

s u

u s

iu s gu

v s

S E

V

i

τ

τ τ

∞

=

=

⎡ ⎤ − − ⎣ ⎦ =

⎡ ⎤ +− − ⎣ ⎦

∑

∏ . 

The time path of investment that maximizes this expression in the presence of adjustment costs is 

( )

1 1

s

. p 1

R R R R R RR R

s s s s FT s bs IT s

R RR R

s s bs

I q b f fZ

K

τ

β τ

+ + −Ω + Ω + Ω + = Ω −

The expression for relationship between ‘marginal q’ and ‘average q’ in the rental housing sector 

is analogous to that in the composite good sector. 

 

By comparison, in the owner-occupied housing sector, since imputed rents are untaxed and 

maintenance expenditures are not deductible while mortgage interest and property taxes are 

deductible, total taxes are 

(1 ) O OO

s is is ps s

O

s ss s Tz z K =− + − τ ττ i B , 

where s z is the fraction of individuals who are itemizers. The flow of (untaxed) imputed rents to 

owner-occupiers is 

(1 ) O OO O O O O O O O O

s s s ss ss s s s s s s S p F w L i B T mK BN E I = − − − − + + − +Φ

The expressions for individual level arbitrage and firm value are analogous to those in the rental 

housing sector, and investment in the owner-occupied sector is 

1

s

. p

O O O OO

s ss s

O OO

s s

Iq b

K β

+ −Ω + Ω = Ω 

The expression for relationship between ‘marginal q’ and ‘average q’ in the owner-occupied 

housing sector is analogous to that in the composite good sector. 
26

Individual Behavior 

 

On the individual side, the model has a dynamic overlapping generations framework with fiftyfive generations alive at each point in time. There is a representative individual for each 

generation, who has an economic life span (which begins upon entry into the work force) of 

fifty-five years, with the first forty-five of those years spent working, and the last ten spent in 

retirement. Individual tastes are identical so that differences in behavior across generations are 

due solely to differences in lifetime budget constraints. An individual accumulates assets from 

the time of “economic birth” that are used to finance both consumption over the life cycle, 

especially during the retirement period, and the making of bequests. The model follows 

Fullerton and Rogers (1993) in including a relatively primitive “target model” of bequests, with 

the real values of bequests assumed to be fixed and thus unaffected by changes in economic 

conditions, including changes in income. 

At any point in time s, the consumer maximizes rest-of-life utility LUs subject to a lifetime 

budget constraint that requires the present value of lifetime wealth including inheritances to 

equal the present value of lifetime consumption including bequests. In particular, an individual 

of age a at time s = t chooses the time path of consumption of an aggregate consumption good 

and leisure in each period s to maximize rest-of-life utility 

( )

( )

1 1 54 ( )

1 1

t a

s

s s t

s t

U a LU

σ

σ

σ ρ

− + −

−

=

= − +

∑ , 

where σ is the intertemporal elasticity of substitution, ρ is the pure rate of time preference, and 

U a s( ) is assumed to be a CES function of consumption of the aggregate consumption good and 

leisure in period s with an intratemporal elasticity of ε and a leisure share parameter of E a . The 

aggregate consumption good is modeled as a CES function of the composite good and aggregate 

housing services (including a minimum purchase requirement for both goods), with aggregate 

housing services in turn modeled as CES function of owner-occupied and rental housing 

services. In addition, as described in detail in Diamond and Zodrow (2005), the model includes 

a simple social security system, government purchases of the composite good, transfer payments, 

a hump-backed wage profile over the life cycle, a progressive tax on wage income, and constant 

average marginal tax rates applied to interest income, dividends, and capital gains. The 

progressive labor tax uses a quadratic approximation to average and marginal tax rates similar to 

the method used by Auerbach and Kotlikoff (1987). 

International capital flows 

Although the focus of the model is on the U.S. domestic economy, it includes a simple 

representation of international capital flows, which are assumed to respond to differences in 

after-tax rates of return in the US and the “rest of the world.” This approach represents a 

compromise between the standard closed economy approach and the alternative of a completely 

open economy in which international capital is perfectly mobile and the international return to 
27

capital is fixed. Following Goulder, Shoven and Whalley (1983), capital imports (or exports) in 

period s are governed by the constant elasticity expression 

W F US

s s

W W

KK r

K r

εκ

− ⎛ ⎞ = ⎜ ⎟ ⎝ ⎠

, 

where W K is the fixed rest-of-the-world capital stock,28 W

r is the fixed rest-of-the-world return 

to capital, US

sr is the return after taxes to capital in the US (given the fixed debt-asset ratio of b ), 

F Ks is foreign exports of capital to the US in period s , and εκ is a constant (positive) elasticity 

that determines the extent of international capital flows in the model. Thus, foreign exports of 

capital to the US are 

1

W

F W

s US

s

r K K

r

εκ ⎡ ⎤ ⎛ ⎞ = − ⎢ ⎥ ⎜ ⎟ ⎢ ⎥ ⎝ ⎠ ⎣ ⎦

 . 

For example, if US W

sr r > as a result of the reform, then the US has positive capital imports in 

period s ( 0) F Ks > . 

Capital imports are treated as perfect substitutes for domestic capital. Given the level of capital 

imports in each period, the model is closed simply by assuming that the returns, after US taxes, 

to foreign capital are included in the aggregate demand for the corporate good and non-corporate 

goods, in fixed proportions equal to the rate of these two goods in the initial equilibrium. This 

approach effectively implies that the US is renting capital services from abroad in each period, 

with foreign capital owners spending an amount equal to their after-tax rents on the two US 

composite goods so that aggregate demand for the goods equal aggregate supplies for those 

goods. There is no additional international trade in goods or services in the current version of the 

model. 

Market Equilibrium 

All markets are assumed to be perfectly competitive. Market equilibrium in the model requires 

that total consumer demand, obtained by aggregating the demands of each of the 55 generations 

alive at any point in time, must equal aggregate supply in each of the four production sectors. In 

addition, factor demands must equal factor supplies in the labor and capital markets, the total 

amounts of debt and equity held as individual wealth must equal firm stocks of debt and equity, 

the government is allowed to finance government spending with tax revenues and government 

bonds as long as the debt to GNP ratio is constant in the long run, and both individual and firm 

expectations regarding the time paths of future prices must be satisfied in equilibrium. 

 

28 Note that W K is fixed within a period, but must increase between each period at a rate equal to the growth rate of 

the US economy so that a long run equilibrium can be attained.