Tax Policy and the US Economy: Enhancements to Our Modeling Framework

The TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. Foundation models tax policy using our proprietary Taxes and Growth model, illustrating the economic, revenue, and distributional impacts of different changes to the federal tax code. We’ve recently implemented improvements to the model that have been underway for the past several years, and we will be detailing them further in our forthcoming model methodology update.

First, on an annual basis, we update the underlying baseline data in the model using the Congressional Budget Office baseline. Our model now reflects the January 2025 baseline, which projects larger tax and economic variables than last year’s baseline. Both changes impact the revenue estimates we produce. While we have updated to the new baseline, our model still retains the ability to simulate tax policy changes within the 2025 through 2034 budget window.

Second, we implemented a matched database. We augmented our tax data input by statistically matching data from the Current Population Survey (CPS) from Census. The expanded data brings imputed demographic information, such as age and gender, as well as income splits for joint filers. With income split information among joint filers, we enhanced our payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. model and fully integrated it with our individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. simulator. The matched database also allows us to model certain policy proposals that would convert nonfilers into tax filers.

On top of that, we improved our distribution table by measuring simulated tax changes over an expanded definition of income instead of over adjusted gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” (AGI). Our new distribution tables will be formatted as below.

Note: Market income includes adjusted gross income (AGI) plus 1) tax-exempt interest, 2) non-taxable social security income, 3) the employer share of payroll taxes, 4) imputed corporate tax liability, 5) employer-sponsored health insurance and other fringe benefits, 6) taxpayers’ imputed contributions to defined-contribution pension plans. Market income levels are adjusted for the number of exemptions reported on each return to make tax units more comparable. After-tax income is market income less: individual income tax, corporate income tax, payroll taxes, estate and gift tax, custom duties, and excise taxes. The 2025 income break points by percentile are: 20%-$17,080; 40%-$37,364; 60%-$71,067; 80%-$125,315; 90%-$181,001; 95%-$255,840; 99%-$583,741. Tax Units with negative market income and non-filers are excluded from the percentile groups but included in the totals.
Source: Tax Foundation General Equilibrium Model, February 2025.

Third, we’ve completed changes to our user cost of capital as detailed in our prior research paper here. The user cost of capital formula separates the required rate of return for businesses and individual savers. Tax Foundation continues to model the US as a small open economy, which means that the US is fully open to foreign capital inflows to finance private investment and public debt and that the long-run after-tax rate of return on business assets is fixed. Other models take a different approach: for example, the Joint Committee on Taxation has moved toward a partially open economy assumption while the Congressional Budget Office incorporates large crowd-out effects. Ultimately, no model provides a perfect representation of the real world, yet each sheds light on different aspects that impact the fiscal debate.

Our assumptions have implications for how changes in domestic saving impact economic aggregates, whether domestic saving changes because of changes in tax burdens on saving or changes in the budget deficit.

In Tax Foundation’s modeling, if the US increases the tax burden on saving, such as through an increase in the estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. or capital gains and dividends taxes, it discourages Americans from saving. The resulting reduction in domestic saving does not decrease domestic investment because foreigners are willing to lend to the US so that profitable investments continue to take place. More importantly, the reduction in domestic saving shrinks national income. While GDP remains largely unchanged, a higher tax burden on saving shrinks national income owned by Americans, as measured by GNP. Instead of investment returns flowing to Americans, they flow to foreign savers.

Under Tax Foundation’s model, if the US spends more or raises less revenue and it results in an increase in the budget deficit, that reduces domestic saving, but it does not reduce investment and GDP. Instead, as a higher budget deficit requires the US government to borrow more, and as interest payments on the debt made to foreigners goes up, American incomes go down.

Finally, the Tax Foundation has constructed a more detailed model of corporate federal tax liabilities. The model uses a set of representative firms and data from the Internal Revenue Service and the Bureau of Economic Analysis to produce detailed corporate tax liability and effective tax rate estimates by industry, firm type, and country of corporate residence. We are now able to capture details such as profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. responses, general business credits, and key provisions such as the treatment of subpart F income, global intangible low-taxed income (GILTI), and income that qualifies for the foreign derived intangible income (FDII) deduction. Even with more details on the corporate model, however, modeling the economic and revenue effects of policies that impact cross border investment remains subject to a high level of uncertainty, not least of which is that the effects partially depend on an assumption that foreign tax policies remain stable.

We can simulate new provisions, such as the corporate alternative minimum tax (CAMT) and stock buyback tax, both enacted into law in 2022, using company-level financial statement data that is synced with our broader corporate model. The corporate tax model also provides a detailed way to simulate changes to depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. deductions by asset type.

We look forward to continuing our work to illustrate the trade-offs of different types of taxes and inform the ongoing tax policy debate by modeling changes to the US federal tax code.

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