This Appendix provides an overview of theoret­ical issues relevant to macroeconomic modeling of the Economic Growth Package. In addition, it includes specific modeling techniques used to apply these theoretical perspectives to the DRI- WEFA U.S. Macroeconomic Model.

ECONOMIC MODEL

Heritage Foundation economists in the Center for Data Analysis (CDA) used the DRI-WEFA model to analyze the fiscal and economic effects of the Economic Growth Package.^[35] The September 2002 forecast from the DRI-WEFA U.S. Macroeco­nomic Model was modified to make it consistent with the long-term budget and economic projec­tions published by the Congressional Budget Office in August 2002.^[36] CDA analysts used this forecast as the baseline by which to analyze the effects of the President's proposal. Since both the DRI-WEFA model and the CBO projections termi­nated in 2012, CDA analysts extended its forecasts to FY 2013 using a linear trend of the dividend component forecast.^[37]

CDA economists first simulated the dividend exclusion component as if it were a separate pro­posal. Then changes associated with other compo­nents of the plan were "stacked" upon those changes made for the dividend component. This method allowed the researchers to identify the effects of the dividend plan separately from those of the remaining components. In each case, the effects of the static decline in federal revenue were introduced into the DRI-WEFA model.

CDA researchers applied information from three sources to calculate the year-by-year static revenue reductions resulting from the President's propos­als. The first was the U.S. Department of the Trea­sury's year-by-year cost estimates of the plan spanning federal FY 2003 through FY 2008, bro­ken down by plan component. The second was the Treasury Department's cumulative 11-year cost estimate of the plan, spanning federal FY 2003 to FY 2013, broken down by plan component.^[38] CDA analysts independently estimated these com­ponents for FY 2009 through FY 2013.^[39]

DIVIDEND TAX PROPOSAL

User Cost of Capital

The key element of the President's plan is the proposal to end the double taxation of corporate dividends by excluding dividend income from the personal income tax base. This proposal would affect the rate of capital accumulation in the nation's economy by reducing the user cost of cap­ital. Calculations by Kevin Hassett^[40] and the Council of Economic Advisers^[41] indicate that this reform would reduce the user cost of capital by 4 percent to 7 percent for investment in equipment and substantially more for investment in struc­tures. In simulating the dividend component of the Economic Growth Package, CDA analysts used an estimate of 5.5 percent as the static assumption for the amount that the dividend tax reform reduces the user cost of capital.^[42]

The DRI-WEFA model does not contain a vari­able that directly reflects the user cost of capital. However, changes in the user cost of capital can be represented by changes in federal rates of taxation on corporate income. Consequently, CDA analysts adjusted one of the federal corporate tax rate vari­ables in order to reflect the reduction in the user cost of capital. However, this adjustment did not change the average federal tax rate on corporate income. The federal average tax rate on corporate income was not altered because the President's proposal does not call for any change in the statu­tory corporate tax rate.

Reduction in Personal Income Tax Collections

The President's plan to end the double taxation of dividends excludes corporate dividend income from the federal personal income tax base. Since the DRI-WEFA model does not provide a direct method for excluding dividends from the personal income tax base, CDA analysts simulated the effect of the proposal by reducing the average federal tax rate on personal income. This variable was reduced by an amount corresponding to the static reduction in personal income tax collections asso­ciated with the plan's dividend component.

Increased Dividend Payouts

The Treasury Department estimates that the President's dividend proposal would increase the dividend payout rate by 2 percentage points above the baseline in 2004 and 4 percentage points above baseline from 2005 through 2013.^[43] CDA researchers took account of this increase by adjust­ing upward a model variable corresponding to cor­porate dividends paid to persons.

To examine the effects of increasing the payout rate, CDA analysts performed a sensitivity analysis by conducting an alternative simulation in which the dividend payout rate was not adjusted upward. The alternative simulation projects that the 2004 through 2013 annual average increases in GDP, employment, and disposable income would be $64 billion, 808,000, and $109 billion, respec­tively. The results from this alternative simulation were not materially different from those reported in this study. (See Table 2.)

Lowering Marginal Propensity to Consume Out of Increased Disposable Income

Ending the double taxation of corporate divi­dends would provide relief to taxpayers directly owning shares in corporate enterprises. These tax­payers typically are persons with relatively higher saving rates and therefore relatively lower marginal propensities to consume. CDA analysts adjusted model variables controlling personal consumption expenditures in order to reduce consumption below the amount that would otherwise have been projected. The goal was to balance the relatively higher tendency to save against the tendency to increase spending due to a growth in net wealth.^[44]

The CDA reduced consumption by an amount equal to half of the dividend tax relief during the forecast period. In consultation with Global Insight, Inc., owners of the DRI-WEFA model, CDA analysts balanced the depressive effect of this consumption reduction on GDP by making offset­ting adjustments to five component variables of personal income. The combined effect of these changes left personal income within an average of 95 percent of the unadjusted level of personal income.

