The House and Senate Republican leadership recently announced their interest in using a portion of the current and expected consolidated budget surplus to cut individual income tax payments. One prominent variant of this tax cut agenda calls for marginal tax rates on individual taxable income to be reduced by 10 percent.1 For example, taxpayers who paid income taxes last year at the 15 percent rate would calculate their 1999 taxes at 13.5 percent, a rate that is 10 percent lower than last year's.
This report explores the implications for federal revenues and U.S. economic performance of a uniform 10 percent rate reduction in marginal tax rates for individuals effective for the tax year beginning January 1, 1999. Analysts with The Heritage Foundation's Center for Data Analysis (CDA) simulated the rate reduction using the Center's Individual Income Tax Model to estimate changes in individual income tax liabilities and collections over an 11-year period, 1999 through 2009.2 These "static" liability changes then were introduced into the WEFA U.S. Macroeconomic Model to estimate the likely economic effects over this same 11-year period and to determine the "dynamic" budgetary effects of the tax law change.3
CDA analysts also simulated the effects of this tax cut for the U.S. economy under two other alternative future scenarios. The first was for an economy growing more slowly than the WEFA baseline forecast. The second simulation was for an economy in which growth rates are faster. The methodological details of this analysis are contained in Appendix A.
SUMMARY
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Effect on Tax Revenues. Federal revenues from the individual income tax fall by $797 billion over the fiscal year (FY) 2000 through FY 2009 period under static economic and tax strategy assumptions. However, a dynamic simulation of the 10 percent rate cut shows that federal revenues decline by $633 billion over this same period, which implies a revenue feedback from the economy of 21 percent. Significantly, were such a proposal also to reduce long-term capital gains tax rates by 10 percent (raising the productive capacity of today's near-capacity economy), this feedback would have been higher and several of the fiscal years--especially the first five years--would have contained lower tax revenue reductions.4
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Effect on Surplus. Under static assumptions, cutting tax rates by 10 percent leaves $1.768 trillion of the Congressional Budget Office's (CBO) forecasted surpluses over FY 2000 through FY 2009 available for Social Security reform and other purposes. This amount equals 69 percent of the consolidated or unified budget surplus between FY 2000 and FY 2009, or significantly more than the percentage that President Clinton and the congressional leadership agree should be devoted to Social Security reform.
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Effect on Individual Tax Liabilities. The rate reduction gives almost all taxpayers a lower tax bill. The most notable exception is for individuals who pay the Alternative Minimum Tax (AMT). The average tax liability reduction in 1999 would be about $700 for taxpayers currently paying in the 15 percent and higher tax brackets. The average reduction in tax liability for taxpayers in the 28 percent bracket is over $1,050 in 1999.
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Impact on Economy. This proposed tax law change most likely would lead to a stronger economy. A simulation of this tax policy proposal using the WEFA U.S. Macroeconomic Model5 shows that:
Gross domestic product (GDP) rises by an average of $35.9 billion per year after inflation between FY 2000 and FY 2009. Per capita, inflation-adjusted disposable income also rises by an average of $339 per year because of lower taxes and a stronger economy.
Total civilian employment rises by an average of 289,000 per year over this ten-year period, unemployment falls below baseline in every year of the forecast, and wages and salaries increase modestly.
Personal savings increase by $39.4 billion at the end of FY 2009, accompanied by an increase in the personal savings rate from 4.7 percent to 4.9 percent.
Economic growth would be improved as a result of the 10 percent reduction in marginal tax rates if the U.S. economy grows below current expectations, as some forecasters predict. This tax policy change also would add to economic growth in an economy that grows faster than current forecasts. In other words, the view that tax cuts weaken a slowly growing economy and overheat a rapidly growing economy is not supported by our analysis.
THE STATIC AND DYNAMIC REVENUE EFFECTS
The Tax Cuts for All Americans Act (S. 3) and the 10 Percent Tax Cut Act (H.R. 3) contain the legislative language for the 10 percent rate cut. These bills retain the current law definition of taxable income and the tax base. They also make the tax rate reduction effective on January 1, 1999.
The tax rates on long-term capital gains are not affected by these two bills. Thus, taxes on long-term capital gains would continue at rates set in the Taxpayer's Relief Act of 1997, or at 10 percent for taxpayers whose non-capital gains income is taxed at the current-law level of 15 percent and 20 percent for those paying taxes at the next four higher marginal rates. All other income taxed by the individual income tax schedules (for example, Schedule C filers, partnership income, and sub-chapter S corporation income) would be taxed at the lower rates.
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These lower dynamic revenue reductions, however, are largely offset by a dynamic increase in federal outlays. About 87 percent of the increase in outlays is due to higher interest payments on federal debt because the tax cut reduces the amount of surplus devoted to reducing publicly held debt. The remaining increase in federal outlays stems from higher than forecasted cost-of-living adjustments and higher prices for the goods and services purchased by the federal government.
Even with these increases in outlays, however, the resulting ten-year surplus available for Social Security reform and other programs is only 4.2 percent lower than the static surplus estimate. Indeed, Table 1 shows that the proposed rate reduction would leave large budget surpluses available for Social Security reform or other purposes. President Clinton and congressional leaders of both parties have pledged themselves to allocating 62 percent of the ten-year unified budget surplus to "saving Social Security." The CBO forecasts a total of $2.565 trillion in surpluses from FY 2000 to FY 2009. The static estimates of Table 1 show that the 10 percent rate cut would leave 69 percent available for Social Security.
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HOW THE 10% TAX CUT PLAN AFFECTS INDIVIDUAL TAXPAYERS
Reducing each of the five marginal individual income tax rates results in lower tax liabilities for most taxpayers; the principal exception is those individuals who pay the Alternative Minimum Tax. The average reduction in federal tax liability in 2000 would be slightly over $700.9 Taxpayers who currently file at the 28 percent tax rate would see their tax liability fall by over $1,050 in tax year 1999.10 Overall, taxpayers would see their tax liabilities fall by $73 billion in 1999.
This aggregate reduction in tax liabilities produces savings for a diverse set of taxpayers. CDA analysts chose four taxpayer profiles to illustrate the benefits from the tax cut, which are summarized in Chart 3. These profiles are based on data extracted from the March 1998 Current Population Survey of the U.S. Census Bureau.
For example, if tax year 2005 is taken as a convenient reference point (roughly halfway through the ten-year forecast period), a single black female teacher who makes $42,323 today and likely would make $54,880 in 2005 would see her taxes fall by $834 in 2005, or by 9 percent. This amount is roughly equivalent to three months of groceries.11
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For a married taxpayer like a lumber industry truck driver with a 13-year-old son, the tax savings of $1,125 in 2005 could pay for books and student fees for the boy's first year of college. Had these tax savings been accumulated in an interest-bearing account between 2000 and 2005, they would be sufficient to pay for a significant part of a year's tuition at a public college. If college was not in the young man's plans, these tax cuts probably would be sufficient to pay for vocational training in many professions and for the costs of certification.
More generally, it is important to understand how low- and moderate-income taxpayers would benefit from the 10 percent tax cut plan. A vast percentage of taxpayers who pay taxes at the current 15 percent rate either are young men and women beginning careers and families or retired taxpayers living generally on relatively fixed incomes. Reducing taxes on these taxpayers has the effect of permitting young Americans to keep more of their money for education and child care and increases the disposable income of retirees for the purchase of such things as prescription drugs and medical services.
Additional financial resources in the hands of young taxpayers increase the probability that they will move up the economic ladder, which is a central principle of sound tax policy. Similarly, permitting retired taxpayers to retain more of their income reduces the burden on government for meeting the income shortfalls of elderly Americans. Both effects are present in the 10 percent rate reduction proposal.
