Office of Tax Analysis 

U.S. Department of the Treasury 

A Summary of the Dynamic Analysis of the Tax Reform Options 

Prepared for the 

President’s Advisory Panel on Federal Tax Reform 

By 

Robert Carroll 

Deputy Assistant Secretary for Tax Analysis, U.S. Department of the Treasury 

John Diamond 

Kelly Fellow in Tax Policy, The James A. Baker III Institute for Public Policy, Rice 

University 

Craig Johnson 

Office of Tax Analysis, U.S. Department of the Treasury 

and 

James Mackie III 

Office of Tax Analysis, U.S. Department of the Treasury 

For the American Enterprise Institute Conference on 

Tax Reform and Dynamic Analysis 

May 25, 2006 
i

Executive Summary 

Background: 

The President’s Advisory Panel on Federal Tax Reform (the Tax Panel) released its report on 

reform of the federal income tax on November 1, 2005. The Tax Panel unanimously recommended 

two reform options: the Simplified Income Tax (SIT) and the Growth and Investment Tax (GIT). 

Both reform options are a hybrid of an income and consumption based tax. The Tax Panel also 

extensively examined a Progressive Consumption Tax (PCT). The Treasury Department’s Office of 

Tax Analysis (OTA) provided estimates to the Tax Panel on the likely growth effects for each of 

these plans. 

Dynamic Analysis:

The Office of Tax Analysis (OTA) provided a dynamic analysis of the Tax Panel’s tax reform 

options. This paper illustrates the value that dynamic analysis can provide to policy makers on the 

economic benefits of changes in tax policy. The dynamic analysis of the Tax Panel’s tax reform 

options focused on the broad economic effects in both the long-run and over the transition path. 

The analysis also illustrated that the various tax reform options considered by the panel can be 

expected to have very different effects on economic growth depending primarily to what extent they 

reduce the tax on capital income. 

Dynamic Analysis Models: 

Three different models were used in the dynamic analysis to reflect the uncertainty inherent in 

modeling individual and firm behavior and the associated tax-induced behavioral responses. The 

use of several modeling frameworks allowed for a range of estimates to reflect the sensitivity of the 

results to underlying assumptions and modeling approaches. The models were 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. 

The three models used by the Treasury Department for this dynamic analysis include: 

(1) Solow growth model; 

(2) Ramsey infinite horizon growth model; and 

(3) Overlapping generations (OLG) life-cycle model. 

Summary of Results:

All of these models predict that fundamental tax reform could lead to substantial increases in the 

national capital stock and national income. For example, the models suggest that the GIT 

recommended by the Tax Panel could lead to long-run increases in the capital stock ranging from 

5.6 to 20.4 percent and long-run increases of national income ranging from 1.4 to 4.8 percent. The 

simulated growth effects of the SIT plan were considerably smaller, with long-run increases in the 

capital stock ranging from 0.9 to 2.3 percent and national income increases ranging from 0.2 to 0.9 

percent. The growth effects of the PCT were the largest of the three plans, with long-run increases 

in the capital stock ranging from 8.0 to 27.9 percent, and long-run increases in national income 

ranging from 1.9 to 6.0 percent. 
1

A Summary of the Dynamic Analysis of the Tax Reform Options Prepared for the 

President’s Advisory Panel on Federal Tax Reform 

1. Introduction 

On January 7, 2005, President Bush established the President’s Advisory Panel on Federal Tax 

Reform (hereafter, the Tax Panel). The President charged the Tax Panel to develop revenue 

neutral options to reform the federal income tax code that would: (1) reduce compliance and 

administrative costs relative to existing law; (2) maintain an appropriate level of progressivity 

and reflect the importance of homeownership and charitable giving; and (3) promote long-run 

economic growth and job creation. The Tax Panel released its report on November 1, 2005.1

 

The Tax Panel unanimously recommended two reform options: the Simplified Income Tax 

(SIT) and the Growth and Investment Tax (GIT). Both reform options are a hybrid of an income 

and consumption based tax. The Tax Panel also extensively examined a Progressive 

Consumption Tax (PCT).2 The Office of Tax Analysis in the Department of the Treasury 

provided estimates to the Tax Panel on the likely growth effects for each of these three plans. 

This paper provides background information on the models and assumptions used to simulate the 

economic growth effects of the tax reform options presented in the Tax Panel’s report. The 

paper also illustrates the value that dynamic analysis can provide to policy makers on the 

economic benefits of changes in tax policy. The analysis focuses on the broad economic effects 

of the Tax Panel’s proposed reform options in both the long-run and over the transition path. 

Importantly, all of the proposed reforms would increase national income or output, some by as 

much as 6.0 percent in the long-run. 

The Treasury used variants of three standard economic growth models to estimate the 

macroeconomic responses associated with the Tax Panel’s proposed reform options. The use of 

multiple models reflects the uncertainty that is inherent in modeling individual and firm behavior 

and the associated tax-induced behavioral responses. The use of several modeling frameworks 

allows for a broader range of potential economic effects in an effort to provide a reasonable 

range of results. These types of models have all been used to estimate the dynamic effects of 

policy changes in prior policy analyses, most notably in the 1997 Joint Committee on Taxation 

Symposium on Dynamic Scoring and in recent analyses by both the staffs of the Joint Committee 

on Taxation and the Congressional Budget Office.3

 

The three models used by the Treasury for this analysis include: (1) a Solow growth model 

(similar to that found in many macroeconomic textbooks); (2) a Ramsey infinite horizon growth 

model; and (3) an overlapping generations (OLG) life-cycle model. The models are 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. The models ignore cyclical disruptions in the 

 

1

 The President’s Advisory Panel on Federal Tax Reform (2005). 

2

 See the tables in the appendix for important features of the reform plans. 

3

 See Joint Committee on Taxation (1997) and Congressional Budget Office (2005). 
2

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

fully employed. The Solow and Ramsey models are closed economy models that abstract from 

international capital flows and foreign trade. The OLG model includes a simple international 

sector. The OLG model also includes four production sectors, while the other two models have a 

single aggregate production sector. 

