Dynamic scoring (or dynamic revenue estimating) for tax legislation has been an issue of interest for at least the past 25 years. House Rule 13 has required, since 2003, that the Joint Committee on Taxation (JCT) provide a macroeconomic impact analysis of legislation to amend the Internal Revenue Code, or a statement explaining why it is not calculable; the first analysis was in 2003. The current Senate Budget Resolution ( S.Con.Res. 8 ) includes a similar provision requiring the Congressional Budget Office (CBO), with the assistance of the JCT, to prepare a supplemental estimate incorporating the feedback effects into a cost estimate for legislation with provisions affecting revenues that have a revenue impact of $5 billion or more in any fiscal year. These analyses are not part of the official score, but rather provide projected feedback effects, although some may argue that feedback effects should be included in revenue estimates. Currently, both the House and the Senate tax-writing committees are considering tax reform legislation that would broaden the base by limiting deductions. Some have advocated a revenue-neutral tax reform that allows fully offsetting rate reductions and some a tax reform that also raises revenue. An important issue of debate is the expected effect on the overall economy from a reform of the tax code. Many uncertainties arise with respect to dynamic scoring, which depend on the type of model used, the behavioral responses built into the models, and assumptions about activities of other agents or supplemental policies that are necessary to solve some types of models. The complexity is expanded in the case of tax reform, because base broadening can also have effects on effective tax rates that could offset part or all of the behavioral effects due to changes in statutory rate reduction. This report first explains dynamic scoring, including the types of effects incorporated and the types of models used, as well as what groups conduct or have conducted macroeconomic analysis of tax changes. The following section discusses the specific issues associated with tax reform. The final section discusses general issues surrounding the use of various models and reviews the empirical evidence on supply side responses (labor supply and savings or investment) and how these effects are incorporated in current models used by JCT, CBO, the Treasury Department, and academic researchers. The discussion of economic modeling is necessarily more technical than that in most CRS reports. The first section, therefore, provides an overview with a less technical summary of the analysis and findings in this report. The main body of the report follows. Dynamic scoring, as a general term, is revenue estimation that accounts for behavioral changes. When referring to tax legislation, the term dynamic revenue estimating is also used. The legislative requirements cited above, however, have a narrower effect since many behavioral responses are already included in conventional revenue estimates. The rules commonly referred to as requiring a dynamic score require macroeconomic effects, incorporating the effects of legislative changes on aggregate economic output. Dynamic scoring as used in this report refers to incorporating those macroeconomic effects. It is often discussed in connection with revenue legislation because tax revisions may cause "supply side" effects (changes in labor supply and savings) due to changes in effective average and marginal tax rates. Current revenue estimates by the Joint Committee on Taxation include a variety of micro-economic behavioral responses that affect revenue yields. For example, increasing capital gains taxes is assumed to cause a reduction in realizations that reduces the potential revenue gain. A variety of other behavioral responses are considered in preparing estimates. These estimates, however, keep total output (i.e., GDP) fixed. Effects on output have been provided in some cases, but are not included in formal scorekeeping. The effects of dynamic scoring on revenues depend on numerous factors: the types of effects included, the types of models used, and the magnitude of behavioral responses (elasticities) incorporated in the model. Three types of effects have been considered in previous studies by the Joint Committee on Taxation and the Congressional Budget Office: (1) the short run stimulus effect where a tax cut increases demand and output in an underemployed economy, while a tax increase reduces output; (2) the effect of deficits or surpluses on crowding out or crowding in investment due to government borrowing; and (3) the supply side effects (increases or decreases in labor supply, domestic savings, and net investment from abroad in response to changes in effective tax rates). There are reasons to consider only the supply side effects since the other two effects also occur with spending changes. There are especially strong reasons to exclude stimulus effects, since permanent changes in the tax code should not depend on fiscal timing. That is, a permanent tax code change should not be evaluated more or less favorably because it is enacted during a recession. Moreover, the short run stimulus effects may be offset by the Federal Reserve System. Supply side effects from tax cuts are often presumed to increase output. However, they can either increase or decrease output because of offsetting income and substitution effects. A tax cut, by