DYNAMIC ECONOMIC AND BUDGETARY EFFECTS OF THE BASELINE SIMULATION
A dynamic simulation of reducing marginal income tax rates by 10 percent across the board indicates that the tax cut plan would increase the number of jobs and stimulate economic growth. This simulation further shows that family budgets would improve as a result of growing wages and salaries, as well as significant increases in personal disposable income and personal savings.
To analyze the economic effects on jobs and economic growth of cutting income tax rates, Heritage analysts used the December 1998 Long-Term U.S. Macroeconomic Model of the WEFA Group. CDA and WEFA economists reconstructed the December model for The Heritage Foundation to embody the economic and budgetary assumptions published by the Congressional Budget Office in January 1999.12 This specifically adapted model uses CBO assumptions to produce dynamic simulations of policy changes.13 (See Appendix A for a description of how lower marginal income tax rates were incorporated into this version of the WEFA U.S. Macroeconomic Model.)
The Heritage analysis using the WEFA model and CBO economic assumptions indicates that cutting income tax rates would help families and increase job opportunities over the ten-year period between fiscal years 2000 and 2009. (See Appendix B.) Specifically, the Heritage analysis suggests that reducing marginal income tax rates by 10 percent across the board would:
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Increase economic growth by 0.3 percentage points in FY 2000 from 1.6 percent to 1.9 percent, and by 0.1 percentage points in FY 2002. By the end of FY 2009, the real gross domestic product would be $29.6 billion more than the CBO baseline forecast.
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Increase disposable personal income in FY 2009 by $106.3 billion in 1992 inflation-adjusted dollars, or by $918 for the average household. In response to this significant increase in family budgets, consumer spending would rise by $78.5 billion in 1992 dollars by FY 2009.
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Increase household savings. Personal savings would increase by $39.4 billion, or $340 for the average household, by the end of FY 2009, and the savings rate would rise by 0.2 percentage points to 4.9 percent.
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Increase job creation. Lowering taxes on Americans would increase job opportunities by 365,000 in FY 2005 and reduce the unemployment rate by 0.1 percentage points to 5.6 percent.
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Produce a positive economic "feedback" for the Treasury. "Static" estimates that do not account for the tax increase's influence on the economy's performance suggest that lower income tax rates would decrease revenues to the federal Treasury by $797 billion over ten years. However, a more "dynamic" analysis using the WEFA model suggests that, because the tax cut increases economic growth, the larger tax base would generate more tax revenue ($164 billion) and moderate the expected aggregate revenue loss to the Treasury estimated under the static analysis. In other words, when the tax cut's effect on economic performance is taken into account, the actual "loss" to the Treasury is 79 percent of the purely static reduction in tax revenues over ten years.
Reducing income tax rates would lower the CBO forecast of a $2.565 trillion surplus over the FY 2000 to FY 2009 period to $1.694 trillion, a reduction of 34 percent. However, nearly 66 percent of the CBO's forecasted surplus would remain, to be used to save Social Security and for other purposes. Moreover, without any other policy changes, publicly held debt as a percent of GDP would fall from 40 percent at the end of FY 1999 to just 14 percent at the end of FY 2009. Federal interest payments on the debt would fall from 12 percent of spending in FY 1999 to just 4 percent in FY 2009.
DYNAMIC ECONOMIC EFFECTS IN THE SLOW AND FASTER GROWTH ALTERNATIVE SCENARIOS
Proponents of marginal tax rate reductions often hear that such a policy change would weaken a slowly growing economy and overheat one that is growing rapidly. CDA analysts tested these criticisms using slow- and fast-growth variants of the WEFA baseline model. Our analysis using these two variants does not support either form of the criticism.
In addition to the boost to economic activity, there is another implication of the 10 percent tax cut proposal that policymakers might consider: Enacting this tax policy change might make a possible slowing of the U.S. economy easier on all Americans. Many economic forecasters expect this long-running economic expansion to slow down in the latter half of 1999 and 2000.14 Forecasters base their prognosis of future economic growth on the mounting evidence that economic decline throughout Asia and Latin America is pushing down key sectors of the U.S. economy, particularly those that rely on exports and commodity production. The United States may have been spared significant slowing in 1998 as a result of substantial inflows of capital from economically troubled regions, but forecasters do not expect this source of support for the U.S. economy to continue indefinitely. Thus, economists generally expect the rate of economic expansion to subside over the next two years.
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In light of this increasingly probable prospect, CDA analysts simulated the 10 percent tax cut plan in a highly sluggish economy, in which the United States enters much lower growth in 1999 and remains in a slowly growing economy throughout 2000.15 How much better would U.S. economic performance be in such a slow-growth economy if Congress enacted the 10 percent tax cut plan?
Charts 4, 5, and 6 show the effects of a 10 percent tax rate reduction on three key economic indicators: the level of gross domestic product, inflation-adjusted disposable personal income, and the level of personal savings. The bars in these graphs show how much the slow-growth economy differs from the "normal" growth economy, or the WEFA baseline of continued, steady economic expansion. For example, Chart 4 shows that the slow-growth economy produces $34 billion less domestic product than the WEFA baseline in 1999. By 2002, this slow-growth economy is $142 billion smaller than the baseline. However, changing tax policy today by cutting marginal tax rates by 10 percent restores over $35 billion in output to this slow economy.
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The results are more dramatic for inflation-adjusted disposable personal income and the level of personal savings. Although the tax policy change makes little difference to the level of disposable income in 1999, it significantly mutes or reverses the slow-growth forecasts in the remainder of the six-year period. In fact, the tax cut makes a $100 billion difference in 2004, or $916 for the average household, when the slow-growth decrease of $71 billion becomes an increase above baseline of $29 billion.
For personal savings, each year of the forecast shows higher levels than those in the slow-growth economy without tax cuts (see Chart 6). For the first three years, 1999 through 2001, the decline in savings without tax cuts becomes an increase above baseline. This result, when combined with the other economic indicators, clearly points to an unexpected benefit of this tax policy proposal: If the economy declines, as some economists expect, the level of decline will be less and the keys to recovery--savings and consumption--will be strengthened.
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A few forecasters believe that the rapid economic growth of the past three years will continue into the next several years. That is, they hold that the current economic expansion will weather the turmoil in Asia and Latin America, and that the U.S. economy will grow at even faster rates than the baseline for the next three or four years. This "fast-growth" scenario raises a set of economic policy considerations that are different from those raised by the slow-growth scenario. For example, will the Federal Reserve raise interest rates to slow the economy, and will businesses be able to borrow funds to fuel their growth given the great need of foreign governments for new sovereign debt?
The fast-growth variant of the WEFA baseline sheds some light on the capacity of the U.S. economy to absorb the tax cut if growth is faster than expectations over the next few years.16 Charts 7-9 show the change in gross domestic product, inflation-adjusted disposable personal income, and personal savings in the fast-growth variant of the WEFA baseline model. Like the slow-growth results, the modeling exercise indicates that reducing marginal tax rates by 10 percent supports stronger economic performance across the forecast period.
NOTE ON INCOME TAX AND CAPITAL GAINS TAX REDUCTIONS IN A FULL-EMPLOYMENT ECONOMY
There is a slight reduction in capital taxation contained in the 10 percent marginal rate cut plan. Although the proposal reduces tax rates on labor income, it specifically excludes long-term capital gains from the 10 percent rate cuts. This exclusion means that the tax premium on capital changes very little,17 which results in small changes in investment over the ten-year forecast period.
From the standpoint of policy changes that support stronger economic growth, this exclusion is an important deficiency in the 10 percent tax cut plan. Tax policy changes that principally affect labor income may do little to stimulate investment in new and expanded plant and equipment. The added economic growth from the tax policy change that appears in the WEFA model simulation stems primarily from additional consumption. A cut in capital taxes, such as a cut in the capital gains tax rate, would have added more growth to the simulated economy by stimulating private investment.