The Solow growth model is the simplest of the three models. The model assumes the economy 

produces a single good, and the amount of production is determined by the amount of labor and 

capital supplied by the household sector. The amount of savings and investment in each period 

depend only on the prices in that period. The responsiveness of savings (capital supply) to the 

after-tax interest rate is determined by a parameter in the aggregate savings supply function. 

This parameter is chosen so that the savings response in the model falls within the range of 

empirical evidence. In this version of the model, labor supply does not vary with changes in the 

after-tax wage rate. 

There are three main differences between the Solow growth model and the other two models. 

First, the Ramsey and the OLG models assume that consumers and firms incorporate future 

prices into their current period decisions of how much to save, work and produce. Second, the 

Ramsey and the OLG models assume that representative consumers maximize their level of well 

being by choosing consumption and leisure over their lifetimes subject to resource constraints on 

time and money. These individual level decisions determine the aggregate level of labor supply 

and savings in each year. Third, reform-induced asset price effects that result from the 

differential treatment of old and new capital under some tax reform proposals are allowed to 

affect economic decisions of firms and individuals in the Ramsey and OLG models. 

The primary difference between the Ramsey and OLG models is that households in the Ramsey 

model have an infinite time horizon, that is, current households care about the well being of their 

children in the future just as much as their own welfare. In contrast, in the OLG model, 

households are assumed to live an economic life of 55 years corresponding to real-life ages from 

21 to 75.4

 Thus, households in the OLG model do not respond to economic events beyond the 

end of their lifespan. 

All of these models predict that fundamental tax reform could lead to substantial increases in the 

national capital stock and national income. For example, the models suggest that the GIT plan 

recommended by the Tax Panel could lead to long-run increases in the capital stock ranging from 

5.6 to 20.4 percent and long-run increases of national income ranging from 1.4 to 4.8 percent. 

The simulated growth effects of the SIT plan were considerably smaller, with long-run increases 

in the capital stock ranging from 0.9 to 2.3 percent and national income increases ranging from 

0.2 to 0.9 percent. 

The remainder of the paper is organized as follows. Section 2 describes each of the three models 

used in this analysis in greater detail. Section 3 outlines the methodology employed in 

simulating the economic effects of the tax reform options. Section 4 describes and explains the 

results and the last section concludes. 

 

4

 Concerns of parents about their children are incorporated through a bequest motive that specifies a target bequest 

that is independent of economic conditions beyond the time of death of the donor. 
3

2. Model Descriptions 

We used variants of three standard economic growth models. 

 

2.1 Neoclassical Growth (Solow) Model 

 

A representative competitive firm combines capital (K) and labor (L) inputs according to a 

standard Cobb-Douglas technology to produce the economy’s single good, 

( , ) , 0 1 1 = = < < − α α α

t K L AKt Lt Y f , (1) 

where α is the parameter that determines capital’s share of income and A is the scale parameter. 

The firm demands labor until the wage equals the marginal product of labor and demands capital 

until the interest rate equals the marginal product of capital. 

In the Solow model, economic decisions depend only on current year economic conditions. In 

addition, households and firms do not optimize an objective function, such as individual well 

being or business profits. Instead it is a reduced form model; that is, aggregate labor supply and 

savings adjust to after-tax wage and interest rates assuming responses that are determined by 

fixed parameters that are set consistent with the consensus range of empirical estimates. In this 

version of the model, the labor supply elasticity with respect to the wage rate equals zero, at the 

bottom of this range. 

The rate of savings out of national income (st) is determined by, 

[ ] ( ) η τ t t k s = b r 1− (2) 

where rt is the rate of return to capital at time t, τk is the tax rate on capital income, η is the 

savings rate elasticity with respect to the after-tax rate of return and b is a constant. The savings 

rate elasticity is set equal to 0.4.5

 

Government raises revenue through a flat rate labor tax and a flat rate capital tax rate set equal to 

the estimated marginal effective tax rate on capital income. Government revenues finance an 

exogenously specified time path of public services. 

The Solow model easily conforms to empirical estimates of labor and saving supply elasticities. 

In contrast, in the Ramsey and OLG models the labor supply and savings behaviors are more 

complicated, can vary over time, and depend on parameters that can be difficult to estimate. 

However, aggregate savings elasticities are also extremely difficult to measure and the type of 

estimates used for this model are not invariant to policy or demographic changes.6

 

5

 See Engen, Gravelle and Smetters (1997) and Bernheim (2002) for reviews of the literature. 6

 See Elmendorf (1996) and Bernheim (2002) for further discussion. 
4

2.2 Ramsey Growth Model 

 

Production of the model’s single good is determined by the amount of labor and capital supplied 

by the household sector using the same Cobb-Douglas production technology employed in the 

Solow model, where labor is hired until the wage equals the marginal product of labor. Firm 

investment decisions follow the “q” theory of investment, where firms invest as long as the 

increase in the stock market value of the firm exceeds the replacement cost of the asset. 

Specifically, firms invest until the marginal after-tax cost of the investment equals the value of 

the firm. 

t t q =1 , (3) − zτ

where z is the fraction of investment that is effectively expensed and τ is the firm’s tax rate. This 

approach distinguishes between the tax treatment of old and new capital and incorporates asset 

price changes caused by changes in the tax regime.7

 However, the simple version of the Ramsey 

model used in the simulations does not include adjustment costs associated with expanding or 

contracting the stock of capital. 

A representative consumer chooses levels of annual consumption (C) and leisure (LE) to 

maximize lifetime utility, 

( )

⎟

⎟

⎟

⎟

⎟

⎠

⎞

⎜

⎜

⎜

⎜

⎜

⎝

⎛

+ ⎟

⎟

⎠

⎞ ⎜

⎜

⎝

⎛

+ −

= −

−

∞

=

− −

∑ γ

σ

γ γ α

ρ

σ

1 1

1 1

0

1 1/ 1 1/

1

1

1 1

1

t

t e t

t

LU C LE , (4) 

subject to a lifetime budget constraint, where αe is the preference parameter for leisure, σ is the 

intertemporal elasticity of substitution, γ is the intratemporal elasticity of substitution between 

consumption goods and leisure and ρ is the rate of time preference. As indicated in Table 1, the 

intertemporal substitution elasticity equals 0.25 and the intratemporal elasticity equals 0.8. 