increasing income, causes an increase in consumption, including consumption of leisure, which reduces labor supply. This effect is the income effect. A tax cut that affects marginal earnings will cause leisure to be more costly relative to consumption which will increase labor supply. This effect is the substitution effect. Income and substitution effects also occur for savings. A reduction in the tax rate on the return to savings, and the higher return, means that one can consume more now and more in the future, reducing savings. This effect is the income effect. At the same time, the lower tax rate (and higher yield) makes the price of future consumption lower and increases savings, the substitution effect. These effects are typically measured as an elasticity: the percentage change in quantity divided by the percentage change in price or income. For example, if the labor supply elasticity with respect to the wage rate is 0.2, a 10% increase in wages will cause a 2% (0.2 times 10%) increase in labor supply. The projected effects of a tax change on output and revenues depend on the design of the tax change, the type of model, and the magnitude of income and substitution elasticities. Two very different types of models for estimating supply side response are a simple growth model with labor and savings supply responsive to wages and rates of return, and an intertemporal model with a complex theoretical structure in which individuals allocate leisure and consumption over time. The behavioral responses rely on many aspects of these intertemporal models which are not always transparent. During the budget horizon, labor supply is likely to be the dominant factor, in part, because additional capital tends to accumulate slowly. Output increases when the labor supply or the capital stock increases, with labor supply the larger input. A tax change affects the capital stock by affecting savings or investment, which is typically only 2% to 3% of the capital stock. Even if the saving rate increased by 50% in the first year, the capital stock would only increase by about 1%. Outside the budget window, capital accumulation may become more important and, for some reforms, can dominate the effects on labor. With a revenue neutral tax reform, where rate cuts are financed by base broadening, the focus is generally on supply side effects, since the effects on short term demand or the deficit and crowding out should be negligible. Moreover, in a revenue neutral change there are no income effects in the aggregate to reduce supply as would be in case in a rate cut alone. If the change is also distributionally neutral any effects arising from these factors are even less likely. Thus the focus of dynamic effects is on substitution effects. In a tax reform, it is crucial to recognize that the behavioral response cannot be measured solely by statutory rate changes. The effective marginal tax rate determines this behavioral response and changes in the income base that change the share of income taxed at the margin also affect this marginal effective tax rate. It is possible for base broadening provisions to raise effective marginal tax rates more than enough to offset the effects of a cut in statutory tax rates, leading to a contraction rather than an expansion in output. This potential for base broadening to affect marginal effective rates means that it is not possible to project the effects of a base broadening tax reform that specifies the rates but does not specify how the revenue is to be offset by base broadening. When there is a revenue loss or gain or when marginal effective tax rates change there can be supply side responses. The following points can be made: In simple transparent supply side models that directly incorporate labor supply and savings responses as indicated by empirical evidence, feedback effects on revenues are expected to be small, in the neighborhood of 3% to 8%. That is, a revenue loss will be reduced by 3% to 8%, and a revenue gain will be increased by 3% to 8% in an overall tax cut. Effects might be slightly larger in open economies. More complex intertemporal models can yield similar results with respect to wage tax cuts, if similar elasticities are embedded in the models. In these models, spending must match taxes in the long run, so the results depend on how deficits or surpluses are addressed. An examination of models currently or recently used indicates that many of these models have implicit behavioral responses for labor supply that are much larger than those that are contained in simpler growth models, or that can be supported with empirical evidence. The JCT's intertemporal model, however, has elasticities similar to those found in empirical studies. Responses in intertemporal models to changes in taxes on capital income can be large. These models have a rigid structure that causes responses in savings that reflect reducing consumption today for more consumption many years in the future to a degree that is unlikely and not empirically studied. In addition, they cause an increase in labor supply to shift leisure from the present to many years in the future that is also not likely or supported by empirical evidence. One question is whether the more desirable theoretical structure of these models balances the lack of empirical justification. The remainder of this report provides a more detailed analysis. Dynamic scoring normally employs models of the aggregate economy.