Such a cut in capital taxes can be especially important in a rapidly growing economy. With the current annualized growth rate of the U.S. economy above 3 percent and unemployment at near-record post-World War II lows, many economists recommend that businesses seek to add capital rather than expensive labor that is in short supply. However, the failure to reduce the tax premiums on capital in a fashion proportional to that on labor means that less of this substitution takes place, which shows up in our economic model as only a modest increase in private investment from FY 2000 to FY 2009. Put another way, in the view of many economists, the key to growth in an economy with very low unemployment and productive capacity at high levels is to expand productive capacity by stimulating investment through reductions in taxes on capital.
CONCLUSION
Reducing marginal income tax rates for individual taxpayers would produce numerous fiscal and economic benefits. Not only would taxpayers see their tax liabilities drop by $797 billion between fiscal years 2000 and 2009, but the stronger economy would expand the tax base and return $164 billion in new tax revenues. Average tax liabilities in 1999 would decline by $700, with tax savings flowing to taxpayers in every filing category and family type.
The economic benefits are equally widespread. Over the forecast period, gross domestic product would expand by an average of $35.9 billion after inflation, civilian employment would grow throughout the ten-year period by an average 289,000 above baseline, and personal disposable income after inflation would increase by $106.3 billion by the end of FY 2009. Given the currently strong economy but low savings rate, the healthy expansion of personal savings is a particularly important result: Enacting a 10 percent rate cut would support an average $40.6 billion increase in personal savings between FY 2000 and FY 2009.
Moreover, the implementation of this tax policy change appears to support stronger economic growth in either a slow-growth or fast-growth economy. While some analysts argue that tax rate reductions are unaffordable in a sluggish economy or overheat an economy growing at annual rates well above current baseline forecasts, the modeling results do not support this view. The 10 percent rate reduction significantly improves economic performance in the slow-growth variant of the baseline model. In the fast-growth variant, the 10 percent tax rate reduction appears to be fully absorbed by the economy and to support additional growth.
William W. Beach is John M. Olin Senior Fellow in Economics and Director of the Center for Data Analysis at The Heritage Foundation. D. Mark Wilson is former Labor Economist in the Center for Data Analysis. Ralph A. Rector, Ph.D. is Project Manager for the Center for Data Analysis. Rea S. Hederman is Research Analyst in the Center for Data Analysis. Aaron B. Schavey is a former Economic Policy Analyst in the Center for Data Analysis.
Appendix A: Methodology
Heritage economists follow a two-step procedure in analyzing the revenue and economic effects of proposed tax policy changes.
First, analysts estimate the taxpaying population eligible for the tax change, the base of taxable income absent any change in the economy, and the appropriate tax rates and credits. Revenue estimates based on these calculations are frequently called "static" estimates, largely because they are unaffected by changes in the behavior of taxpayers that stem from tax policy reforms.
Second, these static revenue changes are introduced into the WEFA U.S. Macroeconomic Model.18 The WEFA model has been designed in part to estimate how the general economy is reshaped by policy reforms, such as tax law changes. CDA and WEFA economists have developed a model for The Heritage Foundation to embody the economic and budgetary assumptions published by the Congressional Budget Office in January 1999. This specifically adapted model produces dynamic responses from the CBO baseline as a result of proposed policy changes.
The following sections describe how Heritage economists developed the static estimates described in the report, how these static results and other assumptions were used to develop the case studies described in the report, and how the static estimates were introduced into the WEFA model to estimate the dynamic economic and budgetary results.
STATIC REVENUE ESTIMATE
Static revenue changes are computed using the IRS 1994 Public Use File produced by the Statistics of Income Division (SOI). This file is the latest available public use micro-database released by the IRS and is a sample of tax returns filed in 1994.
Heritage Foundation analysts used a tax simulation model to estimate tax liability under current law and the proposed changes contained in the Tax Cuts for All Americans Act (S. 3) and the 10 Percent Tax Cut Act (H.R. 3) that have been introduced in the 106th Congress. The Heritage model also accounts for major changes introduced into tax law by the Tax Reform Act of 1997, such as the Child Tax Credit. The only change made in the model was to reduce marginal tax rates by 10 percent for each tax bracket.19 Tax changes were computed for each record in the IRS 1994 SOI Public Use File.
Heritage analysts adjusted the static revenue estimates to reflect the fact that a portion of the taxes on capital gains income would not be affected by the reduction in regular tax rates because of the special treatment of capital gains income. This adjustment was based on the amount of income that was subject to the lower capital gains rate in 1994 and projected to 2009 using data from the Congressional Budget Office's January 1999 economic and budget outlook.
Heritage analysts also estimated the amount that proposed tax reductions would be offset by increases in Alternative Minimum Tax revenues. As economic growth and inflation require more and more taxpayers to begin paying the AMT, the number of taxpayers eligible for the proposed tax cut declines and the amount of income subject to the AMT increases. The increase in the number of AMT taxpayers was projected to 2009 using data from a Joint Committee on Taxation (JCT) report on the Individual Alternative Minimum Tax.20 Heritage analysts applied the estimated number of AMT taxpayers to an estimate of the mean regular tax paid by AMT taxpayers that was developed using data from the JCT AMT report and the IRS 1994 SOI Public Use File.21 The estimated increase in AMT tax revenue was then used to partially offset the static decline in income tax revenue resulting from the proposed tax rate reductions.
The first two years of the static revenue estimate were further adjusted to reflect the difference between the effective date of the tax cut and the actual timing of changes in the withholding tables, estimated tax payments, and amount of tax refunds received in 2000. Although the effective date of both H.R. 3 and S. 3 is January 1, 1999, Heritage analysts assumed that the Treasury Department will not change the withholding tables until January 1, 2000. Therefore, just 25 percent of the $72.7 billion, or $18.2 billion, is returned to taxpayers in the final two quarters of 1999.22 The remaining 75 percent of the 1999 static tax cut estimate, or $54.5 billion, is returned to taxpayers in the first two quarters of 2000 in the form of higher tax refunds.
CASE STUDIES
The case studies were taken from the March 1998 Current Population Survey conducted by the Bureau of the Census. The reported income for each case was adjusted to the years 2000 and 2005 using earnings and other income forecasts provided by the WEFA U.S. Macroeconomic Model. In one instance, the family in the 36 percent tax bracket was assumed to use itemized deductions instead of the standard deduction. They were given the average amount of itemizations for their income level, as reported in the SOI database.
The tax for the case studies was determined by subtracting the amount of exemptions and deductions from total income and then taxing that amount by the appropriate bracket. Federal tax computations for the examples use values that have been adjusted for increases in inflation.23 These case studies are snapshots in time and do not reflect changes that might occur over the period in marital status, family size, or employment status.
DYNAMIC ECONOMIC AND BUDGETARY ESTIMATES
The WEFA model contains a number of variables that are used to simulate proposed policy changes. The following changes were made in the model.
The WEFA model contains a variable that measures the total amount of all federal taxes on individual income as a percentage of the nominal personal income tax base. Heritage adjusted this average effective tax rate downward for each of the forecast years to reflect our static revenue decrease estimates.
Labor Force Participation and Average Weekly Hours
Small adjustments were made in the model's exogenous labor force participation rate and the number of hours worked to account for the dynamic effects of decreasing marginal income tax rates. These adjustments are based on previous research by Heritage economists and the Congressional Budget Office study Labor Supply and Taxes, dated January 1996. This change increases the labor force participation rate by 0.1 percentage points per year from 2000 to 2009, and average weekly hours by 0.2 hours per week.