The government raises revenue through a flat rate labor tax and a capital tax that approximates 

the current and proscribed tax burden on old and new capital through a combination of a flat tax 

rate on capital income plus the portion of investment that is effectively expensed.8

 Government 

revenues finance an exogenously specified time path of public services, which are assumed to be 

separable from the consumption of other goods and services and leisure in the utility function. 

The Ramsey model assumes that the representative consumer lives forever and has perfect 

foresight. While in actuality the economy is not populated by individuals with infinite life spans, 

an infinite planning horizon can be justified if consumers are members of families in which each 

generation cares as much about the well-being of future generations as it would about its own 

well-being for each period in the future. An important implication of the forward looking nature 

 

7

 See Auerbach and Kotlikoff (1987) for further discussion of this approach. 

8

 See Auerbach (1996) for further description of this method of approximating capital income taxation. 
5

of consumers in the Ramsey model is that future fiscal policies, such as those used to achieve 

budget neutrality, affect current economic decisions made by consumers. 

The structure of the Ramsey model implies that in the long-run the capital stock will always 

adjust sufficiently to keep the after-tax return to capital constant. This implies an infinitely 

elastic supply of savings in the long-run. 

 

2.2 Overlapping Generations Model (OLG) 

 

For the Tax Panel report analysis, the Treasury Department used the OLG model developed by 

Tax Policy Advisers, LLC.9

 An overview of the model follows, with important equations and 

further explanation provided in Appendix B. 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 the tax advantages of home ownership. Similar to the 

previous two models, each production function takes the standard Cobb-Douglas 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, as 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. 

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.10 

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, similar to the Ramsey model, 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 equals 

 

9

 See http://www.taxpolicyadvisers.com. 

10 An alternative approach 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. 
6

0.35 and the intratemporal substitution elasticity between goods and leisure equals 0.6.11 These 

parameter values yield an aggregate labor supply elasticity that is lower than the value assumed 

in Altig et al. (2001) and Auerbach and Kotlikoff (1987). This labor supply elasticity is 

consistent with most of the empirical literature; it is, however, inconsistent with the relatively 

large labor supply elasticities found in the recent work of Prescott (2005) and Davis and 

Henreckson (2005).12 

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 GDP in the initial steady state. The government must finance an exogenously specified time 

path of public services and satisfy an annual budget constraint.13 The tax instruments available 

to the government in the initial equilibrium include (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 interest income, dividends and capital gains. 

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.14 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 capital is fixed. There is no international trade of 

goods in the current version of the model. 

3. Framework for analysis 

Each model is calibrated to replicate certain economic aggregates over the Administration’s 

policy baseline over the 10-year budget window. In particular, the initial model tax rates on 

labor and capital income are set to match the respective average marginal effective tax rates 

under the Administration’s policy baseline averaged over the budget window.15 In the initial 

equilibrium, the economic growth rate equals the combined population growth rate and rate of 

 

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

plausible range of values for these parameters. 

12 To be precise, the parameters yield a Frisch elasticity of labor supply, which measures the labor supply elasticity 

holding the marginal utility constant, equal to 0.48 which is consistent with the range of estimates reported in 

Browning, Hansen, and Heckman (1999). 13 The model can also accommodate the issuance of debt as long as the ratio of government debt to GDP constant in 

the long run. Thus, the government is required to adjust revenues so that the debt issues do not grow at a faster rate 

than GDP. 

14 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. 15 The Administration’s baseline assumes the current individual tax rates, including the special rates on dividends 

and capital gains would remain at 2005 levels and not increase as under current law. Also, the temporary patch on 

the individual Alternative Minimum Tax (AMT) would not be extended and the Administration’s Lifetime Savings 

Accounts (LSAs) and Retirement Savings Accounts (RSAs) budget proposals would be enacted. 
7

growth in technological change, both of which are held fixed over time.16 The changes to the tax 

system are assumed to occur simultaneously and without anticipation by households or firms. 

As households and firms respond to the effect of the tax changes on after-tax wages and interest 

rates, savings and investment increase, the capital stock increases and labor supply changes. 

Eventually the economy returns to the original steady-state rate of growth, but at a different level 

of economic activity along the new growth path than the previous steady-state growth path. This 

implies that the percentage changes reported in Table 3 are changes in levels, not growth rates. 

Table 1 shows the important behavioral parameter assumptions made for each model. The 

economic results discussed below are sensitive to these parameter values and it is common to 

include sensitivity analysis of changing certain parameter values in this type of research. We do 

not include sensitivity analysis in this paper for two reasons. First, previous research has 

generally demonstrated the extent to which each of the models used in this analysis are sensitive 

to parameter values.17 Second, our use of multiple models for this analysis with our chosen 

parameter values already provides a certain amount of sensitivity analysis. The Solow growth 

model, with no labor response and a moderate savings response, represents the lower end of the 

likely behavioral responses, while the Ramsey model with its infinitely elastic savings response 

represents the upper end. The OLG model’s savings response, with its target bequests, is 

generally in between these two models, and its labor supply substitution response is calibrated to 

be lower than the Ramsey model.18

Each of the plans has been estimated by the Treasury to be revenue neutral over the budget 

window compared to the Administration’s policy baseline under conventional scoring 

procedures. The new average marginal tax rates on capital and labor income over the budget 

window that result from this standard revenue estimating analysis are then used to specify the 

initial tax parameters for the reformed tax system in the dynamic models. Table 2 lists the initial 

tax rates for the policy baseline and each of the reform options. Yet given the simplifying 

assumptions in the dynamic models as well as the embedded behavioral responses, there is no 

reason to expect that budget neutrality would be maintained for any particular year in the models 

by using these tax rates. There are numerous fiscal policy responses that could be adopted to 

meet the government’s budget balance requirements throughout the period of reform.19 The 

analysis in this report assumes that average and marginal tax rates are adjusted in each year to 

maintain a constant level of real government spending for each year after the reform.20 This 

implies that each tax reform plan raises the same amount of revenue in each period within the 

models, even if the initial specifications for the plans imply different present values of revenues. 

