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Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates 1 (December 2005)

handle is hein.congrec/cbo8104 and id is 1 raw text is: A series of issuze summaries from the Congressional Budget Office DECEMBER 1, 2005 Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates Sinmary Chang11es InI ta\ Policy Canl influcence the econlomly, an1d th1ose 'conIOmIC effcts Can1 intur Wilaffe'ct theC federalI but)L. AlthIoughl convenItional estimaItes Of tthe budgetaryt- c'[fect of tax polickcs incorporaIte ava riety of behavioral effects, they are, nlonetheless, ba sed on a fixed econiomic baseline. For that reCason, th1ey do nlot in1clude thie budgetary im1pact of any possible ma croeconlomllic effects of tax policie's. Tis br,-ief by theC CongreISSIOnal Budge1t Office (CBO) anialyes the macrocoonmic effects of a simpleI taxI Policy: a 10 Percent reduItctionl InI all fed- eral ra\x rates oni individuial Income. Because thlere is l1il conISensuIs onl ectly ho0W tax cuts affect [the econIomyI, CB) based its analy1SSil nI a numberCI of different: setLs of aIssutttionIs ab[out how\ peCople re- sponid to chianges inI tax\ policy, hiow openi the econi- omyi is) to flowNs of foreign Capital, anld hlow the reve- nueI loss from11 t1he taI cutC might evnua% C heL,11 ncffset. Undi~er th1ose var1ious aIssumIptions, CBO estimated effeVtS Onl ou~tput ranging111 from ncrase of 0.5 per- cenlt to 0.8 per-cent over the first five years oniaer age, and from a decrease of 0.1I pecentiii to anl in- crease of 1. 1 percent over the secondl five years. The budgetary impaP ct of thle econlomlic chlanges) waIs CAI- imated to offset between 1 percentr and 22 percenit Of theC reCvenueI loss from11 theC taX cut over_ the fir-st five years and add as muILch as 5 pecentiii to that loss or* offset aS muILCh aS,32 percenit of it overI the seconld fi Ne year Is. Douglas Holt -Eakin; Dir;ctor/ Tax policy affects the economy in a variety of ways. Changes in marginal tax rates and changes in after-tax in- comes affect people's choices about how they divide their time between work and leisure and how they divide their income between consumption and saving. Those choices in turn affect the amount of labor and productive capital available to generate economic output. Tax policy also in- fluences overall demand for goods and services, which af- fects output in the short run. Finally, tax policy affects the composition and level of output by changing the relative returns to different economic activities. All those eco- nomic effects in turn influence the federal budget. As part of its annual analysis of the President's budgetary proposals, the Congressional Budget Office (CBO) has for the past several years analyzed the potential economic effects of those proposals. The total estimated economic effects in those analyses include the effects of tax propos- als, but they also include the effects of various spending proposals. Moreover, the tax proposals comprise policies with different economic effects-for example, some pro- visions may tend to increase output while others may tend to decrease it. Therefore, CBO's macroeconomic analysis of the overall budget provides limited informa- tion about the estimated effects of particular tax policies. To illustrate more clearly how CBO estimates the eco- nomic effects of tax policies, this brief analyzes the eco- nomic and budgetary effects of a relatively simple tax pro- posal: a 10 percent reduction in personal income tax rates.' CBO finds that such a cut in taxes might increase output by amounts roughly in the range of zero to 1 per- cent on average over the first 10 years, among other eco- nomic effects. Under various assumptions, those macro- economic effects are estimated to offset between 1 percent and 22 percent of the revenue loss from the tax 1. A more detailed discussion of this analysis can be found in Robert Dennis and others, Macroeconomic Analysis of a 10 Percent Cut in Income Tax Rates, C130 Technical Paper 2004-7 (May 2004). f

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