Corporate AAA Bond Rates and 30-Year Treasury Bond Rates
Heritage economists decreased the corporate AAA bond rate by 3 basis points to reflect the lower tax rates on interest and dividend income reported on personal income tax forms. In 1994, 5.1 percent of adjusted gross income was interest and dividend income. Heritage economists also decreased the 30-year Treasury bond rate to maintain the historic interest rate spread between the two rates. The corporate AAA bond rate is a component in the WEFA model equation that calculates the cost of capital. This change decreases the corporate bond rate and 30-year Treasury bond rate by 2 basis points from 2000 to 2009.
Heritage economists decreased the business sector price index to reflect the lower tax rates on business income reported on personal income tax forms. In 1994, 7.4 percent of adjusted gross income was business, partnership, and subchapter S corporate income. Heritage economists assume that lower tax rates on this income will lower the rate of increase in the business sector price index. This change decreases inflation by 0.1 percentage points per year.
The model assumes that the Federal Reserve Board will react to this policy change as it has historically. This assumption was embodied in the Heritage model simulation by including the stochastic equation in the WEFA model for monetary reserves. This assumption increases both short-term and long-term interest rates by 20 basis points from 2006 to 2009, but has little effect on interest rates from 2000 to 2005.
Appendix B:
How Cutting Tax Rates by 10%
Would Affect Selected Economic Indicators
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1. See the 10 Percent Tax Cut Act (H.R. 3), introduced by Representative John Kasich (R-OH), and the Tax Cuts for All Americans Act (S. 3), introduced by Senator Rod Grams (R-MN).
3. "Static" analysis of tax law changes generally means calculating liability and collections changes under an assumption of no change in taxpayer behavior. This assumption holds constant the economic and tax strategy behavior of taxpayers, introduces the tax law change, and recalculates tax liabilities. For example, a static analysis of a reduction in tax rates would not assume a change in labor effort by taxpayers, which has the effect of leaving unchanged the total amount of wages and salaries available for taxation. "Dynamic" analysis, however, generally assumes that taxpayers do respond to tax law changes. Thus, analysts would assume that a reduction in tax rates would result in changes in labor effort, which would alter the amount of wages and salaries subject to federal income tax.
4. Some economists estimate that significant capital gains rate reductions could create revenue windfalls for federal and state governments. See Thomas A. Roe Institute for Economic Policy Studies and Center for Data Analysis, "A New Framework for Cutting Taxes: Reforming the Tax Code and Improving Social Security," Heritage Foundation Backgrounder No. 1199, July 1, 1998.
5. WEFA's Mark 11 U.S. Macroeconomic Model was developed in the late 1960s by Nobel Prize-winning economist Lawrence Klein and several of his colleagues at the Wharton Business School of the University of Pennsylvania. It is widely used by Fortune 500 companies, prominent federal agencies, and economic forecasting departments. The methodologies, assumptions, conclusions, and opinions herein are entirely the work of Heritage Foundation analysts. They have not been endorsed by, nor do they necessarily reflect the views of, the owners of the model.
6. These Congressional Budget Office forecasts are on a unified budget basis. With this accounting method, revenues and outlays from "off-budget" programs like Social Security's Old-Age and Survivors Insurance are combined with general revenues (such as the income tax and excise taxes) and "on-budget" programs, such as defense spending. The surplus reflects the net or combined effects of on- and off-budget revenues and outlays. See Congressional Budget Office, The Economic and Budget Outlook for Fiscal Years 2000 through 2009 (Washington, D.C: U.S. Government Printing Office: January 1999).
7. See Appendix A for details on the calculations that resulted in the revenue estimates contained in Table 1.
8. See Appendix A for greater detail on how the Alternative Minimum Tax affects this revenue forecast.
9. This estimate pertains only to those tax filers above the zero tax bracket, or those in tax brackets of 15 percent and higher.
10. These average reductions in tax liabilities are based on the static revenue estimates of Table 1 and projections of the total number of individual income tax returns in tax year 2000. See Appendix A for details on the calculation of static changes in federal revenues.
11. This estimate is based on tabulations from the Bureau of Labor Statistics' Consumer Expenditure Survey and Consumer Price Index estimates resulting from the econmic forecast of a 10 percent tax cut.
12. Congressional Budget Office, The Economic and Budget Outlook for Fiscal Years 2000 through 2009.
13. The reader should note that the WEFA model, like all forecasting models, produces estimates of future economic behavior that are likely to occur, given the assumptions imposed on the model and the economic theory upon which the model is constructed. Forecasts from the WEFA model tend to be in the middle of the range of actual economic outcome in the short run and generally have understated the long-run economic performance of the U.S. economy.
14. The Blue Chip consensus--an average of the forecasts produced by approximately 40 to 50 private-sector economists--and the CBO predict that economic growth will slow from 3.8 percent in 1998 to around 2.4 percent in 1999. See Congressional Budget Office, The Economic and Budget Outlook for Fiscal Years 2000 through 2009, p. 21. WEFA economists currently forecast a 3.2 percent growth in 1999, but see significant slowing in 2000 and 2001 when the growth rate for GDP declines to 1.4 percent and 1.8 percent respectively. WEFA, U.S. Economic Review: Perspective and Prospects, 1998-2004, February 1999, Table 1, p. 1.21.
15. WEFA's "slow-growth" forecast shows U.S. gross domestic product growing at an annual rate of 2.9 percent in 1999 and 1.0 percent in 2000. These two rates are, respectively, 30 and 40 basis points lower than the WEFA baseline forecast for these years.
16. WEFA's "fast-growth" forecast shows the gross domestic product growing at an annual rate of 3.6 percent in 1999 and 1.9 percent in 2000 instead of 3.2 and 1.4 percent, respectively, in the WEFA baseline.
17. Some change in the cost of capital results from lower tax premiums on interest and dividends, which are included in the income subject to the 10 percent marginal tax rate reduction.
18. WEFA's Mark 11 U.S. Macroeconomic Model is an 873 simultaneous-equation quarterly block recursive model of the U.S. economy. The first block describes how aggregate demand, aggregate supply, financial markets, and labor markets interact. The second block uses an input-output framework to forecast industrial production, wages, and employment for individual industries. The methodologies, assumptions, conclusions, and opinions herein are entirely the work of Heritage Foundation analysts. They have not been endorsed by, nor do they necessarily reflect the views of, the owners of the model.
19. The existing regular tax rates of 15, 28, 31, 36, and 39.6 percent would be replaced by rates of 13.5, 25.2, 27.9, 32.4, and 35.64, respectively.
20. Joint Committee on Taxation, Present Law and Issues Relating to the Individual Alternative Minimum Tax ("AMT"), JCX-3-98, February 2, 1998.
21. Heritage analysts have estimated that, as more taxpayers begin paying the AMT, the mean amount of regular tax liability for AMT taxpayers will fall from the 1994 average. The JCT's estimate of the growth in the number of AMT taxpayers was used to project the rate at which the mean regular tax paid by AMT taxpayers would decline.
22. This comes primarily from those taxpayers who adjust their estimated tax payments to reflect the lower tax rates. Because the final quarter of FY 1999 (the third quarter of calendar year 1999) is the first quarter for which Heritage estimates that there will be a tax cut, the FY 1999 annual average static tax cut is just $4.6 billion, or $18.2 billion divided by four.
23. The baseline and tax proposal forecasts of the consumer price index for urban consumers (CPI-U) were used to estimate the value of exemptions, standard deduction, itemized deduction limitation threshold, and tax brackets. Internal Revenue Code (IRC) Sections 1(e), 1(f), 63(c)(4), 68(b)(2), and 151(d)(4) were used to derive the inflation-adjustment formulas. An additional adjustment was made so that the annual CPI-U projections would reflect an annual period beginning September 1, as required by IRC Section 1(f).
