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1 Compendium 

1 of Tax Research 

I 1987 

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Office of Tax Analysis 

Department of the Treasury • Washington, D.C. 20220 
,....

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Compendium 

of Tax Research 

1987 

Office of Tax Analysis 

Department of the Treasury • Washington, D.C. 20220 
For ~le bV the Superintendent of Documents, U.S. Government Printing Office 

Wuhlngton, D . C. 20402 

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PREFACE 

In the development of tax policy for the Executive Branch of the U.S. 

Government. the staff of the Office of Tax Analysis (OTA) engages in 

sophisticated economic research in order to address present and anticipated 

policy issues. In the case of fundamental tax refonn. many policy questions 

could not be answered by the existing literature: the OTA staff had to develop 

new models. incorporate more reaJistic assumptions. and use more comprehensive 

data than were available elsewhere. The resulting analyses provided more than 

sufficient material for a compendium volume, and the publication of some of 

those analyses here help to make such research more widely available. We 

believe the studies included in this Compendium demonstrate the breadth. 

depth. and quality that exemplifies the work of the OTA staff. 

A number of acknowledgments are in order. First, it was Don Fullerton. 

fonner Deputy Assistant Secretary (Tax Analysis), who stressed the advantage 

of more widely disseminating staff analyses and organized the development of 

these papers into a single volume. Second, Assistant Secretary J. Roger Mentz 

strongly supported completion of the Compendium and emphasized its longertenn benefits to the office. Third. Rudie Slaughter was of invaluable 

assistance to the editors. Don Fullerton and Tom Neubig, in preparing the 

final manuscript as a single. unified. volume. Finally. the members of the 

Office of Tax Analysis staff deserve special recognition not simply for the 

models and studies presented here - which represent only a small portion of 

their total efforts on behalf of the public they serve - but for the 

innumerable analyses. testimonies, and briefings that help guide tax policy 

and. in a most recent case. were crucial to to the development of the Tax 

Refonn Act of 1986. 

Finally. it must be stressed that any views expressed in these studies are 

those of the authors and do not necessarily represent the views of the 

Treasury Department. 

~5~ 

C. Eugene Steuerle 

Deputy Assistant Secretary 

(Tax Analysis) 

T~:g~t~ Director 

Office of Tax Analysis 
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AUTHORS 

LEONARD E. BURMAN is a Financial Economist on the Individual Taxation 

Staff of the Office of Tax Analysis. He taught at Bates College 

before coming to the Office of Tax Analysis in 1985. He received his 

Ph.D. in economics from the University of Minnesota. 

JAMES CILKE is a Financial Economist on the Economic Modeling and 

Computer Application Staff of the Office of Tax Analysis. He 

received his Ph.D. in economics from the University of New Mexico in 

1985. 

LOWELL DWORIN is Acting Head. Office of Depreciation Analysis, Office 

of Tax Analysis. He came to the Office of Tax Analysis in 1984 from 

the University of Texas at Austin, where he was a member of the 

Department of Accounting. He received a Ph.D. in physics from 

Columbia University and a Ph.D. in business administration from the 

University of Michigan. 

DON FULLERTON is an Associate Professor of Economics at the 

University of Virginia. He was Deputy Assistant Secretary (Tax 

Analysis) from August 1985 to January 1987. He received his Ph.D. in 

economics from the University of California. Berkeley. 

GERALDINE GERARDI is Acting Deputy Director, Business Taxation Staff. 

Office of Tax Analysis. Prior to Treasury, she was head of the 

Taxation and Government Finance Section of the Congressional Research 

Service, head of the Tax Policy Group at the General Accounting 

Office. and Director of the Financial and Tax Analysis Division at 

the Department of Energy. She has a Ph.D. in economics from American 

University. 

ROBERT E. GILLEITE is a Financial Economist on the Economic Modeling 

and Computer Application Staff of the Office of Tax Analysis. He has 

worked in the Office of Tax Analysis since 1985 after receiving his 

Ph.D. in economics from the University of Maryland. 

HARRY GRUBERT is an International Economist in the Office of Tax 

Analysis. He carne to the Office of Tax Analysis in 1978 after 

working in the Labor Department and the Office of Management and 

Budget. He received his Ph.D. in economics from M.l.T. 

bottom 

v 
vi Authors 

YOLANDA K. HENDERSON is an economist at the Federal Reserve Bank of 

Boston. She was previously Assistant Professor of Economics at 

Amherst College. She received her Ph.D. in economics from the 

University of Pennsylvania. 

JAMES MACKIE is a Financial Economist on the Business Taxation Staff 

of the Office of Tax Analysis. He has worked in the Office of Tax 

Analysis since 1985 after receiving his Ph.D. in economics from the 

University of Virginia. 

HUDSON MILNER is a Financial Economist on the Business Taxation Staff 

of the Office of Tax Analysis. Prior to joining the staff, he worked 

for Data Resources, Inc. and Charles River Associates. He received 

his Ph.D. in economics from the University of Chicago. 

JOHN MUTTI is a profe5sor of International Economics at Grinnell 

College. He was a professor of economics at the University of 

Wyoming from 1974 and 1987. after receiving his Ph.D. at the 

University of Wisconsin. He has also served with the Office of Tax 

Analysis and the Council of Economic Advisers as a senior staff 

economist. 

SUSAN C. NELSON is a Financial Economist on the Business Taxation 

Staff of the Office of Tax Analysis. Before coming to the Office of 

Tax Analysis in 1982. she served as a senior staff economist at the 

President's Council of Economic Advisers. She received her Ph.D. in 

economics from Princeton University. 