 

16 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 tax reform and is commonly used in 

this type of analysis. 

17 See Engen, Gravelle and Smetters (1997), Auerbach (1996) and Altig et al. (2001). 18 The Frisch labor supply elasticity is approximately 0.5 in the OLG model and 0.7 in the Ramsey model. It is 

possible for the initial labor supply response to be stronger in the OLG model due to intergenerational redistribution. 

19 For example, tax rates could be held constant over the budget window and government debt could be increased or 

decreased during that time in order to maintain government spending at constant levels. The government budget 

would then need to be balanced in years outside of the budget window through either changing taxes or the level of 

government spending. 

20 In the Solow and Ramsey models average and marginal tax rates on wages and capital income are adjusted in each 

year to maintain a constant level of real government spending. In the OLG model only the average and marginal 

wage tax rates are adjusted in each year to maintain a constant level of real government spending. 
8

The transition relief provided for existing capital at the time of reform is assumed to be financed 

by increasing tax rates temporarily in each transition year it is allowed. This implies that 

transition relief does not affect the steady-state estimates, although short-run economic results 

are affected as labor taxes increase in the short-run to pay for the transition relief. Previous work 

has noted the profound difference between the long-run economic effects of replacing an income 

tax with a consumption tax versus a wage tax, which can be thought of as a consumption tax 

with complete transition relief for existing capital.21 The approach used in this paper, however, 

is consistent with the static revenue estimates where the revenue neutral tax rates over the budget 

window account for the revenue loss due to transition relief. 

4. Macroeconomic Effects 

4.1 Progressive Consumption Tax Plan 

The Tax Panel’s Progressive Consumption Tax (PCT) is a modified version of David Bradford’s 

X-tax.22 The plan is a bifurcated subtraction-method VAT where labor compensation is 

deducted at the business level and taxed at the individual level at progressive rates of 15, 25 and 

35 percent. All business investment is expensed and interest is generally neither includible in 

nor deductible from the tax base.23 To conform to the President’s directive that tax reform 

recognize the importance of owner-occupied housing, the PCT includes a 15 percent 

nonrefundable capped tax credit for home mortgage interest payments. 

The PCT is equivalent to a broad-based consumption tax imposed at a statutory rate of 35 

percent that provides subsidies to debt-financed owner-occupied housing (through the 15 percent 

mortgage interest credit) and to the wages of lower income individuals.24 In general, the primary 

distinction between income and consumption based taxes is that under an income tax the normal 

return to capital is taxed, while under a consumption tax the normal return to capital is not 

taxed.25 In the case of the PCT, expensing of business investment implies a marginal effective 

tax rate equal to zero on the normal rate of return to business investment since the value of the 

upfront deduction just equals the present value of tax paid on the normal return to that 

investment. As shown in Table 2, the marginal effective tax rate on all investment under the 

PCT is a negative 3.7 percent due to the subsidy provided to owner-occupied housing. 

 

21 See Auerbach and Kotlikoff (1987). 

22 See Bradford (1986). 

23 To maintain the economic effect of expensing for financial institutions, the cash flow treatment extends to 

financial transactions, that is, principal and interest inflows would be taxable and principal and interest outflows 

would be deductible. 

24 The PCT differs from a pure consumption base in other ways as it retains preferences for charitable giving and for 

employee compensation given in the form of employer provided health insurance, although in the latter case the 

preference is capped and smaller than under current law. 25 Recent literature, for example, see Hubbard (2005), has emphasized that the return to capital is comprised of four 

components: (1) the normal return to waiting; (2) returns to market power, entrepreneurial skills or ideas (economic 

rents); (3) the return to risk-taking; and (4) returns that reflect good or bad luck. Only the first component is 

exempted from taxation under a consumption tax. The models used in this paper assume economic certainty and 

perfect competition, implying that the latter three components of the return to capital are not directly included in the 

models. 
9

While the business cash flow tax effectively exempts the normal rate of return on new 

investments from taxation, it does impose a one-time tax on business capital existing at the time 

of reform to the extent that transition relief is not provided. The PCT includes transition relief 

for old capital equivalent to approximately $400 billion over the first four years following the 

enactment of tax reform.26 The present value of the transitional depreciation deductions is 

approximately one-quarter of the present value of future depreciation deductions under current 

law, which implies that the vast majority of existing business capital faces a one-time tax.27 

For each of our three models, Table 3 shows the effects of the PCT on selected economic 

aggregates. We expect that a switch to a consumption tax would lead to more saving and 

investment which would translate into higher levels of output and eventually into higher levels of 

consumption. Each of our three models obtains these qualitative results. In the long-run, for 

example, the capital stock compared to the baseline increases by 27.9 percent in the Ramsey 

model, 14.0 percent in the OLG model, and by 8.0 percent in the Solow model. This leads to an 

increase in national income (Net National Product) of 6.0 percent in the Ramsey model, 2.8 

percent in the OLG model and by 1.9 percent in the Solow model, while consumption rises by 

5.5 percent in the Ramsey model, 2.2 percent in the OLG model, and 1.9 percent in the Solow 

model. 

These results are similar to other estimates of consumption tax reforms found in the literature.28 

For example, using an OLG model, Altig et al. (2001) estimated that an X-tax would lead to a 

6.4 percent long-run increase in national income and a 21 percent increase in the capital stock.29 

Engen, Gravelle and Smetters (1997), using the same response parameters as in the Solow and 

Ramsey models in this paper, estimated that replacing a 20 percent flat income tax with a 

consumption tax would lead to an increase in national output of 2.3 percent in a Solow model 

and 6.8 percent in a Ramsey model. Our estimates are slightly lower than their responses 

primarily due to the lower initial tax burden on capital income under the policy baseline 

compared to their models.30 

As indicated by these results, the quantitative results differ across the three models. In general, 

the effects of tax reform are largest in the Ramsey model, followed by the OLG model, and then 

 

26 Depreciation allowances for property placed in service before the reform would be phased out evenly over a 

period of 5 years. In the first year of reform, 80 percent of the previous law depreciation allowance would be 

allowed. In the second year this percentage would drop to 60 percent, then 40 percent in the third year, 20 percent in 

the fourth year and zero for the fifth year and following. Similar treatment is allowed for business interest payments 

and receipt and for home mortgage interest. 

