Congressional Predictions Overly Optimistic about Taxes and Growth

February 12, 2013

Analysis Fails to Account for Dynamic Effects of Higher Tax Rates

Washington, D.C., February 12, 2013—The Congressional Budget Office’s most recent predictions paint far too rosy a picture of the nation’s economic outlook given the recent tax increases passed as part of the “fiscal cliff” compromise. These higher rates will reduce long term incentives to invest, hire, and work, leading to less economic growth, according to a new analysis by the Tax Foundation.

“The Congressional Budget Office’s latest Budget and Economic Outlook takes an unduly optimistic view of the long-term effects of recent tax increases,” said Tax Foundation Chief Economist William McBride. “Our model predicts slower economic growth over the next 10 years, meaning a longer period of high unemployment as well as a larger federal debt.”

Congressional Budget Office analysis expects significant additional tax revenue to come from individual income taxes, which they expect to rise due to growth in incomes in general and the new higher tax rates on high-income earners and investors. They project individual income tax revenues to continue increasing over the next decade, at which point they would be at the second highest level on record.

Contrary to projections, however, the evidence indicates that higher tax rates, at least on investors, actually reduce incomes and tax revenues. In January, the top capital gains tax rate was raised from 15 percent to 23.8 percent. The last time this tax rate was increased was in 1986, when it was raised from 20 to 28 percent. At the time the CBO projected that capital gains realizations and tax revenue would drop for one year but rebound thereafter. In fact, capital gains realizations and tax revenue remained depressed for ten years until the tax rate dropped once again to 20 percent in 1997.

The new higher tax rates for high-income earners, investors, and businesses mean less investment and less productive labor. It does not seem that the Congressional Budget Office has accounted for these effects in their long run projection. They expect the economy to grow about 2.3 percent per year after 2019, which is already one point below the average for the past several decades. The Tax Foundation model, however, which takes tax policy into account over the long run, finds that the new tax increases will shrink the economy 1.45 percent over the next five to ten years compared to last year’s rates. As a result, we find the revenue gains from these tax increases are only about one-third of what the CBO projects.

Tax Foundation Fiscal Fact No. 358, “CBO Overly Optimistic about Economic Growth and the Federal Debt” by William McBride is available here.

The Tax Foundation is a nonpartisan research organization that has monitored fiscal policy at the federal, state and local levels since 1937. To schedule an interview, please contact Richard Morrison, the Tax Foundation’s Manager of Communications, at 202-464-5102 or morrison@taxfoundation.org.

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