HOWARD W. NESTER is Deputy Director, Revenue Estimating, Office of 

Tax Analysis. Prior to beginning work at the Treasury in 1975, he 

was a staff economist at the Bureau of Economic Analysis, U.S. 

Department of Commerce. His educational background includes graduate 

studies at Georgetown and George Washington Universities. 

THOMAS S. NEUBIG is Director of the Office of Tax Analysis. He has 

worked in the Office of Tax Analysis since 1980 after receiving his 

Ph.D. in economics from the University of Michigan. 

JAMES R. NUNNS is Deputy Director. Individual Taxation. Office of Tax 

Analysis. He was Director of the Research and Statistics office of 

the New Mexico Taxation and Revenue Department from 1982 to 1986. and 

a financial economist in the Office of Tax Analysis from 1974 to 

1982. He has a Ph.D. in economics from Purdue University. 

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Authors vu 

MARTIN A. SULLIVAN is a Financial Economist on the Business Taxation 

Staff of the Office of Tax Analysis, on-leave from Rutgers 

University, Economics Department. He has a Ph.D. in economics from 

Northwestern University. 

LESLIE F. WHITAKER is a Computer Systems Analyst on the Economic 

Modeling and Computer Applications Staff of the Office of Tax 

Analysis. He has worked for the Office of Tax Analysis since 1984. 

Prior to his current position, he was a Senior Systems Analyst for 

the Economic Research Service. U.S. Department of Agriculture. He 

received his B.S. in Technology of Management from the American 

University. 

ROY A. WYSCARVER is Deputy Director of the Economic Modeling and 

Computer Applications Staff in the Office of Tax Analysis. He has 

worked in the Office of Tax Analysis since 1973 after receiving his 

Ph.D. in economics from Clark University. 
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CONTENTS 

Introduction Don Fullerton 

1. A Guide to Interpreting the Dynamic Elements of 

Revenue Estimates 

Howard W. Nester 

2. The Treasury Individual Income Tax Simulation Model 

James M. Cilke and Roy A. Wyscarver 

3. Family Economic Income and Other Income Concepts Used 

in Analyzing Tax Reform 

Susan C. Nelson 

4. Tabulations from the Treasury Tax Reform Data Base 

James R. Nunns 

S. Investment Incentives Under the Tax Reform Act of 1986 

Don Fullerton, Robert Gillette, and James Mackie 

6. Investment Allocation and Growth Under the Tax Reform 

Act of 1986 

Don Fullerton, Yolanda K. Henderson, and James Mackie 

7. The Treasury Depreciation Model 

Geraldine Gerardi, Hudson Milner, Leslie Whitaker. 

and Roy Wyscarver 

8. The Impact of the Tax Reform Act of 1986 on Trade 

and Capital Flows 

Harry Grubert and John Mutti 

ix 

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43 

77 

101 

131 

173 

203 229 
x Contents 9. Impact of the Corporate Alternative Minimum Tax: 

A Monte Carlo Simulation Study 

Lowell Dworin 

10. The Impact of the Tax Reform Act of 1986 

on Commercial Banks 

Thomas S. Neubig and Martin A. Sullivan 

11. The Use and Abuse of Rental Project Models 

Leonard E. Burman, Thomas S. Neubig, and 

D. Gordon Wilson 

253 

279 

307 

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LIST OF TABLES AND FIGURES 

Tables 

Howard W. Nester 

1.1 Revenue Estimates - Tax Reform Act of 1986 27 

James M. Cilke and Roy A. Wyscarver 

2.1 Essential Attributes Preserved in Reducing the 1981 SOl File 47 

2.2 Target! for Extrapolated 1983 Tax Model 50 

2.3 Items Recalculated by the Tax Calculator 61 

2.4 Tax Model Tabulations for Analysis by Output Table Number . 63 

2.5 Average Marginal Tax Rates on Selected Income Sources Under 1980 Law, 

Current Law, and the Tax Reform Act of 1986 66 

2.6 Distribution of Tax Change and Number of Families Affected by Economic 

Income for Families 69 

Susan C. Nelson 

3.1 Comparison of Personal Income and Family Economic Income, 1983 81 

3.2 Derivation of Family Economic Income from AGI. 1983 83 

3.3 Distributional Comparisons of Corporate and Family Economic Income. !llld 

Individual and Corporate Income Tax Liabilities 88 

3.4 Derivation of Modified Expanded Income from AGI. 1983 91 

3.5 Derivation of "Economic Income" From Modified Expanded Income 92 

3.6 Age Distribution of Dependent Filers. 1983 94 

3. 7 Distribution of Returns and Families. Filers and Nonfilers. Under 

Alternative Income Classifiers 94 

3.8 Distribution of Tax Units Age 16+ By Modified Expanded Income, 

Families By Modified Expanded Income and By Economic Income 95 

3.9 Individual Tax Liabilities Under 1988 Law, Before and After the Tax Reform 

Act of 1986. By Economic Income of Families, Modified Expanded Income of 

Returns Age 16 and Over, and AGI of Returns 96 

Jamu R. Nunns 

4.1A All Returns: Gross Income. Adjustments. Deductions. Exemptions. 

Taxable Income, and Taxes Under 1983 and 1988 Law 104 

4 . 1B Joint Returns: Gross Income. Adjustments, Deductions, Exemptions. 