27 Auerbach (1996) estimated that the present value of remaining depreciation deductions for existing nonresidential 

capital to be approximately one-half the value of these assets. 28 These other estimates generally involve consumption taxes with clean bases. The lack of a clean base in the Tax 

Panel plans does lower the long-run output effects in the OLG model. 

29 Altig et al. (2001) do not examine the effect of including transition relief for their estimates of the X-tax, although 

they do consider allowing full continuation of depreciation allowances for existing assets under the Flat tax, where 

they model transition relief as a reduction in the business cash-flow rate. They find that transition relief reduces the 

long-run gain in national output under the Flat tax from 4.5 to 1.8 percent. Employing their methodology would 

reduce the long-run gains in output from our OLG and Ramsey models, but not to a great extent given that the level 

of transition relief provided under the panel plans is only about one-quarter the amount assumed in their paper. 

30 Engen, Gravelle and Smetters (1997) assumed a decline in the marginal effective tax rate on capital income of 20 

percentage points. Under the PCT, the marginal effective tax rate on capital income falls by 17.6 percentage points. 
10

by the Solow model. The Solow model generates smaller long-term results than the other two 

models because its saving response is smaller and labor supply is inelastic. 

Changes in the accumulation of capital in the short-run generally follow the same pattern across 

models, but the magnitude of these changes vary widely. The Ramsey model generates larger 

short-run effects than the OLG model, while the Solow model generates significantly smaller 

short-run effects. The differences in the short-run effects generated by the OLG and the Ramsey 

model reflect the inclusion of adjustment costs in the OLG model but not in the Ramsey model, 

which slows the expansion of the capital stock, and the lower overall savings response in the 

OLG model. 

The bigger difference, however, is between the OLG and Ramsey models, on one side, and the 

Solow model on the other. With respect to changes in national income, this difference primarily 

reflects labor supply effects, although the Solow model’s relatively small savings elasticity also 

contributes to the smaller increase in output. In the Solow model, labor supply is assumed to be 

unaffected by tax changes. In contrast, short-run labor supply increases in both the OLG and 

Ramsey models. This increase reflects the intertemporal substitution of leisure caused by the 

increase in the after-tax rate of return. In the OLG model, the short-run increase in labor supply 

also reflects the shift in the tax burden from younger to older generations as a result of the 

reduction in taxation of the return to capital and the one-time tax on old capital. The tax on old 

capital reduces lifetime resources at the time of reform for older generations which leads these 

generations to decrease their consumption of leisure and other goods in response to the negative 

income effect.31 The elimination of the tax on the normal rate of return to lifetime saving, which 

raises the after-tax return, induces younger generations to work more in order to take advantage 

of the higher rate of return (stated differently, the higher return they earn as a result of the 

intergenerational shift in the tax burden induces them to shift both consumption and leisure into 

the future). In both models, the increase in labor supply increases national income in the short 

run, but the increase in labor supply in the Ramsey model is larger. The larger labor supply 

response in the Ramsey model over the budget window relative to the OLG model is explained 

by the use of the flat labor tax system in the Ramsey model, which leads to a smaller increase in 

marginal tax rates than in the OLG model under the reform. 

4.2 Growth and Investment Tax Plan 

The Tax Panel did not recommend a complete replacement of the existing income tax system 

with a consumption tax. Instead the Tax Panel recommended the hybrid Growth and Investment 

Tax (GIT), which is similar to the PCT, but on top of the bifurcated VAT structure, interest, 

dividends and capital gains are subject to a 15 percent tax rate at the individual level. This 

allows for lower tax rates on business cash-flow and wages compared to the PCT. The plan also 

expands opportunities to save in tax-preferred accounts that are similar to the Administration’s 

Lifetime Savings Accounts (LSAs) and Retirement Savings Accounts (RSAs) proposals, but 

with higher annual contribution limits. In particular, the plan would allow Save for Family 

accounts and Save for Retirement accounts. Each account would have an annual contribution 

limit of $10,000 in after-tax dollars, earnings would accumulate tax-free and qualified 

 

31 However, note that the retirement decision is exogenous, so retired workers do not re-enter the work force and as 

workers reach the models retirement age of 45 they are forced to retire. 
11

withdrawals would be tax-free. Withdrawals from the Save for Retirement accounts could be 

made without penalty only at age 58 and older, or in the event of death or disability. 

Withdrawals from Save for Family accounts could be made without penalty at any time for 

qualified expenditures for health or medical costs, education or training expenses, purchases of a 

primary residence, and for taxpayers age 58 and older. In addition, $1,000 may be withdrawn 

annually from the Save for Family account for any purpose without penalty.32 

The combination of the effects of the new savings accounts and the relatively low statutory tax 

rate on individual capital income implies that the marginal effective tax rate is only 4.8 

percentage points higher under the GIT in relation to the PCT, and thus, we would expect the 

growth effects for the GIT to be almost as large as the PCT.33

This is confirmed by the results shown in Table 3. Again, moving to full expensing of business 

investment encourages growth in the capital stock, and hence national income over time, which 

is tempered slightly by the increase in taxation of capital income at the individual level. For 

example, the growth in the capital stock in the long-run equals 20.4, 9.8 and 5.8 percent in the 

Ramsey, OLG and Solow growth models, respectively, which is over 70 percent of the growth in 

the capital stock experienced under the PCT for each model. Similarly, the long run increase in 

national income under the GIT for each model is greater than 70 percent of the increase for the 

PCT, with increases of 4.8, 2.2 and 1.4 percent for the Ramsey, OLG and Solow growth models, 

respectively. 