The House and Senate Republican leadership recently announced their interest in using a portion of the current and expected consolidated budget surplus to cut individual income tax payments. One prominent variant of this tax cut agenda calls for marginal tax rates on individual taxable income to be reduced by 10 percent.1 For example, taxpayers who paid income taxes last year at the 15 percent rate would calculate their 1999 taxes at 13.5 percent, a rate that is 10 percent lower than last year's.
This report explores the implications for federal revenues and U.S. economic performance of a uniform 10 percent rate reduction in marginal tax rates for individuals effective for the tax year beginning January 1, 1999. Analysts with The Heritage Foundation's Center for Data Analysis (CDA) simulated the rate reduction using the Center's Individual Income Tax Model to estimate changes in individual income tax liabilities and collections over an 11-year period, 1999 through 2009.2 These "static" liability changes then were introduced into the WEFA U.S. Macroeconomic Model to estimate the likely economic effects over this same 11-year period and to determine the "dynamic" budgetary effects of the tax law change.3
CDA analysts also simulated the effects of this tax cut for the U.S. economy under two other alternative future scenarios. The first was for an economy growing more slowly than the WEFA baseline forecast. The second simulation was for an economy in which growth rates are faster. The methodological details of this analysis are contained in Appendix A.
SUMMARY
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Effect on Tax Revenues. Federal revenues from the individual income tax fall by $797 billion over the fiscal year (FY) 2000 through FY 2009 period under static economic and tax strategy assumptions. However, a dynamic simulation of the 10 percent rate cut shows that federal revenues decline by $633 billion over this same period, which implies a revenue feedback from the economy of 21 percent. Significantly, were such a proposal also to reduce long-term capital gains tax rates by 10 percent (raising the productive capacity of today's near-capacity economy), this feedback would have been higher and several of the fiscal years--especially the first five years--would have contained lower tax revenue reductions.4
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Effect on Surplus. Under static assumptions, cutting tax rates by 10 percent leaves $1.768 trillion of the Congressional Budget Office's (CBO) forecasted surpluses over FY 2000 through FY 2009 available for Social Security reform and other purposes. This amount equals 69 percent of the consolidated or unified budget surplus between FY 2000 and FY 2009, or significantly more than the percentage that President Clinton and the congressional leadership agree should be devoted to Social Security reform.
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Effect on Individual Tax Liabilities. The rate reduction gives almost all taxpayers a lower tax bill. The most notable exception is for individuals who pay the Alternative Minimum Tax (AMT). The average tax liability reduction in 1999 would be about $700 for taxpayers currently paying in the 15 percent and higher tax brackets. The average reduction in tax liability for taxpayers in the 28 percent bracket is over $1,050 in 1999.
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Impact on Economy. This proposed tax law change most likely would lead to a stronger economy. A simulation of this tax policy proposal using the WEFA U.S. Macroeconomic Model5 shows that:
Gross domestic product (GDP) rises by an average of $35.9 billion per year after inflation between FY 2000 and FY 2009. Per capita, inflation-adjusted disposable income also rises by an average of $339 per year because of lower taxes and a stronger economy.
Total civilian employment rises by an average of 289,000 per year over this ten-year period, unemployment falls below baseline in every year of the forecast, and wages and salaries increase modestly.
Personal savings increase by $39.4 billion at the end of FY 2009, accompanied by an increase in the personal savings rate from 4.7 percent to 4.9 percent.
Economic growth would be improved as a result of the 10 percent reduction in marginal tax rates if the U.S. economy grows below current expectations, as some forecasters predict. This tax policy change also would add to economic growth in an economy that grows faster than current forecasts. In other words, the view that tax cuts weaken a slowly growing economy and overheat a rapidly growing economy is not supported by our analysis.
THE STATIC AND DYNAMIC REVENUE EFFECTS
The Tax Cuts for All Americans Act (S. 3) and the 10 Percent Tax Cut Act (H.R. 3) contain the legislative language for the 10 percent rate cut. These bills retain the current law definition of taxable income and the tax base. They also make the tax rate reduction effective on January 1, 1999.
The tax rates on long-term capital gains are not affected by these two bills. Thus, taxes on long-term capital gains would continue at rates set in the Taxpayer's Relief Act of 1997, or at 10 percent for taxpayers whose non-capital gains income is taxed at the current-law level of 15 percent and 20 percent for those paying taxes at the next four higher marginal rates. All other income taxed by the individual income tax schedules (for example, Schedule C filers, partnership income, and sub-chapter S corporation income) would be taxed at the lower rates.
These lower dynamic revenue reductions, however, are largely offset by a dynamic increase in federal outlays. About 87 percent of the increase in outlays is due to higher interest payments on federal debt because the tax cut reduces the amount of surplus devoted to reducing publicly held debt. The remaining increase in federal outlays stems from higher than forecasted cost-of-living adjustments and higher prices for the goods and services purchased by the federal government.
Even with these increases in outlays, however, the resulting ten-year surplus available for Social Security reform and other programs is only 4.2 percent lower than the static surplus estimate. Indeed, Table 1 shows that the proposed rate reduction would leave large budget surpluses available for Social Security reform or other purposes. President Clinton and congressional leaders of both parties have pledged themselves to allocating 62 percent of the ten-year unified budget surplus to "saving Social Security." The CBO forecasts a total of $2.565 trillion in surpluses from FY 2000 to FY 2009. The static estimates of Table 1 show that the 10 percent rate cut would leave 69 percent available for Social Security.
HOW THE 10% TAX CUT PLAN AFFECTS INDIVIDUAL TAXPAYERS
Reducing each of the five marginal individual income tax rates results in lower tax liabilities for most taxpayers; the principal exception is those individuals who pay the Alternative Minimum Tax. The average reduction in federal tax liability in 2000 would be slightly over $700.9 Taxpayers who currently file at the 28 percent tax rate would see their tax liability fall by over $1,050 in tax year 1999.10 Overall, taxpayers would see their tax liabilities fall by $73 billion in 1999.
This aggregate reduction in tax liabilities produces savings for a diverse set of taxpayers. CDA analysts chose four taxpayer profiles to illustrate the benefits from the tax cut, which are summarized in Chart 3. These profiles are based on data extracted from the March 1998 Current Population Survey of the U.S. Census Bureau.
For example, if tax year 2005 is taken as a convenient reference point (roughly halfway through the ten-year forecast period), a single black female teacher who makes $42,323 today and likely would make $54,880 in 2005 would see her taxes fall by $834 in 2005, or by 9 percent. This amount is roughly equivalent to three months of groceries.11
For a married taxpayer like a lumber industry truck driver with a 13-year-old son, the tax savings of $1,125 in 2005 could pay for books and student fees for the boy's first year of college. Had these tax savings been accumulated in an interest-bearing account between 2000 and 2005, they would be sufficient to pay for a significant part of a year's tuition at a public college. If college was not in the young man's plans, these tax cuts probably would be sufficient to pay for vocational training in many professions and for the costs of certification.
More generally, it is important to understand how low- and moderate-income taxpayers would benefit from the 10 percent tax cut plan. A vast percentage of taxpayers who pay taxes at the current 15 percent rate either are young men and women beginning careers and families or retired taxpayers living generally on relatively fixed incomes. Reducing taxes on these taxpayers has the effect of permitting young Americans to keep more of their money for education and child care and increases the disposable income of retirees for the purchase of such things as prescription drugs and medical services.
Additional financial resources in the hands of young taxpayers increase the probability that they will move up the economic ladder, which is a central principle of sound tax policy. Similarly, permitting retired taxpayers to retain more of their income reduces the burden on government for meeting the income shortfalls of elderly Americans. Both effects are present in the 10 percent rate reduction proposal.