Taxable Income and Taxes Under 1983 and 1988 Law 108 

4.2A All ltemizer Returns: Gross Income, Adjustments, Deductions, 

Exemptions, Taxable Income and Taxes Under 1983 and 1988 Law 

· 4.2B Joint Itemizers Returns: Gross Income. Adjustments, Deductions, 

Exemptions. Taxable Income and Taxes Under 1983 and 1988 Law 

4 .3 Correspondence Between Table 4. lA. 4 . lB. 4.2A. 4 .2B. and 

1983 Form I 040 

4.4 Tax Return Income. Additional Items in Economic Income. and Tax Items 

112 

117 

123 

for Families in 1983 125 

XI 
xii Tables and Figures 

Tabhs Pa1e 

Don Full~non, Roben Gill~tt~ . and Jam~s Macki~ 

5.1 Cost Recovery Periods in Fullerton (1987) 136 5.2 Cost Recovery Parameters in the Corporate Sector 138 5.3 Personal Tax Rates 141 

5.4 Present Value of Cost Recovery Allowances for Corporate Assets 144 5.5 Asset Specific Investment Incentives in the Corporate Sector 146 5.6 Summary Measures 148 

5. 7 Cost of Capital and Effective Tax Rate by Industry lSI 5.8 Components of Tax Reform 152 5.9 Individual Arbitrage Compared with Firm Arbitrage 155 S. I 0 Alternative Real Rates of Return 157 5. II Alternative Financing J 58 5. 12 Influence of Inflation on Effective Tax Rates 161 S. 13 Indention and Effective Tax Rates 163 5. 14 Accounting Rules for Multi-period Production 168 

Don Full~non, Yolanda K. H~nd~rson , and James Mackie 

6. 1 Tax Rate Parameters 177 6.2 Tax Parameters for Each Asset I 79 

6.3 Investment Incentives for Each Asset in the Corporate Sector 182 6.4 Investment Incentives With New View of Dividend Taxes 184 6.5 Investment Incentives With Old View of Dividend Taxes 184 

6.6 Marginal Effective Total Tax Rates for Each Industry 185 6.7 Eventual Allocation of Corporate Capital Across Asset Types I 96 6. 8 Eventual AJiocation of Capital Across Sectors 196 6. 9 Eventual Output and Capital Stock by Industry 197 

Geraldine G~rardi, Hudson Miln~r. us/it Whita.ku. and Roy Wyscatvu 1. I Assumptions Underlying Qualified Progress Expenditures 212 7.2 Revenue Changes from the Capital Cost Recovery Provisions in the 

Tax Reform Act of 1986, 1986

-1992 216 

7.3 Total Investment by ACRS Depreciation Class Before TRA 86, 1986

-1992 218 

7.4 Total Deductions by ACRS Depreciation Class Before TRA 86, 1986-1992 219 1.5 Summary of the Effects of the Proposals to Repeal the Investment Tax 

Credit of TRA 86, 1986

-I 992 220 

7.6 Revenue Estimates for Expensing Provision Changes in TRA 86 221 

7.7 Total Investment by TRA 86 Depreciation Class, 1986

-1992 222 

7.8 Total Depreciation Deductions by TRA 86 Depreciation Class. 1986-1992 223 

7.9 Revenue Estimates for Depreciation Schedule Changes in TRA 86. 

1986-1992 223 

7. 10 Summary of the Revenue Changes Associated with Capital Cost Recovery 

Provisions of TRA 86. 1986-1992 224 

1. II Comparison of Depreciation Systems 226 

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Tables and Figures xiii 

Harry GruiHrt and John Mutti 

8. 1 Changes in Sectoral Tax Rates Resulting from Basic Changes in 

Domestic Taxation 234 

8.2 Fully-Phased-In Annual Revenue Increase of Foreign Provisions 236 

8.3 Short-Run Impact of Tax Reform 246 

8.4 Long-Run Impact of Basic Tax Changes With Varying Degrees of Capital 

Mobility 247 

8 .5 Long-Run Impact of Tax Reform Including Passive Loss Rule, Uniform 

CapitaJization Rules, and AMT 249 

Low~// Dworin 

9 . I Optimal Decision Parameters in the Absence of the Minimum Tax and the 

Resulting Financial Performance Under Non-Stochastic and Stochastic 

Economic Conditions 260 

9 .2 Optimal Decision Parameters in the Presence of the Minimum Tax and the 

Resulting Financial Performance Under Non-Stochastic and Stochastic 

Economic Conditions 264 

9 .3 Financial Results for an "Airline" Earning a Constant Pre-tax Return: 

The 7% and 13% Cases 269 

9.4 Five-Year AMT Revenue Estimates From Conventional (Approximate) and 

Stochastic (Exact) Procedures, and Percentage Differences 270 

Thomas S. N~ubig and Martin A Sullivan 

10.1 Corporate Tax Rate 284 

10.2 Extrapolation Assumptions Used in Banting Model Simulations 289 

10.3 Estimated Use of the Experience Bad Debt Reserve Method 290 

10.4 Effect of Tax Reform Provisions on Banks' Federal Tax Liability and 

After-Tax Inr.ome Between 1987 and 1991, Total 5-Year Changes 295 

10.5 The Effects of Tax Reform on SmaJI and Large Commercial Banks, by 

Year. 1987-1991 298 

Leonard E. Burman, Thomas S. Neubig , and D. Gordon Wilson 

11.1 Sample Spread Sheet Calculator for ACRS Low-Income Housing 309 

11.2 Three Measures of Effective Tax Rates for RentaJ Housing Investment 

in 1985 315 

11 .3A Effect of Marginal Tax Rates on Rental Housing Investment (Pre-TRA86 

Parameters) 317 

11 .3B Effect of Marginal Tax Rates on Rental Housing Investment (TRA86 

Parameters) 317 

I 1.4A Effect of Tax Reform Provisions on User Costs Stacked Separately and 

Together Compared to 1985 Law (Assumptions I) 319 
xiv Tables and figures 

Tables Page 

L~onard E. Bu1711D1f , Thomas S. N~ubig, and D. Gordon Wilson 

11 .4B Effect of Tax Reform Provisions on User Costs Stacked Separately and 

Together Compared to 1985 Law (Assumptions II) 320 

11 .5 Present Value of Low-Income Housing Tax Incentives Relative to 1985 Law 326 

