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How CBO Analyzes the Effects of Changes in Federal Fiscal Policies on the Economy 1 (November 2014)

handle is hein.congrec/cbo1982 and id is 1 raw text is: . _4.--NOV EMBER 2014 How CBO Analyzes the Effects of Changes in Federal Fiscal Policies on the Economy Summary Analyzing the effects on the overall economy of changes in federal fiscal policies-that is, policies governing taxes and spending-requires complex modeling and a signifi- cant amount of time. The Congressional Budget Office (CBO) undertakes such analyses in certain reports and for some major pieces of legislation; some of those analy- ses include the feedback effects of changes in the econ- omy on the federal budget.1 CBO estimates the economic effects of changes in fiscal policies in both the short term and the longer term. The agency conducts its analyses using evidence about the effects of similar policies that have been implemented previously and using results from a variety of economic models. In the short term, changes in fiscal policies affect the overall economy primarily by influencing the demand for goods and services by consumers, businesses, and governments, which leads to changes in output relative to potential (maximum sustainable) output. For example, 1. CBO's estimates of the budgetary effects of proposed legislation generally do not reflect changes in behavior that would affect total output in the economy, such as any changes in the labor supply or private investment resulting from changes in fiscal policy. That is, CBO's cost estimates generally do not include what is sometimes known as dynamic scoring. The convention of not incorporating macroeconomic effects in cost estimates, a practice that has been followed in the Congressional budget process since it was established in 1974, primarily reflects several facts: Doing macroeconomic analysis of all proposed legislation would not be feasible; nearly all proposed legislation analyzed by CBO would have negligible macroeconomic effects (and thus negligible feedback to the federal budget); and estimates of macroeconomic effects are highly uncertain. decreases in taxes and increases in government spending generally boost demand, which encourages businesses to gear up production and hire more workers than they otherwise would; tax increases and spending cuts gener- ally reduce demand, which has the opposite effects. In addition, changes in the supply of labor (the number of hours of labor that workers would like to provide) can affect output in the short term if the labor market is sufficiently tight-that is, if the demand for workers is high relative to the supply. In the longer term, changes in fiscal policies primarily affect output by altering people's incentives to work and save as well as businesses' incentive to invest, thereby changing potential output. For example, policy changes that reduce marginal tax rates-the percentage of an additional dollar of earnings that is unavailable to a tax- payer because it is paid in taxes-generally encourage more work and saving. As another example, policy changes that reduce the federal deficit typically lead to more national saving (the total amount of saving by households, businesses, and governments) and invest- ment, ultimately boosting output and income. Changes to fiscal policies may also affect potential output by alter- ing the amount of government investment (for example, spending or tax subsidies for infrastructure, education and training, or research and development). How Does CBO Estimate the Short-Term Effects of Changes in Fiscal Policies on the Overall Economy? CBO assesses the short-term effects of changes in fiscal policies on the overall economy by estimating the impact of those policies on the demand for goods and services and combining those results with estimates of the

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