DYNAMIC ECONOMIC AND BUDGETARY EFFECTS OF THE BASELINE SIMULATION
A dynamic simulation of reducing marginal income tax rates by 10 percent across the board indicates that the tax cut plan would increase the number of jobs and stimulate economic growth. This simulation further shows that family budgets would improve as a result of growing wages and salaries, as well as significant increases in personal disposable income and personal savings.
To analyze the economic effects on jobs and economic growth of cutting income tax rates, Heritage analysts used the December 1998 Long-Term U.S. Macroeconomic Model of the WEFA Group. CDA and WEFA economists reconstructed the December model for The Heritage Foundation to embody the economic and budgetary assumptions published by the Congressional Budget Office in January 1999.12 This specifically adapted model uses CBO assumptions to produce dynamic simulations of policy changes.13 (See Appendix A for a description of how lower marginal income tax rates were incorporated into this version of the WEFA U.S. Macroeconomic Model.)
The Heritage analysis using the WEFA model and CBO economic assumptions indicates that cutting income tax rates would help families and increase job opportunities over the ten-year period between fiscal years 2000 and 2009. (See Appendix B.) Specifically, the Heritage analysis suggests that reducing marginal income tax rates by 10 percent across the board would:
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Increase economic growth by 0.3 percentage points in FY 2000 from 1.6 percent to 1.9 percent, and by 0.1 percentage points in FY 2002. By the end of FY 2009, the real gross domestic product would be $29.6 billion more than the CBO baseline forecast.
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Increase disposable personal income in FY 2009 by $106.3 billion in 1992 inflation-adjusted dollars, or by $918 for the average household. In response to this significant increase in family budgets, consumer spending would rise by $78.5 billion in 1992 dollars by FY 2009.
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Increase household savings. Personal savings would increase by $39.4 billion, or $340 for the average household, by the end of FY 2009, and the savings rate would rise by 0.2 percentage points to 4.9 percent.
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Increase job creation. Lowering taxes on Americans would increase job opportunities by 365,000 in FY 2005 and reduce the unemployment rate by 0.1 percentage points to 5.6 percent.
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Produce a positive economic "feedback" for the Treasury. "Static" estimates that do not account for the tax increase's influence on the economy's performance suggest that lower income tax rates would decrease revenues to the federal Treasury by $797 billion over ten years. However, a more "dynamic" analysis using the WEFA model suggests that, because the tax cut increases economic growth, the larger tax base would generate more tax revenue ($164 billion) and moderate the expected aggregate revenue loss to the Treasury estimated under the static analysis. In other words, when the tax cut's effect on economic performance is taken into account, the actual "loss" to the Treasury is 79 percent of the purely static reduction in tax revenues over ten years.
Reducing income tax rates would lower the CBO forecast of a $2.565 trillion surplus over the FY 2000 to FY 2009 period to $1.694 trillion, a reduction of 34 percent. However, nearly 66 percent of the CBO's forecasted surplus would remain, to be used to save Social Security and for other purposes. Moreover, without any other policy changes, publicly held debt as a percent of GDP would fall from 40 percent at the end of FY 1999 to just 14 percent at the end of FY 2009. Federal interest payments on the debt would fall from 12 percent of spending in FY 1999 to just 4 percent in FY 2009.
DYNAMIC ECONOMIC EFFECTS IN THE SLOW AND FASTER GROWTH ALTERNATIVE SCENARIOS
Proponents of marginal tax rate reductions often hear that such a policy change would weaken a slowly growing economy and overheat one that is growing rapidly. CDA analysts tested these criticisms using slow- and fast-growth variants of the WEFA baseline model. Our analysis using these two variants does not support either form of the criticism.
In addition to the boost to economic activity, there is another implication of the 10 percent tax cut proposal that policymakers might consider: Enacting this tax policy change might make a possible slowing of the U.S. economy easier on all Americans. Many economic forecasters expect this long-running economic expansion to slow down in the latter half of 1999 and 2000.14 Forecasters base their prognosis of future economic growth on the mounting evidence that economic decline throughout Asia and Latin America is pushing down key sectors of the U.S. economy, particularly those that rely on exports and commodity production. The United States may have been spared significant slowing in 1998 as a result of substantial inflows of capital from economically troubled regions, but forecasters do not expect this source of support for the U.S. economy to continue indefinitely. Thus, economists generally expect the rate of economic expansion to subside over the next two years.
In light of this increasingly probable prospect, CDA analysts simulated the 10 percent tax cut plan in a highly sluggish economy, in which the United States enters much lower growth in 1999 and remains in a slowly growing economy throughout 2000.15 How much better would U.S. economic performance be in such a slow-growth economy if Congress enacted the 10 percent tax cut plan?
Charts 4, 5, and 6 show the effects of a 10 percent tax rate reduction on three key economic indicators: the level of gross domestic product, inflation-adjusted disposable personal income, and the level of personal savings. The bars in these graphs show how much the slow-growth economy differs from the "normal" growth economy, or the WEFA baseline of continued, steady economic expansion. For example, Chart 4 shows that the slow-growth economy produces $34 billion less domestic product than the WEFA baseline in 1999. By 2002, this slow-growth economy is $142 billion smaller than the baseline. However, changing tax policy today by cutting marginal tax rates by 10 percent restores over $35 billion in output to this slow economy.
The results are more dramatic for inflation-adjusted disposable personal income and the level of personal savings. Although the tax policy change makes little difference to the level of disposable income in 1999, it significantly mutes or reverses the slow-growth forecasts in the remainder of the six-year period. In fact, the tax cut makes a $100 billion difference in 2004, or $916 for the average household, when the slow-growth decrease of $71 billion becomes an increase above baseline of $29 billion.
For personal savings, each year of the forecast shows higher levels than those in the slow-growth economy without tax cuts (see Chart 6). For the first three years, 1999 through 2001, the decline in savings without tax cuts becomes an increase above baseline. This result, when combined with the other economic indicators, clearly points to an unexpected benefit of this tax policy proposal: If the economy declines, as some economists expect, the level of decline will be less and the keys to recovery--savings and consumption--will be strengthened.
A few forecasters believe that the rapid economic growth of the past three years will continue into the next several years. That is, they hold that the current economic expansion will weather the turmoil in Asia and Latin America, and that the U.S. economy will grow at even faster rates than the baseline for the next three or four years. This "fast-growth" scenario raises a set of economic policy considerations that are different from those raised by the slow-growth scenario. For example, will the Federal Reserve raise interest rates to slow the economy, and will businesses be able to borrow funds to fuel their growth given the great need of foreign governments for new sovereign debt?
The fast-growth variant of the WEFA baseline sheds some light on the capacity of the U.S. economy to absorb the tax cut if growth is faster than expectations over the next few years.16 Charts 7-9 show the change in gross domestic product, inflation-adjusted disposable personal income, and personal savings in the fast-growth variant of the WEFA baseline model. Like the slow-growth results, the modeling exercise indicates that reducing marginal tax rates by 10 percent supports stronger economic performance across the forecast period.
NOTE ON INCOME TAX AND CAPITAL GAINS TAX REDUCTIONS IN A FULL-EMPLOYMENT ECONOMY
There is a slight reduction in capital taxation contained in the 10 percent marginal rate cut plan. Although the proposal reduces tax rates on labor income, it specifically excludes long-term capital gains from the 10 percent rate cuts. This exclusion means that the tax premium on capital changes very little,17 which results in small changes in investment over the ten-year forecast period.
From the standpoint of policy changes that support stronger economic growth, this exclusion is an important deficiency in the 10 percent tax cut plan. Tax policy changes that principally affect labor income may do little to stimulate investment in new and expanded plant and equipment. The added economic growth from the tax policy change that appears in the WEFA model simulation stems primarily from additional consumption. A cut in capital taxes, such as a cut in the capital gains tax rate, would have added more growth to the simulated economy by stimulating private investment.