11 .6 User Cost Estimates Under a Range of Parameter Values 336 

II. 7 Project Model Estimates of Break-Even Rent Compared to the CPI for 

Urban Rents Using Historical Values - 1975 to 1985 339 

11 .8 Input Parameters and Baseline Values 

11 . 9 Comparison of Real Estate Tax Provisions Before and After Enactment 

of the Tax Reform Ad of 1986 

FIJUres 

Jom~s M. Cilu and Roy A. Wyscarv~r 

2 . I A Typical Loss function 

2.2 Graph of + (x) 

Don Fulluton. Yolanda K. H~nd~rson, and James Mackie 

6 . 1 A Diagrammatic Summary of the Model 

6 .2 Savings Elasticity and the Welfare Gain from the Tax Reform Act of 1986 

6 .3 Asset Substitution and the Welfare Gain from the Tax Reform Act of 1986 

6.4 Sectoral Substitution and the Welfare Gain from the 

Tu Reform Act of 1986 

Thomas S. Neubig and Manin A Sullivon 

10. 1 Commercial Bank Actual Net Charge-offs and Estimated Tax Bad Debt 

Deductions, 1978-1984 

10.2 Commercial Bank Holdings of Tax-Exempt Loans and Securities 

L~onard E. Burman, Thomas S. Neubig. and D. Gordon Wilson 

I J • l Effect of TRA86 on User Costs 

11.2 

11.3A 

11 .3B 

Effect of Tax Rates on User Cost 

Long-Run Supply and Demand for Rental Housing Assuming Perfectly 

Elastic Supply 

Long-Run Supply and Demand for Rental Housing Assuming Perfectly 

Inelastic Demand 

11.3C Long-Run Supply and Demand for Rental Housing Assuming Constant 

Elasticity of Supply and Demand 

11.4 Predicted Versus Actual Rents. 1975-1985 

11 .5 Flow Chart of Treasury Rental Investment Calculator 

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INTRODUCTION 

Don Fullerton 

President Reagan's State of the Union address of February 1984 started the 

Treasury Department's Office of Tax Policy on a major year-long project to 

prepare and analyze myriad interacting provisions of comprehensive tax reform. 

This project was undertaken by economists in the Office of Tax Analysis and 

attorneys on the staffs of the Tax Legislative Counsel and International Tax 

Counsel. The project resulted in the November J 984 Treasury Department Report 

to the President Tax Reform for Fairness, Simplicity, and Economic Growth, and 

the May 1985 President's Tax Proposals to the Congress for Fairness, Growth, 

and Simplicity. After extensive Congressional deliberation on those and many 

other proposals. the President signed the Tax Reform Act of 1986. This Act 

included many of the Treasury Department's original tax reform proposals. 

Economic analyses of the various tax reform proposals involved novel and 

path-breaking approaches to new public policy issues. Economists in the 

Office of Tax Analysis (OTA) had to analyze hundreds of different tax proposals for their effects on economic efficiency, distribution, and revenue. 

These analyses required the development of many different economic models and 

databases. During the development and legislative consideration of this 

historic tax reform, OTA economists generally did not present their research 

for wider dissemination. 

This Compendium includes eleven papers by OTA staff. The papers provide 

descriptions of some of the most important quantitative methods and models 

used at the Office of Tax Analysis. The papers focus on diverse aspects of 

the domestic and international economy. and they provide new results about the 

potential effects of the Tax Reform Act of 1986. 

. Wider dissemination of research results and methodologies is essential to 

remain at the frontiers of any field. Researchers benefit from critical 

review and suggestions. Moreover, other economists are interested in the 

I would likt to thank all of tlrC' staff of the Office' of Tar A11alysis a11d particularly tlrC' 

authors for h~lp with the summoriC's of tlrC'ir papers. 
2 Don Fullerton 

research of OTA economists and might use it to do new research that could 

advance future analyses of tax policy. Indeed. most economists have been 

concerned almost exclusively with the distributional and efficiency effects of 

taxes, ignoring methods of revenue estimation that were so crucial to the 

development of "revenue neutral" tax reform. Other economists can Jearn from 

the path-breaking work of Treasury economists, suggest improvements, and push 

further the frontiers of tax policy analyses. Such an interchange is one 

purpose of this Compendium. 

Wider dissemination of research results and methodologies can also clarify 

misunderstandings and focus attention on critical issues in need of further 

research. One example of an important misunderstanding is that critics of 

revenue estimates accused Treasury economists of using "the assumption that 

the loophole closings and lower rates will have no effect whatever on the 

behavior of taxpayers, the growth of taxable income or anything else in the 

economy" (Wall Street Journal editorial, April 3, 1985). Despite explanations 

from the Treasury, the belief persisted that "revenue estimates are based on 

static analyses, which assumes that cutting rates X% will reduce revenues X%. 

By now everyone knows that this is crudely inaccurate" (Wall Street Journal 

editorial, August 5, 1986). Disagreements about the assumed degree of 

behavioral response will remain, but this Compendium should fmally debunk the 

myth of static revenue estimates. 