The explanations for the differences in the results across the models are similar to the 

explanations for the differences under the PCT. Savings responses in the Ramsey and OLG 

models are greater than in the Solow model, which leads to greater capital accumulation and 

output in the long-run in those models compared to the Solow model. In the short-run, the 

output responses are dominated by the labor response. It is unclear, however, whether labor 

supply should increase more under the GIT relative to the labor supply response under the PCT. 

Lower tax rates on labor income should increase labor supply through the substitution effect, but 

the increased taxation of capital income reduces the initial increase in the after-tax rate of return 

and thus the intertemporal substitution of leisure would be less important under the GIT 

compared to the PCT. In the Ramsey model, the initial labor supply response is slightly smaller 

under the GIT, but in the long-run as the after-tax rate of return returns to the steady-state level 

and the intertemporal effect disappears, the increase in labor supply is larger under the GIT. The 

initial labor supply responses in the OLG model are higher than under the PCT and nearly as 

high as in the Ramsey model. Long-run output gains in the Ramsey model are larger than the 

OLG model due to greater capital accumulation in the Ramsey model. 

4.3 Simplified Income Tax Plan 

The other Tax Panel recommendation is the Simplified Income Tax (SIT). The plan reduces the 

double taxation of corporate income by providing full dividend exclusion and 75 percent 

 

32 In contrast, the Administration’s LSA/RSA proposal limits annual contributions to $5,000 and withdrawals from 

LSAs can be made for any purpose without penalty. 

33 Given the relatively high tax rate on labor income in the PCT, it is possible that implementing a low-rate capital 

income tax and reducing labor taxes could lead to an increase in output. 
12

exclusion of capital gains on corporate stock. Other capital gains are taxed at ordinary rates. 

The top marginal rate for corporations falls to 31.5 percent and the top individual rate falls to 33 

percent. The rate reductions are paid for by broadening the individual and business tax bases. 

As in the GIT, tax preferred saving opportunities are also expanded. A simplified system for 

depreciation allowances is also proposed; note that using the parameters suggested in the report 

would slow down the cost recovery for capital slightly. On net, the effective marginal tax rate on 

capital income falls by just under 2 percentage points compared to the baseline under the SIT and 

the corresponding dynamic effects are expected to be small. 

Again, the results from Table 3 confirm the expectation that the SIT will have a relatively small 

effect on long-term capital deepening and economic growth. For example, the capital stock is 

only 2.3 percent higher in the long-run in the Ramsey model, 1.3 percent higher in the OLG 

model, and 0.9 percent higher in the Solow model. The growth in national income is only 0.3 

percent in the Ramsey model and 0.2 percent in the Solow model. 

The surprising result for the SIT is that long-run national income increases by 0.9 percent in 

OLG model. The OLG model is the only model that includes multiple production sectors and 

efficiency gains should occur as capital reallocates away from the noncorporate and housing 

sectors towards the corporate sector. This leads to an increase in the tax base which leads to 

lower marginal tax rates on labor income and an increase in labor supply. While it is not too 

surprising that the OLG results are larger than the Ramsey model for the SIT, the results are 

nonetheless surprisingly large. 

5. Discussion and Conclusion

The Tax Panel was charged with developing options for reforming the current federal income tax 

system that are simple, fair and pro-growth. Tradeoffs are inherent in the design of a tax system 

as simple tax plans may not be considered fair, and options that are considered fair may be 

relatively inefficient. This paper examines the economic growth effects of three of the tax 

reform options discussed by the Tax Panel. We find that the options that move the tax system in 

the direction of a consumption tax base the most, the PCT and GIT, provide the greatest 

increases in capital accumulation and national output. This result is consistent with a wide body 

of previous research.34 

The models and methodology used in this analysis are commonly applied in other research on 

the macroeconomic effects of tax reform. Nevertheless, the models face certain limitations, 

which we will now discuss briefly. First, the Ramsey and Solow growth models do not account 

for international trade or capital flows and, as a result, could overestimate or underestimate the 

investment response to tax reform. The lack of an international sector in these models generally 

is due to the complexity in properly modeling this sector. 

The OLG model does include a simple representation of international capital flow sensitivity to 

after-tax rates of return, but this inclusion has small effects on the overall results. For the PCT 

and GIT, the after-tax rate of return to capital in the U.S. increases in the short-run, leading to an 

increase in net foreign capital flows into the U.S. relative to the baseline. Then as capital 

 

34 For example, see Joint Committee on Taxation (1997) and Altig et al. (2001). 
13

deepening occurs the after-tax return to capital falls and in the long-run net foreign capital flows 

into the U.S. decrease relative to the baseline. Indeed, including international capital flows 

mitigates the long-run increase in investment and net national product that result from 

implementation of the reforms as suggested in the closed economy version of the OLG model. 

Second, the OLG and Ramsey models generally are frictionless, that is, it is costless to change 

capital and labor supply in any particular period, easier than is likely in the real world. The OLG 

model accounts for this on the investment side by including adjustment costs to changing 

investment levels, which helps to moderate the initial savings response in the model. The 

Ramsey model does not include adjustment costs and thus short-run investment levels in this 

model are likely to be higher than would realistically occur. Likewise, the initial labor supply 

response in both models may be overstated since adjustment costs are ignored. 

Third, these models do not account for short-term disruptions in the economy that may occur 

when moving to a new tax system. Nor do these models account for changes in monetary policy. 

However, the focus of these models is on long-term growth and how changes in the tax system 

could enhance economic growth and thus abstracting from short-term cyclical effects is useful 

for clarifying this analysis. 

Fourth, none of these models directly account for risk. Since a portion of savings is 

precautionary and not very sensitive to changes in the interest rate, the implied elasticity of 

savings with respect to the after-tax interest rate in the certainty Ramsey and OLG models is 

likely to be higher than in a model that incorporate risk.35 To partially offset the lack of risk in 

these models, the intertemporal elasticity of substitution used in the models was chosen to reflect 

values near the lower range of the empirical estimates. Also, in the OLG model, households 

have a simple target bequest motive that also tends to mitigate the savings response.36

Finally, these models do not capture all of the gains likely to occur from reforming the tax 

system, such as: (1) the reduced costs of compliance and administration that would come from a 

simpler tax system; (2) the efficiency gains resulting from reducing the tax distortion between 

debt and equity financing; (3) with the exception of the OLG model, the models do not account 

for any gains resulting from a more efficient allocation of capital across production sectors; and 

(4) the efficiency gains from reducing current law distortions in the taxation of different types of 

capital, such as equipment and structures. 