Such a cut in capital taxes can be especially important in a rapidly growing economy. With the current annualized growth rate of the U.S. economy above 3 percent and unemployment at near-record post-World War II lows, many economists recommend that businesses seek to add capital rather than expensive labor that is in short supply. However, the failure to reduce the tax premiums on capital in a fashion proportional to that on labor means that less of this substitution takes place, which shows up in our economic model as only a modest increase in private investment from FY 2000 to FY 2009. Put another way, in the view of many economists, the key to growth in an economy with very low unemployment and productive capacity at high levels is to expand productive capacity by stimulating investment through reductions in taxes on capital.
CONCLUSION
Reducing marginal income tax rates for individual taxpayers would produce numerous fiscal and economic benefits. Not only would taxpayers see their tax liabilities drop by $797 billion between fiscal years 2000 and 2009, but the stronger economy would expand the tax base and return $164 billion in new tax revenues. Average tax liabilities in 1999 would decline by $700, with tax savings flowing to taxpayers in every filing category and family type.
The economic benefits are equally widespread. Over the forecast period, gross domestic product would expand by an average of $35.9 billion after inflation, civilian employment would grow throughout the ten-year period by an average 289,000 above baseline, and personal disposable income after inflation would increase by $106.3 billion by the end of FY 2009. Given the currently strong economy but low savings rate, the healthy expansion of personal savings is a particularly important result: Enacting a 10 percent rate cut would support an average $40.6 billion increase in personal savings between FY 2000 and FY 2009.
Moreover, the implementation of this tax policy change appears to support stronger economic growth in either a slow-growth or fast-growth economy. While some analysts argue that tax rate reductions are unaffordable in a sluggish economy or overheat an economy growing at annual rates well above current baseline forecasts, the modeling results do not support this view. The 10 percent rate reduction significantly improves economic performance in the slow-growth variant of the baseline model. In the fast-growth variant, the 10 percent tax rate reduction appears to be fully absorbed by the economy and to support additional growth.
William W. Beach is John M. Olin Senior Fellow in Economics and Director of the Center for Data Analysis at The Heritage Foundation. D. Mark Wilson is former Labor Economist in the Center for Data Analysis. Ralph A. Rector, Ph.D. is Project Manager for the Center for Data Analysis. Rea S. Hederman is Research Analyst in the Center for Data Analysis. Aaron B. Schavey is a former Economic Policy Analyst in the Center for Data Analysis.
Heritage economists follow a two-step procedure in analyzing the revenue and economic effects of proposed tax policy changes.
First, analysts estimate the taxpaying population eligible for the tax change, the base of taxable income absent any change in the economy, and the appropriate tax rates and credits. Revenue estimates based on these calculations are frequently called "static" estimates, largely because they are unaffected by changes in the behavior of taxpayers that stem from tax policy reforms.
Second, these static revenue changes are introduced into the WEFA U.S. Macroeconomic Model.18 The WEFA model has been designed in part to estimate how the general economy is reshaped by policy reforms, such as tax law changes. CDA and WEFA economists have developed a model for The Heritage Foundation to embody the economic and budgetary assumptions published by the Congressional Budget Office in January 1999. This specifically adapted model produces dynamic responses from the CBO baseline as a result of proposed policy changes.
The following sections describe how Heritage economists developed the static estimates described in the report, how these static results and other assumptions were used to develop the case studies described in the report, and how the static estimates were introduced into the WEFA model to estimate the dynamic economic and budgetary results.
STATIC REVENUE ESTIMATE
Static revenue changes are computed using the IRS 1994 Public Use File produced by the Statistics of Income Division (SOI). This file is the latest available public use micro-database released by the IRS and is a sample of tax returns filed in 1994.
Heritage Foundation analysts used a tax simulation model to estimate tax liability under current law and the proposed changes contained in the Tax Cuts for All Americans Act (S. 3) and the 10 Percent Tax Cut Act (H.R. 3) that have been introduced in the 106th Congress. The Heritage model also accounts for major changes introduced into tax law by the Tax Reform Act of 1997, such as the Child Tax Credit. The only change made in the model was to reduce marginal tax rates by 10 percent for each tax bracket.19 Tax changes were computed for each record in the IRS 1994 SOI Public Use File.
Heritage analysts adjusted the static revenue estimates to reflect the fact that a portion of the taxes on capital gains income would not be affected by the reduction in regular tax rates because of the special treatment of capital gains income. This adjustment was based on the amount of income that was subject to the lower capital gains rate in 1994 and projected to 2009 using data from the Congressional Budget Office's January 1999 economic and budget outlook.
Heritage analysts also estimated the amount that proposed tax reductions would be offset by increases in Alternative Minimum Tax revenues. As economic growth and inflation require more and more taxpayers to begin paying the AMT, the number of taxpayers eligible for the proposed tax cut declines and the amount of income subject to the AMT increases. The increase in the number of AMT taxpayers was projected to 2009 using data from a Joint Committee on Taxation (JCT) report on the Individual Alternative Minimum Tax.20 Heritage analysts applied the estimated number of AMT taxpayers to an estimate of the mean regular tax paid by AMT taxpayers that was developed using data from the JCT AMT report and the IRS 1994 SOI Public Use File.21 The estimated increase in AMT tax revenue was then used to partially offset the static decline in income tax revenue resulting from the proposed tax rate reductions.
The first two years of the static revenue estimate were further adjusted to reflect the difference between the effective date of the tax cut and the actual timing of changes in the withholding tables, estimated tax payments, and amount of tax refunds received in 2000. Although the effective date of both H.R. 3 and S. 3 is January 1, 1999, Heritage analysts assumed that the Treasury Department will not change the withholding tables until January 1, 2000. Therefore, just 25 percent of the $72.7 billion, or $18.2 billion, is returned to taxpayers in the final two quarters of 1999.22 The remaining 75 percent of the 1999 static tax cut estimate, or $54.5 billion, is returned to taxpayers in the first two quarters of 2000 in the form of higher tax refunds.
CASE STUDIES
The case studies were taken from the March 1998 Current Population Survey conducted by the Bureau of the Census. The reported income for each case was adjusted to the years 2000 and 2005 using earnings and other income forecasts provided by the WEFA U.S. Macroeconomic Model. In one instance, the family in the 36 percent tax bracket was assumed to use itemized deductions instead of the standard deduction. They were given the average amount of itemizations for their income level, as reported in the SOI database.
The tax for the case studies was determined by subtracting the amount of exemptions and deductions from total income and then taxing that amount by the appropriate bracket. Federal tax computations for the examples use values that have been adjusted for increases in inflation.23 These case studies are snapshots in time and do not reflect changes that might occur over the period in marital status, family size, or employment status.
DYNAMIC ECONOMIC AND BUDGETARY ESTIMATES
The WEFA model contains a number of variables that are used to simulate proposed policy changes. The following changes were made in the model.
The WEFA model contains a variable that measures the total amount of all federal taxes on individual income as a percentage of the nominal personal income tax base. Heritage adjusted this average effective tax rate downward for each of the forecast years to reflect our static revenue decrease estimates.
Labor Force Participation and Average Weekly Hours
Small adjustments were made in the model's exogenous labor force participation rate and the number of hours worked to account for the dynamic effects of decreasing marginal income tax rates. These adjustments are based on previous research by Heritage economists and the Congressional Budget Office study Labor Supply and Taxes, dated January 1996. This change increases the labor force participation rate by 0.1 percentage points per year from 2000 to 2009, and average weekly hours by 0.2 hours per week.