The Office of Tax Analysis staff uses a diverse array of computer models to 

perform their analyses of the effects of a tax change on economic behavior, 

government revenue. the distribution of tax burdens. and the efficiency of the 

economy. The staff works with large samples of individual, corporate and 

other tax returns, demographic data from the Bureau of the Census. production 

data from the Bureau of Economic Analysis, consumption data from the Bureau of 

Labor Statistics, and other data from many sources. These data are combined 

in various ways using the latest statistical techniques. providing a detailed 

picture of the sources and uses of income for a large sample of taxpayers and 

families. Analysts can then "simulate" the effects of changes in a tax, even 

one that does not exist yet. by calculating the new tax liability and behavioral response of each taxpayer and family in the sample. 

The next section of this introduction provides a summary of each of the 

eleven papers in the Compendium. It describes the nature of the models that 

are used and the provisions of the Tax Reform Act of 1986 that are analyzed, 

and it summarizes the results. A final section of the introduction comes back 

to the issue of model-building. That section discusses the appropriate size 

and use of different models. interrelationships among models. and how some of 

the models might be improved. 

SUMMARIES OF THE PAPERS 

The first paper is "A Guide to Interpreting the Dynamic Elements of Revenue 

Estimates." by Howard W. Nester. This paper is a good starting point because 

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Introduction 3 

it outlines in general terms the process involved in estimating Federal 

revenue. Such estimates might be provided for legislative proposals or for 

budget receipts under the existing tax system. The paper includes discussion 

of the objectives of revenue estimates. different types of behavioral assumptions. issues in their interpretation. and examples of behavioral responses 

included in Treasury estimates of the Tax Reform Act of 1986. 

The main message is that Treasury estimates contain many microeconomic 

behavioral responses but are constrained within the macroeconomic forecast of 

the Administration. However. the Administration macroeconomicforecaststhemselves often include induced effects such as increases in GNP or investment 

resulting from tax changes. even though these are not directly attributable to 

any single tax law provision. 

Chapters 2-4 discuss the design and some applications of the Treasury 

Individual Income Tax Model and Database. The second paper in this volume is 

"The Treasury Individual Income Tax Simulation Model," by James M. Cilke 

and Roy A. Wyscarver. This paper explains the motivations of the Treasury 

in building their largest single model. listing the many diverse uses of the 

modeL Included is a short history and basic outline of the model. The paper 

goes on to describe in detail the data bases used by the model, how they were 

merged to provide a comprehensive picture of each household in the sample, how 

missing items were imputed. how the components were individually "aged 11 to 

represent later years. and how the whole data set was extrapolated over the 

future five-year budget period. 

The paper also describes the computer programs for the model, and it 

provides a description of the tax calculator. It presents a narrative account 

of how the model was used during the tax reform process. and it includes some 

basic model tabulations. For example. it shows how tax reform lowers the 

average (over all taxpayers) of marginal tax rates on wages, interest, 

dividends. and noncorporate income, while raising that on capital gains. 

Finally. the paper discusses future modifications to the tax model. 

The third paper is "Family Economic Income and Other Income Concepts 

Used in Analyzing Tax Reform. 11 by Susan C. Nelson. It points out that the 

apparent distributional consequences of fundamental tax refonn depend to a 

large extent on the way taxpayers are classified, that is, on the income 

measure used and the unit of analysis chosen. The paper examines the implications of analyzing taxes on the basis of families rather than tax units, of 

including nonfilers as well as filers in the analysis. and of choosing income 

measures broader than adjusted gross income (AGI). 

In particular. the paper focuses on the concept of economic income. as 

defined by Haig and Simons. and on attempts by the Treasury Department to 

measure it for Treasury I and the President's Proposals. Measured "economic 

income" is compared to personal income in the National Income and Product 

Accounts. to AGI. and to the measure used recently by the Joint Tax Committee. 

here termed" modified expanded income " (MEl). The paper discusses some of the 

difficulties in attempting to quantify the Haig-Simons concept with available 
4 Don Fullerton 

data, most importantly the treatment of pensions, corporate income, and capital gains. Finally. it compares the conc1usions that would be drawn about 

the distributional consequences of the Tax Reform Act of 1986 if the change in 

taxes is analyzed by AGI of returns, MEl of adult returns, or by "economic 

income" of families. It finds that the method of classification can substantially affect the apparent distributional consequences of reform. 

The fourth paper in the Compendium is "Tabulations from the Treasury Tax 

Reform Data Base," by James R. Nunns. The Treasury tax reform data base is a 

microdata file that contains 198,000 "records." Each record represents a tax 

return (or potential tax return) and contains a large number of tax and nontax 

variables. Also, each is associated with other tax returns (of filers and 

nonfilers) in its family unit. Tax returns are appropriately weighted so that 

the flle represents the entire U.S. population. All data items are at 1983 

levels. Earlier papers in this Compendium show how the data base is constructed. how it is used, and how income is defined. 

The tabulations presented here supplement these earlier papers, showing 

major tax and nontax items in the data base. The tabulations are divided into 

two sets. The first set covers major tax variables under 1983 law and posttax reform law (1988 law). for tax returns of ftlers classified by adjusted 

gross income. Separate tables are shown for all returns, joint returns, all 

returns that itemize deductions. and joint returns that itemize. These tables 

are designed to show the major impacts of the Tax Reform Act of 1986 in a 

format useful to state tax analysts and others working with tax return data. 

The second set of tabulations is aimed at analysts interested in the relationship between adjusted gross income and economic income. This set. which 

consists of a single table, shows the major items in economic income for 

families, by economic income class. 