Adjustment for Taxation of Additional Dividend Income

Since the DRI-WEFA model does not directly allow the exclusion of dividends from the federal personal income tax base, additional dividend income results in an increase in the tax base above the baseline. CDA analysts used a model variable that accounts for the difference in the definition of National Income and Product Accounts (NIPA) and the unified budget receipts to remove this additional dividend income from federal personal income tax collections, thus lowering total federal revenues under the simulation.

Non-Residential Fixed Investment

CDA analysts found that the DRI-WEFA model's response of non-residential fixed invest­ment to the user cost of capital was lower than that supported by recent literature.^[45] Consequently, when modeling the dividend component of the President's plan, researchers adjusted model vari­ables controlling investment. In performing this adjustment, CDA researchers were guided by an assumption that the static elasticity of gross invest­ment with respect to the user cost of capital was
-1.2 percent for equipment and -0.64 percent for structures.^[46]

The reduction in the user cost of capital could be expected to exert a positive impact on the nation's economy by stimulating gross non-resi­dential investment. Recent advances in the model­ing of investment behavior show that reductions in the cost of capital brought about through tax pol­icy lead to increased expenditures on business investment. Federal policymakers may find, how­ever, that attempts to reduce the user cost of capi­tal through tax reductions are partially offset by changes in federal fiscal balances.

CDA analysts adjusted model variables control­ling investment to account for the possible effect of increased publicly held debt on gross investment. The CDA assumed that 60 cents of every dollar of increased net publicly held debt would displace private gross investment.^[47] Therefore, the CDA's forecasted increases in non-residential fixed investment are lower than they would have been in the absence of crowding out.^[48]

Wages

CDA researchers initially found that the fore­casted ratio of additional GDP to additional employment was high by historical standards. Based on consultations with Global Insight, Inc., CDA analysts adjusted a model variable control­ling wages to adjust this ratio. Left unadjusted, the higher ratio of GDP to employment would have increased federal revenues in the simulation.

Imports

CDA analysts initially found that the forecasted ratio of imports to GDP was high by historical standards. Analysts also initially found that the forecasted ratio of imported capital equipment to increased non-residential investment was higher than would be supported by historical averages. Therefore, based on consultations with Global Insight, Inc., CDA analysts adjusted model vari­ables controlling the level of imports.

Federal Monetary Authority Response

CDA analysts assumed that the dividend exemption plan would not hinder the Federal Reserve's basic objective of maintaining economic growth without disturbing price stability. This assumption necessitated a slightly more accommo­dating monetary policy than is built into the adapted DRI-WEFA model. Researchers therefore reduced slightly a variable controlling the federal funds rate in the DRI-WEFA model. This change did not prevent the Federal Reserve from respond­ing to the implementation of the plan in the simu­lation.

OTHER PROVISIONS IN THE ECONOMIC GROWTH PACKAGE

The remaining components of the President's plan consist of accelerations of the phase-ins for various provisions of the Economic Growth and Tax Reform Reconciliation Act of 2001 (EGTRRA), including reductions in marginal personal income tax rates, marriage penalty relief, widening of the 10 percent tax bracket, and increasing the child tax credit. In addition, the President's plan would increase the amount of the AMT exemption and provide for increased small business expensing. CDA analysts introduced these tax changes into the model by altering the variable controlling the average federal tax rate on personal income. These changes are in addition to those made to account for the dividend exclusion.

Labor Force Participation Rate

The acceleration of marginal tax rate cuts and the alternative minimum tax hold-harmless provi­sions would account for most of the reduction in marginal federal tax rates compared to the base­line. The four remaining components are the acceleration of the expansion of the 10 percent bracket, the acceleration of the increase in the child tax credit, the acceleration of marriage pen­alty relief, and raising the limits on expensing for small businesses. These four tax law changes would alter average federal personal income taxes somewhat but not significantly change marginal rates for most taxpayers.

Economic theory suggests that reductions in marginal personal income tax rates would increase participation in the labor force. The marginal rate cuts would, in turn, benefit the economy by strengthening the incentives to work and save. Stronger economic incentives could be expected to increase the labor force participation of some groups. In fact, microeconomic theory indicates that lowering marginal tax rates on labor income generally increases labor force participation.

One important modeling consideration, there­fore, is the responsiveness of labor participation to changes in after-tax income, commonly referred to as the participation labor supply elasticity. A meta-study performed by the Congressional Budget Office examined the range of estimates for this elasticity with respect to after-tax inflation-adjusted income. It found that estimates were as low as 0.1 percent and as high as 0.2 percent.^[49]

CDA researchers estimated the amount that the proposal would add to labor market participation by applying an appropriate elasticity to the static reduction of average federal personal income tax rates associated with the marginal tax rate cuts and a portion of the AMT provision. Analysts used an estimate in the middle of a range published by the CBO as an appropriate labor supply elasticity. Spe­cifically, for each static 1 percent increase in after-tax labor income, the labor supply was assumed to rise by 0.15 percent. Researchers applied this 0.15 percent rate to the increase in after-tax labor income directly attributable to those provisions in the plan that would reduce marginal personal income tax rates.