Corporate AAA Bond Rates and 30-Year Treasury Bond Rates
Heritage economists decreased the corporate AAA bond rate by 3 basis points to reflect the lower tax rates on interest and dividend income reported on personal income tax forms. In 1994, 5.1 percent of adjusted gross income was interest and dividend income. Heritage economists also decreased the 30-year Treasury bond rate to maintain the historic interest rate spread between the two rates. The corporate AAA bond rate is a component in the WEFA model equation that calculates the cost of capital. This change decreases the corporate bond rate and 30-year Treasury bond rate by 2 basis points from 2000 to 2009.
Heritage economists decreased the business sector price index to reflect the lower tax rates on business income reported on personal income tax forms. In 1994, 7.4 percent of adjusted gross income was business, partnership, and subchapter S corporate income. Heritage economists assume that lower tax rates on this income will lower the rate of increase in the business sector price index. This change decreases inflation by 0.1 percentage points per year.
The model assumes that the Federal Reserve Board will react to this policy change as it has historically. This assumption was embodied in the Heritage model simulation by including the stochastic equation in the WEFA model for monetary reserves. This assumption increases both short-term and long-term interest rates by 20 basis points from 2006 to 2009, but has little effect on interest rates from 2000 to 2005.
Appendix B:
How Cutting Tax Rates by 10%
Would Affect Selected Economic Indicators
1. See the 10 Percent Tax Cut Act (H.R. 3), introduced by Representative John Kasich (R-OH), and the Tax Cuts for All Americans Act (S. 3), introduced by Senator Rod Grams (R-MN).
3. "Static" analysis of tax law changes generally means calculating liability and collections changes under an assumption of no change in taxpayer behavior. This assumption holds constant the economic and tax strategy behavior of taxpayers, introduces the tax law change, and recalculates tax liabilities. For example, a static analysis of a reduction in tax rates would not assume a change in labor effort by taxpayers, which has the effect of leaving unchanged the total amount of wages and salaries available for taxation. "Dynamic" analysis, however, generally assumes that taxpayers do respond to tax law changes. Thus, analysts would assume that a reduction in tax rates would result in changes in labor effort, which would alter the amount of wages and salaries subject to federal income tax.
4. Some economists estimate that significant capital gains rate reductions could create revenue windfalls for federal and state governments. See Thomas A. Roe Institute for Economic Policy Studies and Center for Data Analysis, "A New Framework for Cutting Taxes: Reforming the Tax Code and Improving Social Security," Heritage Foundation Backgrounder No. 1199, July 1, 1998.
5. WEFA's Mark 11 U.S. Macroeconomic Model was developed in the late 1960s by Nobel Prize-winning economist Lawrence Klein and several of his colleagues at the Wharton Business School of the University of Pennsylvania. It is widely used by Fortune 500 companies, prominent federal agencies, and economic forecasting departments. The methodologies, assumptions, conclusions, and opinions herein are entirely the work of Heritage Foundation analysts. They have not been endorsed by, nor do they necessarily reflect the views of, the owners of the model.
6. These Congressional Budget Office forecasts are on a unified budget basis. With this accounting method, revenues and outlays from "off-budget" programs like Social Security's Old-Age and Survivors Insurance are combined with general revenues (such as the income tax and excise taxes) and "on-budget" programs, such as defense spending. The surplus reflects the net or combined effects of on- and off-budget revenues and outlays. See Congressional Budget Office, The Economic and Budget Outlook for Fiscal Years 2000 through 2009 (Washington, D.C: U.S. Government Printing Office: January 1999).
7. See Appendix A for details on the calculations that resulted in the revenue estimates contained in Table 1.
8. See Appendix A for greater detail on how the Alternative Minimum Tax affects this revenue forecast.
9. This estimate pertains only to those tax filers above the zero tax bracket, or those in tax brackets of 15 percent and higher.
10. These average reductions in tax liabilities are based on the static revenue estimates of Table 1 and projections of the total number of individual income tax returns in tax year 2000. See Appendix A for details on the calculation of static changes in federal revenues.
11. This estimate is based on tabulations from the Bureau of Labor Statistics' Consumer Expenditure Survey and Consumer Price Index estimates resulting from the econmic forecast of a 10 percent tax cut.
12. Congressional Budget Office, The Economic and Budget Outlook for Fiscal Years 2000 through 2009.
13. The reader should note that the WEFA model, like all forecasting models, produces estimates of future economic behavior that are likely to occur, given the assumptions imposed on the model and the economic theory upon which the model is constructed. Forecasts from the WEFA model tend to be in the middle of the range of actual economic outcome in the short run and generally have understated the long-run economic performance of the U.S. economy.
14. The Blue Chip consensus--an average of the forecasts produced by approximately 40 to 50 private-sector economists--and the CBO predict that economic growth will slow from 3.8 percent in 1998 to around 2.4 percent in 1999. See Congressional Budget Office, The Economic and Budget Outlook for Fiscal Years 2000 through 2009, p. 21. WEFA economists currently forecast a 3.2 percent growth in 1999, but see significant slowing in 2000 and 2001 when the growth rate for GDP declines to 1.4 percent and 1.8 percent respectively. WEFA, U.S. Economic Review: Perspective and Prospects, 1998-2004, February 1999, Table 1, p. 1.21.
15. WEFA's "slow-growth" forecast shows U.S. gross domestic product growing at an annual rate of 2.9 percent in 1999 and 1.0 percent in 2000. These two rates are, respectively, 30 and 40 basis points lower than the WEFA baseline forecast for these years.
16. WEFA's "fast-growth" forecast shows the gross domestic product growing at an annual rate of 3.6 percent in 1999 and 1.9 percent in 2000 instead of 3.2 and 1.4 percent, respectively, in the WEFA baseline.
17. Some change in the cost of capital results from lower tax premiums on interest and dividends, which are included in the income subject to the 10 percent marginal tax rate reduction.
18. WEFA's Mark 11 U.S. Macroeconomic Model is an 873 simultaneous-equation quarterly block recursive model of the U.S. economy. The first block describes how aggregate demand, aggregate supply, financial markets, and labor markets interact. The second block uses an input-output framework to forecast industrial production, wages, and employment for individual industries. The methodologies, assumptions, conclusions, and opinions herein are entirely the work of Heritage Foundation analysts. They have not been endorsed by, nor do they necessarily reflect the views of, the owners of the model.
19. The existing regular tax rates of 15, 28, 31, 36, and 39.6 percent would be replaced by rates of 13.5, 25.2, 27.9, 32.4, and 35.64, respectively.
20. Joint Committee on Taxation, Present Law and Issues Relating to the Individual Alternative Minimum Tax ("AMT"), JCX-3-98, February 2, 1998.
21. Heritage analysts have estimated that, as more taxpayers begin paying the AMT, the mean amount of regular tax liability for AMT taxpayers will fall from the 1994 average. The JCT's estimate of the growth in the number of AMT taxpayers was used to project the rate at which the mean regular tax paid by AMT taxpayers would decline.
22. This comes primarily from those taxpayers who adjust their estimated tax payments to reflect the lower tax rates. Because the final quarter of FY 1999 (the third quarter of calendar year 1999) is the first quarter for which Heritage estimates that there will be a tax cut, the FY 1999 annual average static tax cut is just $4.6 billion, or $18.2 billion divided by four.
23. The baseline and tax proposal forecasts of the consumer price index for urban consumers (CPI-U) were used to estimate the value of exemptions, standard deduction, itemized deduction limitation threshold, and tax brackets. Internal Revenue Code (IRC) Sections 1(e), 1(f), 63(c)(4), 68(b)(2), and 151(d)(4) were used to derive the inflation-adjustment formulas. An additional adjustment was made so that the annual CPI-U projections would reflect an annual period beginning September 1, as required by IRC Section 1(f).