The remaining chapters describe models dealing with various aspects of the 

taxation of business income. The fifth paper is "Investment Incentives Under 

the Tax Reform Act of 1986." by Don Fullerton. Robert Gillette, and James 

Mackie. The paper begins by noting that the Tax Reform Act of 1986 contains 

multiple changes to the taxation of income from capital. The Act substantially Jowers the top statutory marginal rate on corporate income as well as 

personal tax rates on interest and dividend income. In contrast, the Act 

would eliminate the 60 percent capital gains exclusion and thus raise the 

effective personal rate on realized capital gains. The Act also changes 

capital cost recovery provisions by repealing the investment tax credit and 

replacing ACRS with a system of 8 recovery classes ranging in length from 3 to 

31.5 years. In addition. the Act increases the number of costs that must be 

capitalized into the basis of self-constructed property (including inventory), 

rather than expensed. 

This paper analyzes the combined effect of these changes on marginal 

investment incentives. It uses the cost of capital framework introduced by 

Hall and Jorgenson but extends existing work by (a) including the effect of 

accounting rule changes on the taxation of self-constructed as.sets. (b) using 

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Introduction 5 

a more disaggregated capital stock matrix, and (c) incorporating detailed 

calculations of weighted-average personal marginal tax rates from the Treasury 

individual tax model. Sensitivity analysis indicates that the actual final 

effect of TRA on aggregate investment incentives is uncertain. For most cases 

the paper finds that aggregate investment incentives are somewhat reduced, but 

variations in effective tax rates across assets and sectors are also reduced. 

The sixth paper is "Investment Allocation and Growth Under the Tax Reform 

Act of 1986," by Don FuJierton, Yolanda K. Henderson, and James Mackie. It 

makes use of the cost of capital framework further developed in the previous 

paper. This type of analysis played an important role in evaluating the 

effects of tax reform proposals, but it is traditionally partial equilibrium 

in nature. For example, the previous paper notes that the Tax Reform Act of 

1986 may slightly reduce overall investment incentives, and thus reduce 

investment, but that it also reduces the variance in the effective tax rates 

across assets and thus encourages more efficient utilization of existing 

capital. The net effect is.ambiguous. 

To assess the likely net effect, this paper uses a general equilibrium 

model developed by Fullerton and Henderson. It integrates disaggregate 

marginal cost of capital analysis with the computable general equilibrium 

model for tax policy developed by Fullerton. John Shoven, and John Whalley. 

General results suggest that the capital income provisions of the Act have a 

positive net effect, despite reduced aggregate investment and saving incentives. That is, the efficiency gains from more neutral taxation more than 

offset the adverse effects of reduced investment incentives. Again, however. 

sensitivity analysis indicates that the results vary across different parameter assumptions. 

The seventh paper is "The Treasury Depreciation Model, " by Geraldine 

Gerardi. Hudson Milner, Leslie Whitaker, and Roy Wyscarver. While the 

previous two papers concern the effects of capital cost provisions over the 

life of each asset under broad sets of conditions, this paper describes the 

data and model used for calculating budget-period revenue estimates for 

changes in depreciation rules. These revenue estimates played a major role in 

determining the degree of corporate rate reduction that could be achieved 

through tax reform. The depreciation model calculates deductions and investment tax credits on the basis of investment estimates by type of asset for a 

set of industries. Tentative deductions and credits are adjusted to reflect 

those that must be carried back or forward as a result of inadequate taxable 

income. Thus. the model operates between the macro level (where investment 

can be forecast) and the micro level of the finn (where detail is adequate to 

evaluate alternative proposals). This paper describes the sources of the data 

and the operation of the model. It also discusses the results of simulations 

that evaluate the depreciation changes and repeal of the investment tax credit 

contained in the Tax Reform Act of 1986. 

The eighth paper is "The Impact of the Tax Reform Act of 1986 on Trade and 

Capital Flows." by Harry Grubert and John Mutti. This paper uses a four-
6 Don Fullerton 

sector, two-country general equilibrium model of the U.S._ and the rest of the 

world to assess some of the international implications of tax reform. The 

model includes (a) the basic changes in corporate and personal taxation, (b) 

the changes in the U.S. tax on international investment income, and (c) the 

change in export tax incentives. The last of these includes both the reduced 

effect of Foreign Sales Corporations and the interaction of the source rules 

with the large increase in the number of firms in excess foreign tax credit 

positions. An attempt is also made in some simulations to introduce the 

impact of the passive loss rule, the corporate alternative minimum tax, and 

the uniform cost capitalization rules. 

The domestic changes increase the cost of import-competing goods and 

non-traded goods relative to export goods, so incentives to export increase. 

Results indicate that both exports and imports will increase in the long run, 

but the changes in trade and sectoral output are small. Also, some investment 

will flow abroad because the U.S. tax on foreign investment income declines 

relative to the tax on domestic income. In the short run, this capital 

outflow causes an improvement in the trade balance; in the long run the 

increased net investment income from abroad offsets the increased capital 

outflows and leaves the trade balance virtually unchanged. In summary, the 

international dimensions of the Tax Reform Act of 1986 are not dramatic. The 

simulations also suggest that changes in the merchandise trade balance are not 

a good indicator of U.S. welfare or of sectoral outputs. 

The ninth paper is "Impact of the Corporate Alternative Minimum Tax: A 

Monte Carlo Simulation Study." by Lowell Dworin. Complicated minimum tax 

provisions are often omitted altogether from cost of capital analyses such as 

those discussed above. Revenue estimates include these provisions, but they 

typically take a sample of firms and project forward on the basis of fixed 

economy-wide forecasts. Yet a firm's exposure to the alternative minimum tax 

(AMT) depends upon variations in its gross profit margin, its rate of growth, 

and its financial leverage. This paper develops a Monte Carlo simulation 

model of corporations based on the Hayashi model of the firm, incorporating 

random variations in gross profit margins. By parameterizing the firm 's 

investment and financial decisions, the model calculates endogenously the 

firm's chosen growth rate and degree of financial leverage under alternative 

tax policy options. 