 

35 This would only affect the short-run response in the Ramsey model. 

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

than 10 percent of total wealth. 
14

References

Altig, David, Alan Auerbach, Laurence Kotlikoff, Kent Smetters and Jan Walliser. 2001. 

“Simulating Fundamental Tax Reform in the United States.” American Economic Review

91:574-595. 

Auerbach, Alan. 1996. “Tax Reform, Capital Allocation, Efficiency, and Growth,” in Economic 

Effects of Fundamental Tax Reform edited by Henry J. Aaron and William Gale 

(Brookings Institution Press: Washington, DC): 29-73. 

Auerbach, Alan J. and Laurence J. Kotlikoff. 1987. Dynamic Fiscal Policy (Cambridge 

University Press: Cambridge). 

Bernheim, B. Douglas. 2002. “Taxation and Saving.” in Handbook of Public Economics, Volume 

3 edited by Alan Auerbach and Martin Feldstein (Elsevier Science Publishers: 

Amsterdam). 

Bradford, David F. 1986. Untangling the Income Tax (Harvard University Press: Cambridge, 

MA). 

Browning, Martin, Lars Peter Hansen, and James J. Heckman. 1999. “Micro Data and General 

Equilibrium Models.” University of Copenhagen, Institute of Economics, Discussion 

Papers: 99-10. 

Congressional Budget Office. 2005. An Analysis of the President’s Budgetary Proposals for 

Fiscal Year 2006. 

Cummins, Jason G., Kevin A. Hasset and R. Glenn Hubbard. 1994. “A Reconsideration of 

Investment Behavior Using Tax Reforms as Natural Experiments.” Brookings Papers on 

Economic Activity 2:1-74. 

Davis, Steven J. and Magnus Henrekson, 2004. “Tax Effects on Work Activity, Industry Mix 

and Shadow Economy Size: Evidence from Rich Country Comparisons,” National 

Bureau of Economic Research Working Paper No. 10509. 

Diamond, John and George R. Zodrow, 2005. “Description of the Tax Policy Advisers General 

Equilibrium Model,” manuscript, Rice University. 

Elmendorf, Douglas W. 1996. “The Effect of Interest-Rate Changes on Household Saving and 

Consumption: A Survey.” Finance and Economics Discussion Series No. 1996-27 Board 

of Governors of the Federal Reserve System. 

Engen, Eric, Jane Gravelle and Kent Smetters. 1997. “Dynamic Tax Models: Why they do the 

things they do.” National Tax Journal 50:657-682. 

Fullerton, Don and Diane Lim Rogers. 1993. Who Bears the Lifetime Tax Burden? (Washington, 

D.C.: The Brookings Institution). 
15

Goulder, Lawrence H. 1989. “Tax Policy, Housing Prices and Housing Investment.” Regional 

Science and Urban Economics 19:281-304. 

Goulder, Lawrence H. and Lawrence H. Summers. 1989. “Tax Policy, Asset Prices and Growth: 

A General Equilibrium Approach.” Journal of Public Economics 38:265-296. 

Goulder, Lawrence H., John Shoven and John Whalley. 1983. “Domestic Tax Policy and the 

Foreign Sector: The Importance of Alternative Foreign Sector Formulations to Results 

from a General Equilibrium Tax Analysis Model.” in Simulation Methods in Tax Policy 

Analysis, edited by Martin Feldstein (Chicago: University of Chicago Press). 

Hayashi, Fumio. 1982. “Tobin’s Marginal q and Average q: A neoclassical Interpretation.” 

Econometrica 50:213-224. 

Hurst, Erik, Annamaria Lusardi, Arthur Kennickell, and Francisco Torralba. 2005. 

“Precautionary Savings and the Importance of Business Owners.” National Bureau of 

Economic Research Working Paper 11731. 

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

1997 Tax Symposium Papers (JCS-21-97). 

Keuschnigg, Christian. 1990. “Corporate Taxation and Growth: A Dynamic General 

Equilibrium Simulation Study,” in Johann K. Brunner and Hans-Georg Petersen, eds. 

Simulation Models in Tax and Transfer Policy (Campus Verlag) 245-78. 

Muthitacharoen, Athiphat and George R. Zodrow, forthcoming. “State and Local Taxation of 

Business Property: A Small Open Economy Perspective,” Proceedings of the NinetyEighth Annual Conference on Taxation, National Tax Association. 

Prescott, Edward C., 2005. “The Elasticity of Labor Supply and the Consequences for Tax 

Policy,” in Alan J. Auerbach and Kevin A. Hassett (eds.), Toward Fundamental Tax 

Reform (Washington DC: AEI Press), pp. 123-34. 

The President’s Advisory Tax Panel on Federal Tax Reform. 2005. Simple, Fair, and ProGrowth: Proposals to Fix America’s Tax System (U.S. Government Printing Office: 

Washington, DC). 
16

 

Model Ramsey OLG Solow

Savings rate elasticity n/a n/a 0.40

Uncompensated price elasticity of labor supply n/a n/a 0.00

Intertemporal substitution elasticity 0.25 0.35 n/a

Intratemporal substitution elasticity (between leisure and goods) 0.80 0.60 n/a

Factor substitution elasticity (between capital and labor) 1.00 1.00 1.00

Adjustment costs no yes no

Capital income share 0.25 0.25 0.25

Other Key Initial Variables

Capital/output ratio 3.40 2.82 2.98

Department of the Treasury

 Office of Tax Analysis

Table 1

Base Case Parameters
17

Policy 

Baseline PCT GIT SIT

Average Marginal Tax Rate on Labor Income 0.240 0.264 0.235 0.240

Average Tax Rate on Labor Income 0.130 0.147 0.133 0.128

Marginal Effective Tax Rate on Capital Income 0.139 -0.037 0.011 0.120

Department of the Treasury

 Office of Tax Analysis

Table 2

Tax Parameters
Budget 

Window* Year 20 Long-run

Budget 

Window* Year 20 Long-run

Budge

Windo

National Income

Ramsey Growth Model 2.3% 4.5% 6.0% 1.9% 3.7% 4.8% 0OLG Model 0.7% 2.6% 2.8% 1.5% 2.1% 2.2% 0Solow Growth Model 0.2% 0.6% 1.9% 0.1% 0.4% 1.4% 0