National Saving

Some economists have expressed concern regarding the impact that tax law changes could have on national saving. One concern is that tax reductions could reduce national saving by lower­ing the federal surplus component of national sav­ing more than they would raise the private component of saving.^[50] The fear is that a reduc­tion in national saving could lead to a fall in the capital stock owned by Americans and a fall in future national income. However, the CDA analy­sis of the Economic Growth Package found that implementing the plan would raise national saving compared to the baseline during each year of the forecast.^[51]

CDA Use of the August 2002 Baseline

In performing these simulations, CDA analysts used a baseline derived from the August 2002 eco­nomic and budget projections of the CBO. This section examines how the results of the study might have been different if the January 2003 CBO projections had been used to construct the base­line instead of the August 2002 projections.

Implications for Different Periods

2003-2004

In the near term (through FY 2004), this analy­sis would probably have found a stronger improvement in economic and employment growth if the later forecast had been used. This is because the August projections call for growth of 2.9 percent in real (inflation-adjusted) GDP, while the January 2003 forecast foresees 2.4 percent growth.^[52] Slower growth would have indicated an economy performing further below its potential during 2003 than in the August projections. In such an economic environment, the impact of the plan would likely bring about more growth with­out straining economic capacity than would be the case in the environment described in the August baseline. It is also likely that using the January baseline would have brought about smaller changes in interest rates.

For the year FY 2004, both sets of forecasts pre­dict the same real GDP growth rate. However, in the January 2003 forecast, that GDP growth would be from a lower base because of the slower growth recorded the previous year, so the economic and employment growth effects that year would also likely have been higher if the January CBO forecast had been used to construct the baseline.

2005-2010

In their January projection, the CBO estimates that real GDP in federal FY 2005 will nearly catch up to the real GDP level projected in its August forecast. Real GDP growth for 2005 is projected at 3.5 percent in the January forecast and only 3.1 percent in the August forecast. Consequently, using the January forecast as a baseline rather than the August forecast could have resulted in a find­ing of slower economic growth in the year 2005. In the five full fiscal years following 2005, the growth rates for GDP follow very similar paths, so it is likely that the use of the August baseline did not materially affect study results for that period.

2011-2012

Real GDP growth, profit growth, and wage growth for 2011-2012 declined markedly in the January forecast compared to the August forecast. The January forecast calls for average real GDP growth of 2.5 percent during that period com­pared with 3.0 percent growth in the August fore­cast. Other economic indicators remain essentially unchanged for these years between the two sets of projections. These include the unemployment rate, the three-month Treasury bill rate, and the 10-year Treasury bond rate. Combined, these dif­ferences imply that using the January forecast to construct the baseline would likely have led to finding stronger improvement in economic growth under the President's plan for these years. This occurrence is more likely because the economy would be performing further below potential in the January forecast compared to the August fore­cast.

Long-Term Differences

If the analysis had been performed on a baseline derived from the more recent January 2003 pro­jections, the study would probably have found long-term average results similar to those pre­sented in this paper. This is because of the long-term similarities in the two sets of projections. The similarities indicate the CBO's belief that elements of the economic environment affecting the long term have changed only slightly in the period intervening between the calculations of the two projections.

Over a common 11-year period, the forecasts are very similar in most respects. For example, the August 2002 economic projection shows GDP growing at an average rate of 2.81 percent during 2002-2012, while the later forecast has 2.88 per­cent. The GDP price index is seen growing at 1.97 percent for 2002-2012 in the earlier projection and at 1.98 percent in the later one. The consumer price index grows at an annual average rate of 2.46 percent in the August projection and 2.34 in the January projection. These similarities indicate that the simulation results would not have been sub­stantially different if the later set of CBO projec­tions had been used.

Unlike other economic indicators, there is a noticeable difference in interest rates between the two economic forecasts. The three-month Treasury bill average interest rate during 2002-2012 declines from 4.4 percent in the August 2002 pro­jection to 4.1 percent in the later. The 10-year Treasury bill average interest rate for the same period also falls from 5.7 percent to 5.5 percent. The interest rate differences indicate that using the January baseline might have led to stronger eco­nomic growth than results based on the August baseline. Lower interest rates, for instance, would have indicated that the economy was performing further below its potential in the January projec­tions compared to the August projections.

The broad measures of federal fiscal health are remarkably similar in the two sets of projections. Unified federal revenues in the August forecast total $28.2 trillion (not adjusted for inflation) dur­ing the years 2002-2012 and $28.0 trillion in the January forecast. This change reflects a 0.7 percent decline over the period. Similarly, spending rises from $27.4 trillion to $27.6 trillion between the two forecasts, a 0.7 percent change. Cumulative surpluses fall from $858 billion during the period to $470 billion in the later forecast. This reduction represents a 55 percent decline. However, this large decline is deceptive because it reflects very small underlying changes in both the spending and revenue outlooks.