This model is used to examine the impact of the AMT under both uniform and 

stochastic economic conditions. It is shown that the firm's frequency of 

exposure to the AMT may be significantly greater under stochastic conditions. 

It is also shown that when the response of the firm to its tax environment is 

endogenous, the impact of the AMT on the firm's tax payments is much greater 

than when the response is ignored. However. the results are somewhat ambiguous regarding the importance of incorporating stochastic modeling in the 

revenue estimation process. 

The tenth paper is "The Effect of the Tax Reform Act of 1986 on Commercial 

Banks," by Thomas S. Neubig and Martin A. Sullivan. This paper deals with 

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Introduction 7 

another area where the standard corporate data and model might not be adequate 

to evaluate the Tax Reform Act of 1986. Base-broadening provisions specific 

to banks include the repeaJ of the bad debt reserve method. the recapture of 

existing bad debt reserves. and the disallowance of interest costs used to 

carry tax-exempt securities. Especially for banks. therefore, corporate tax 

return data do not include all of the information on loans. book income, and 

receipts of tax-exempt interest that is necessary to model tax reform proposals. This paper describes the banking tax model that employs an extrapolated cross-section time-series regulatory accounting database to simulate 

alternative tax reform proposals. 

These bank-specific provisions and the alternative minimum tax are commonly 

highlighted when assessing the effects of tax reform on banks. However, this 

paper shows that the added Federal tax liability attributable to these 

provisions is almost entirely offset by rate reduction. Although banks as a 

whole pay more taxes over the 1987-91 period. after-tax incomes may actually 

increase because additional interest income is earned when banks shift their 

portfolios from tax-exempt to taxable securities. The paper goes on to 

compare large and small banks. to evaluate alternative loan-loss scenarios, 

and to consider future extensions of the model. 

The eleventh and final paper in this volume is "The Use and Abuse of Rental 

Project Models. " by Leonard E. Burman. Thomas S. Neubig. and D. Gordon 

Wilson. Using techniques much like those in the cost of capital analysis 

described above, "rental project models" consider the entire life of a 

hypothetical marginal investment in residential or commercial rental property. 

Assuming certain economic conditions, these models can calculate the rent 

that would have to be charged to provide a predetermined "required rate of 

return" to an investor with specific tax characteristics. During tax reform. 

rental project models were used frequently to support both sides of debates 

about the proper tax treatment of rental property. 

This paper first documents the Treasury rental project model and its 

improvement.s over existing analyses. More importantly. the paper shows why 

existing rental project models produce very disparate results. These models 

use different assumptions about the marginal investor, for example, and thus 

generate different required rent levels. The results show incentives for 

particular individuals or institutions to buy or seU each type of rental 

property. but the results for any one investor do not necessarily indicate 

what will happen to market equilibrium rents. The paper thus provides some 

useful guidelines for understanding and critically evaluating rental project 

model analyses. Despite their limitations, rental project models can provide 

valuable insights about how tax policies can affect individual investors· 

behavior and how current and future subsidies are capitalized into land 

values. As examples. the paper examines the effects of various provisions of 

the Tax Reform Act of 1986 on holding periods and asset values under various 

parameter assumptions. 
8 Don Fullerton 

DISCUSSION 

The papers provide interesting analyses of many diverse effects on the 

economy of changes to individual, corporate, domestic, and international tax 

rules in the Tax Reform Act of 1986. Accordingly, they are very useful. An 

overall evaluation of the Act would not be warranted here, however, because 

(a) these eleven papers do not cover many other economic effects of tax 

reform, (b) results are sensitive to alternative assumptions, (c) observers 

will legitimately differ on the desirability of particular effects, and (d) 

these papers do not attempt to incorporate noneconomic objectives and effects 

of tax reform. Summary judgment about tax reform can be made only by combining results here with those of other studies, and with subjective beliefs. 

Instead, these papers are primarily about research developments. The Tax 

Reform Act provides a highly relevant set of tax changes for the application 

of these analytical techniques. Therefore, a more appropriate form of summary 

discussion involves the state of the art available for analyzing tax policy, 

and how it might be improved. 

Most of the papers include some discussion of specific changes that might 

improve the use of the relevant model. It is always possible, for example, to 

search out more and better sources of data, to incorporate more detailed 

features of tax law and economic decisionmaking. to better estimate the behavioral reactions, and to perform more sensitivity analysis. There is always 

more work to be done on disaggregation, the effects of uncertainty, and interactions with other markets. The rest of this introduction will raise a few 

more fundamental questions about the nature of the model-building process. 

A first fundamental question is the degree to which economic models are 

useful. Indeed, the effects of tax policy cannot even be discussed without an 

implicit or explicit model of empirical magnitudes, economic behavior, and 

logical consequences. The advantages of an explicit economic model include 

the care in establishing empirical magnitudes, the rigor in defming behavioral reactions, and the confidence in avoiding logical errors by writing down 

and solving the model. It cannot predict the future, but an economic model 

can clarify which assumptions are most important, whether some qualitative 

results can be stated with confidence. and what range of empirical outcomes is 

most likely. 

A second question involves the appropriate size of the model. The Treasury's individual tax model is described in the paper by Cilke and Wyscarver, 

used in the paper by Nelson. and tabulated in the paper by Nunns. It includes 

198.000 tax returns and takes a half-hour of computer time to solve. It 

requires several staffers to maintain and to set up runs. For most calculations. in fact, the results are not significantly affected by adding the last 

few thousand tax returns or making the last few hours of refinements to the 

model. It is a general purpose model, however. There is some advantage in 

using the same model to answer a series of different questions, some of which 

might involve narrowly defined types of income. It may take 198,000 returns 

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Introduction 9 

to find enough of that income in each bracket to have sufficient confidence in 

the distributional results of changing its tax treatment. Still, it is 

legitimate to ask when the detail provides an improvement; estimates of 

behavioral parameters vary by large orders of often magnitude, or even by 

sign. Results can depend on the assumed parameter in a small model the same 

way they do in a large model. 