Capital Stock

Ramsey Growth Model 5.1% 16.7% 27.9% 3.7% 12.1% 20.4% 0OLG Model 3.3% 9.8% 14.0% 3.0% 7.5% 9.8% 0Solow Growth Model 0.7% 2.5% 8.0% 0.5% 1.8% 5.8% 0

Labor Supply

Ramsey Growth Model 1.4% 0.7% -0.5% 1.3% 1.0% 0.1% -0OLG Model 0.5% 1.0% 0.9% 1.2% 0.7% 0.6% 0Solow Growth Model 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0

Consumption

Ramsey Growth Model -2.7% 2.0% 5.6% -1.6% 2.0% 4.8% -0OLG Model -1.7% 1.3% 2.2% -0.4% 1.3% 1.8% 0Solow Growth Model -0.4% 0.2% 1.9% -0.3% 0.1% 1.4% -0

Net Investment

Ramsey Growth Model 59.1% 43.7% 27.9% 42.6% 31.9% 20.4% 4OLG Model 30.7% 22.4% 15.2% 26.2% 15.3% 10.7% 1Solow Growth Model 7.9% 7.9% 8.0% 5.7% 5.7% 5.8% 0

*Average percentage change over the first ten years after reform enacted.

Department of the Treasury Office of Tax Analysis

Table 3

 Macroeconomic Effects of Tax Reform Options: Percentage Change from Initial Steady-State for Selected Variables an

PCT GIT 
Appendix A: Summary of the Tax Panel Reform Options 

Provisions

Simplified Income Tax Plan 

(SIT)

Growth and Investment Tax Plan 

(GIT)

Progressive Co

Tax rates Taxed at individual rates

Sole proprietorships taxed at individual rates; 

other small businesses taxed at 30%

Sole proprietorships 

small busin

Recordkeeping Simplified cash-basis accountingInvestmentTax rates 31.5% 30% Investment Simplified accelerated depreciationInterest paid DeductibleInterest received TaxableInternational tax system Territorial tax systemCorporate AMTSource: The President's Advisory Panel on Federal Tax Reform (2005)

Table A.1. Summary of Tax Panel Reform Plans for Businesses

Small Business

Not taxable (except for financial institutions

Destination-basis (border tax adjustments

Repealed

Business cash flow tax

Large Business

Expensing (exception for land and buildings under the SIT)

Expensing for all new investment

Not deductible (except for financial institutio
Provisions

Simplified Income Tax Plan 

(SIT)

Growth and Investment Tax Plan 

(GIT)

Progressive Co

Tax rates 15%, 25%, 30% and 33% 15%, 25% and 30% 15%, Alternative Minimum TaxPersonal ExemptionStandard DeductionChild Tax CreditEarned income tax creditMarriage penaltyHome mortgage interestCharitable givingHealth insuranceState and local taxesEducationDefined contribution plansDefined benefit plansRetirement savings plans All savingEducation savings plans All savingHealth savings plans All savingDividends received

Exclude 100% of dividends of U.S. companies 

paid out of domestic earnings Taxed at 15% rate All saving

Capital gains received

Exclude 75% of corporate capital gains from 

U.S. companies, other capital gains taxed at 

ordinary rates Taxed at 15% rate All saving

Interest received (other than tax exempt municipal bonds) Taxed at ordinary income tax rates Taxed at 15% rate All savingSocial Security benefitsSource: The President's Advisory Panel on Federal Tax Reform (2005)

Replaces three-tiered structure with a simple deduction. Married taxpayers with less than $44,000 in income $22,000 

Security benefits; fixes marriage penalty; indexed for inflation

Table A.2. Summary of Tax Panel Reform Plans for Households

No change

Consolidated into Save at Work plans that have simple rules and use current-law 401(k) contribution limits; AutoSave f

saving direction (GIT and PCT plans would make Save at Work accounts "prepaid" or Roth-s

Replaced with Save for Retirement accounts ($10,000 annual limit) available to all taxpayers

Replaced with Save for Family accounts ($10,000 annual limit); would cover education, medical, 

new home costs and retirement saving needs; available to all taxpayers; refundable Saver's 

Credit available to low-income taxpayers

Home Credit equal to 15% of mortgage interest paid; available to all taxpayers; mortgage limited to average regional p

from about $227,000 to $412,000)

Households and FamiliesOther Major Credits and DeductionsIndividual Savings and Retirement

Deduction available to all taxpayers (who give more than 1% of income); rules to address valuatio

All taxpayers may purchase health insurance with pre-tax dollars, up to the amount of the average premium (estimated 

and $11,500 for a family); the limits for the PCT plan are lower, $8,400 for a family

Not deductible

Taxpayers can claim Family Credit for some full-time students, simplified savings plans

Repealed

Replaced with Family Credit available to all taxpayers: $3,300 credit for married couples, $2,800 credit for unmarried 

credit for unmarried taxpayers, $1,150 credit for dependent taxpayers; additional $1,500 credit for each child and $

dependent

Replaced with Work Credit (and coordinated with the Family Credit); maximum credit for working family with one child 

children is $5,800

Reduced; tax brackets and most other tax parameters for couples are double those of individ
21

Appendix B: 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.37 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 = ⎜ ⎟ ⎝ ⎠

 

37 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).
22

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 Bs 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
23

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 .

38 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,39

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 

 

38 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. 

39 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. 
24

( ) (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. 
25

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 
26

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,40 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 > . There is no 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 GDP 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. 

 

40 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.