The Economic Growth and Tax Relief Act of 2001 (H.R. 3) recently introduced by Representative William Thomas (R-CA) would enact the federal income tax rate reductions that President George W. Bush submitted to Congress on February 8 and make the rate change retroactive. It would reduce the current five income tax rate brackets (15 percent, 28 percent, 31 percent, 36 percent, and 39.6 percent) to four lower tax brackets of 10 percent, 15 percent, 25 percent, and 33 percent.¹ While most of the reductions in the tax brackets are to be implemented between 2002 and 2006, H.R. 3 would reduce the 15 percent tax bracket to 12 percent retroactive to January 1, 2001.² H.R. 3 also would repeal the alternative minimum tax (AMT) provisions that offset the refundable child credit and earned income credit. This analysis presents the effects of H.R. 3 on the U.S. economy.

• Increase family savings. By the end of FY 2011, a family of four would be able to save $556 more (adjusted for inflation) than the CBO baseline forecast.⁷ This higher level of personal savings is reflected in a higher savings rate, which on average is 0.6 percentage point above the baseline forecast of the CBO without the tax policy change.

• Increase investment. Investment (adjusted for inflation) would increase by an average of $25 billion per year from FY 2001 to FY 2011. By the end of FY 2011, the net capital stock would be $170 billion higher.

• Slightly increase inflation. Stronger economic growth would raise the average rate of inflation from 2.6 percent to 2.7 percent per year between FY 2001 and FY 2011. However, average inflation would be lower than it was during the 1990s (2.9 percent) and significantly lower than the 3.4 percent rate of inflation last year.

• Modestly raise Treasury bond rates. Under H.R. 3, 10-year Treasury bond rates would increase by an average of 0.3 percentage point per year (from 5.6 percent to 5.9 percent) between FY 2001 and FY 2011.⁸ However, the average 10-year Treasury bond rate would be lower than it was during the 1990s (6.7 percent) and last year (6.0 percent).

Heritage's dynamic analysis also shows that H.R. 3 would exert a positive effect on the federal budget. (See Table B2 in the Appendix.) Specifically, the results suggest that it would:

• Reduce federal tax revenue by $634 billion from FY 2001 to FY 2011. This reduction in federal taxes would be a substantial amount of tax relief for families, and the share of GDP taken by federal taxes would fall from 20.6 percent in FY 2001 to 19.6 percent in FY 2011.

• Produce a positive economic "feedback" for the Treasury. Static estimates that do not account for the tax relief's influence on the economy suggest that H.R. 3 would decrease revenues to the federal Treasury by $948 billion over 11 years.⁹ However, a more dynamic analysis using the WEFA model suggests that because the tax relief would increase economic growth and employment, the larger tax base would generate $314 billion in tax revenue that is unaccounted for in a static analysis. In other words, when the tax relief's effect on economic performance is taken into account, the actual loss to the Treasury is just 67 percent of the purely static reduction in tax revenues over 11 years.

• Increase federal net interest payments by $169 billion from FY 2001 to FY 2011. Total federal spending would rise by $218 billion because of the higher interest payments, higher outlays for the refundable earned income credit and child credit,¹⁰ and slightly higher inflation adjustments to other federal spending.

• Reduce the federal surplus by $852 billion from FY 2001 to FY 2011. Even with this reduction, the total surplus would surpass $5 trillion from FY 2001 to FY 2011. Moreover, because employment and payroll tax revenue will rise, the Social Security surplus would increase by $53 billion, making more resources available over the next 11 years to reform the program.

• Effectively pay off the federal debt. H.R. 3 would decrease federal debt to the lowest possible level that can be redeemed--$818 billion in FY 2011.¹¹ (See Chart 3.) From FY 2001 to FY 2011, federal debt as a percentage of GDP would decline from 30.5 percent to just 4.7 percent.

• Accumulate over $2.3 trillion in uncommitted funds.¹² Without any tax relief, the federal Treasury will likely accumulate $3.2 trillion in excess taxes and interest over the next 10 years.¹³ (See Chart 3.) With the substantial tax relief contemplated by H.R. 3, this amount would decline by $817 billion. The remaining funds will have to be invested with banks and the Federal Reserve or in some other private-sector asset, or they could be used to reform Social Security.

SUBSTANTIAL TAX RELIEF BY STATE

As Table 1 shows, the $948 billion in static tax relief over the next 11 years would be felt differently by each state. The two largest determinants of which states would benefit the most from H.R. 3 are population size and the amount of income taxes paid by the state. California would receive the largest share of tax relief under H.R. 3: $105 billion from FY 2001 to FY 2011, or $9.5 billion per year for the next 11 years. New York ($88.6 billion), Texas ($59 billion), Illinois ($56 billion), and Pennsylvania ($45 billion) round out the top five states.

Small states would also receive substantial tax relief. For example, taxpayers in Delaware would receive $3.8 billion in tax relief over the next 11 years, or $345 million per year. The residents of Maine ($2.8 billion), Montana ($1.8 billion), South Dakota ($1.7 billion), North Dakota ($1.6 billion), and Vermont ($1.5 billion) would receive between $136 million and $254 million in tax relief per year.

CONCLUSION

A dynamic analysis of H.R. 3 shows that it will boost economic activity, create 917,000 new jobs, and strengthen the incomes of taxpayers. The plan reduces excess tax revenue and effectively pays off the publicly held federal debt by FY 2009. Real (or inflation-adjusted) economic growth, which has recently declined sharply from its level of just six months ago, would rise an average of $77 billion per year from FY 2001 to FY 2011. On average, a family of four's after-tax budget would increase by $2,624, leading to an increase in consumption and saving. Spending on everything from health care to school clothes would rise by an average of $90 billion, and savings would increase by an average of $48 billion.

D. Mark Wilson was a Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation. William W. Beach is Director of, and Rea S. Hederman is Manager of Operations for, the Center for Data Analysis at The Heritage Foundation.

Appendix A: Methodology

Heritage economists followed a two-step procedure in analyzing the budgetary and economic effects of the Economic Growth and Tax Relief Act of 2001 (H.R. 3).

First, preliminary static tax revenue estimates for H.R. 3 were obtained from the Joint Committee on Taxation (JCT).¹⁴ The JCT tax revenue estimates are based on a static methodology that does not account for macroeconomic effects of a reduction in tax rates.¹⁵ These effects include changes in the gross domestic product (GDP), interest rates, employment, personal income, and inflation that can significantly affect tax revenues. Thus, static estimates provide a very limited analysis of the economic and budgetary impact of any policy change. To forecast the change in federal tax revenue, spending, and the economy more accurately, a dynamic model must be used.

The JCT's preliminary $958 billion static tax reduction estimate includes $10 billion in higher federal spending that results from the repeal of alternative minimum tax (AMT) provisions that offset the refundable child credit and earned income credit. Heritage economists separated the $948 billion in actual tax reductions from the $10 billion in higher federal outlays to model the proposed legislation more accurately.¹⁶

The second step was to introduce the static revenue and outlay changes into the WEFA U.S. Macroeconomic Model. The WEFA model is a dynamic model of the U.S. economy that is designed to estimate how the general economy is reshaped by policy reforms, such as tax law and spending changes. Heritage economists have developed a revised WEFA model for The Heritage Foundation that embodies the economic and budgetary assumptions published by the CBO in January 2001. This specifically adapted WEFA model produces dynamic responses from the CBO baseline as a result of proposed policy changes.