A third and related question is when to stop expanding one model and start 

building another. The economist must always make a judgment about the marginal benefits of continuing to improve the answers from one model, a choice that 

necessarily means accepting a given framework and set of assumptions, compared 

to the benefits of starting with a new framework but less detail. An example 

is given by the large corporate model that has thousands of tax returns and 

projects over the budget period for each corporation by using economy-wide 

forecasts. This model gives highly detailed answers and is essential to 

address particular aspects of corporate income and activity. Its use necessarily involves accepting its assumptions. Nevertheless, the economist must 

choose which questions are most important to address and which assumptions are 

key to the answers obtained. Dworin 's paper describes a small model used to 

investigate the assumption of unifonn profits and growth. This model essentially takes a set of examples and cannot be used by itself to estimate 

economy-wide effects on revenue or corporate income, but it is a tremendous 

aid to the use and interpretation of results from the corporate model. 

A fourth question is whether two or more models can or should be linked 

together. The endogenous financial and other behavior of Dworin 's model could 

be incorporated into the detailed calculations of the corporate model. For 

that matter, they could be linked simultaneously with the bank model described 

in the paper by Neubig and Sullivan or with the corporate part of the 

depreciation model described in the paper by Gerardi, Milner, Whitaker, and 

Wyscarver. Again it is a judgment, but often such linkages are unwise; bigger 

is not necessarily better. Even if two models appear to cover some of the 

same tax laws or taxpayers, they may deal with separable economic phenomena. 

Little may be gained if one phenomenon is not directly influenced by the 

other, and much may be lost in terms of the ease of model use, interpretation, 

and tractability. 

To take another example, the depreciation model obviously deals with many 

of the same provisions as the cost of capital model in the paper by Fullerton, 

Gillette, and Mackie. That model calculates present values of depreciation 

deductions for many diverse assets, averaging over the economy to get overall 

investment incentives. It therefore uses similar data on asset use by 

industry. There might at least be some advantage to the consistency of using 

the depreciation model to calculate these present values. However, the goals 

of the two models are different. The depreciation model is concerned with 

measuring actual tax revenue over the next five years only. using Administration forecasts of interest rates. inflation rates, and other macroeconomic 

variables. It uses gross investment forecasts, and it is sometimes concerned 
10 Don Fullerton 

with changes in narrow asset categories. Jn contrast, the cost of capital 

model is concerned with incentives for capitaJ fonnation in general. It 

requires depreciation over the life of each asset and weights given by capital 

stocks rather than gross investment. Moreover, part of the point of the cost 

of capital model is to see how incentives vary with changes in the interest 

rate, inflation rate, or other macroeconomic variables. Often qualitative 

results are robust to variations in these parameters, but when quantitative 

results vary significantly with a single unknown parameter like the future 

interest rate. there may be little point to further refinements in the detail 

of depreciation deductions in narrow asset categories. 

Finally. perhaps the most important question involves the use and interpretation of model results. Jn particular, policymakers generaUy use a 

single point estimate rather than qualitative results or a range of answers. 

It is sometimes diffic-ult for the economist to convey a sense for the degree 

of confidence to place in the results. For example, the paper by Nester 

describes how revenue estimators make judgments about the relevant elasticity 

parameters when including behavioral effects. They know that results vary 

with these assumptions, and they perform sensitivity analysis, but the Budget 

requires point estimates for receipts and outlays. One point of the paper 

about rental project models, by Bunnan. Neubig, and Wilson, is that this kind 

of model can generate virtually any kind of result desired. by adept variations in key parameters. 

Sensitivity analysis is particularly important for general equilibrium 

models such as in the paper by Grubert and Mutt.i or by Fullerton, Henderson, 

and Mackie. because of the sheer number of behavioral parameters that must be 

assumed for demand and for supply of each good in each market. Both of those 

papers include considerable sensitivity analysis, but it is hard perhaps for 

the reader to know that the authors have in fact sufficiently varied the 

parameters that are most important. Also, as discussed above. the results may 

be sensitive to model fonn in a way that is difficult to vary. 

AIJ of these questions provide topics for further research. Future 

developments will undoubtedly provide further detail in existing models, 

investigation of new models, and fonnal or infonnal linkages among models. 

lnfonnal linkages might involve using the results of one model as an input to 

another model. It might be fairly straightforward, for example, to take new 

relative prices from a general equilibrium model and insert them into a 

revenue estimating model. A further refinement would take the subsequent 

results of the revenue estimating model and insert them back into the general 

equilibrium model. Fonnal linkages might involve simultaneous solution 

through iteration. The problems are formidable. however. Even the direction 

of price changes in general equilibrium models can be sensitive to modeling 

choices, and it may be unwise to accept a single set of choices for point 

estimates. Also. such linkages can easily become unwieldy. For operational 

purposes. the decision to fix some relative prices in revenue estimating 

models has its advantages. Informal linkages might best insert only the price 

changes that are known with confidence. 

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Introduction I I 

Recognizing the uncertainty about economic effects of tax proposals makes 

enacting any reform more difficult. There is no easy solution to this 

problem. This volume. however. will help clarify some of the problems 

encountered by economists when analyzing alternative tax policies. and the 

advanced nature of the methods available currently to address these problems.