CBO Releases Report on White House 2017 Budget: Summary and Analysis

The Congressional Budget Office (CBO) has recently published their Macroeconomic Analysis of the President’s 2017 Budget. In it the CBO assessed four major topics including changes to the tax code, increased spending to reduce the federal deficit, increases in federal investment, and immigration reform.

Obama’s budget contains roughly $2 trillion in new tax proposals. Among the proposals is a 28% cap on itemized deductions which has previously been analyzed by the Tax Foundation as part of Hilary Clinton’s tax plan. Also forthcoming is a new minimum flat tax on high-income taxpayers and a $10.25 tax per barrel of crude oil, both domestically produced or imported, which will account for one tenth of the total revenue increases predicted. Overall the CBO projects that these changes would increase marginal tax rates on labor and capital income, thereby discouraging work and reducing output.

The Obama administration also proposes to use some of the increased tax revenue to reduce the federal deficit. The CBO forecasts that this would reduce output in the short-term, but might produce a long-term boost in output due to increasing the level of national saving.

Along with increases on deficit spending, Obama has also proposed boosting spending on “surface transportation, education and job-training programs, and research and development.” If done correctly, these public spending projects are projected to start boosting the economies output well after 2026 as there is a significant amount of lag associated with education and research spending.

Finally, the CBO’s largest projected effect on the economy will happen as a result of immigration reform. The Obama administration plans to increase immigration by about 11 million people over a ten year period, which would offset any of the short-term negative effects on aggregate output from the proposed fiscal policies. This policy would increase the size of the labor force and account for “most of the impact of the President’s proposals on the economy.” The immigration proposal would boost overall GNP by adding new workers, but it would also reduce the per-capita average, because the new workers would be poorer than current U.S. residents, and therefore reduce the average. The report makes no claim as to whether current U.S. workers would be better off or worse off as a result of the immigration. This is roughly in line with the general economic literature on immigration; few economists think immigration has a dramatic effect one way or the other on the economic prospects of current residents.

Similarity to Tax Foundation Modeling Principles on Taxes

Some of the CBO’s tax analysis works in the same way as the Tax Foundation’s Taxes and Growth model. Namely, the CBO tracks aggregate marginal tax rates on labor and capital, and an increase in these marginal rates reduces the quantities of labor and capital supplied. As in the Tax Foundation model, and many others, these two factors of production work together to create total output.

Under the CBO’s model, as in the Taxes and Growth model, capital adjusts to a higher rate of return, which can come about if more people are working. The report explains that over the long run, the U.S. capital stock would increase as a result of the large flow of new immigrants:

Over time, the increases in the labor force and in employment would boost output in another way: They would raise capital investment, primarily because the return that people earned on a given amount of investment would be higher under the immigration proposal than it would be under current law. The increased rate of return on capital investment would occur because the larger labor force would make the existing stock of capital scarcer in relation to the supply of labor, which would make each unit of capital—a single computer, for example—more productive. The increase in the rate of return on investment would moderate over time, however, as the stock of capital grew.

This resembles how the capital stock would rise in the Tax Foundation model as a response to more people working. While Tax Foundation does not model immigration policy, this explanation is in line with what would expect from a standard neoclassical production function. Under the Tax Foundation model, one might get a smaller version of this effect from, say, a reduction in payroll taxes. More people would work, which would increase the return to capital. Then more investment would happen until the rate of return fell.

Spending Modeling Under Neoclassical Principles

Much of the spending in the proposal promotes activities that can reasonably be called investment. Surface transportation spending, for example, is relatively straightforward. The CBO calls it “federal investment,” and it contributes to the capital stock just as private sector investment would. It still should pass a rigorous cost-benefit analysis, of course, and not all government projects do, but provided it is well-chosen, this investment should boost productivity by increasing the capital stock, consistent with the general modeling principles Tax Foundation uses on the tax side.

Another kind of investment in the proposal is education investment, or “human capital.” To the extent that education genuinely makes workers more productive, it can be valuable to view it through the same lens as one might view a physical investment into tools workers use on the job. However, not all education is necessarily useful, and a degree for the sake of a degree is not the same as one that specifically provides a worker with skills they will need later.

Areas for Potential Skepticism

The area of the analysis where Tax Foundation would differ most strongly with CBO is in the idea that deficit reduction promotes investment by keeping interest rates low and getting more funds into private capital markets. As the government borrows less, private saving is freed up to invest in private capital projects. Alternatively, if the government borrows more, it “crowds out” private capital projects by taking away the availability of funds. The report explains:

The total amount of saving in the economy, called national saving, is the sum of public saving and private saving. Public saving consists of all surpluses of state and local governments and the federal government, plus government investment in fixed assets, minus all deficits; private saving consists of saving by households and businesses. National saving, along with net borrowing from abroad, finances the nation’s investment in its capital stock—which, again, helps determine how much output the economy can produce.

An increase in the federal budget deficit reduces public saving, other things being equal. In the long run, it also raises private saving—in part because when the government borrows more, interest rates rise throughout the economy, encouraging people to save—and it raises net borrowing from abroad as well, for the same reason. However, the increases in private saving and in net borrowing from abroad only partly offset the decline in public saving. (In its analyses of the long-term effects of changes in deficits, CBO uses ranges of the sizes of those offsets.) Therefore, the net effect of larger deficits in the long run is a smaller capital stock, which reduces output.

At Tax Foundation, in contrast, we believe that increases in private saving and net borrowing from abroad can fully offset a decline in public saving, rather than partially offsetting it. We think this is borne out by recent evidence; in recent years interest rates for government debt have been cheap, and the supply of foreign savings has been extremely plentiful, to the point that it is a common subject of discussion for central bankers around the world. Our views on this are discussed at length here.

For some of its model results, the CBO provides a range of estimates, depending on whether one believes an effect is strong or weak. The report provides estimates both for a weak effect of deficits on investment and for a strong one. We believe that the modeling results from the weak effect are likely to be more informative, and in fact, an even weaker effect (or no effect) might be most appropriate.

What This Tells Us about the Impact of Taxes on the Economy

Does this tell us that one can raise taxes and still grow the economy? Not particularly; the economic growth comes only on an aggregate basis, not on a per-capita basis, and it comes almost entirely from immigration, not from substantial changes to tax levels or structures.

Simply put, a bold immigration proposal matters much more than a modest tax proposal. If the projection of 11 million new full-time residents is an accurate one, that is a far greater change to the U.S. economy than the comparatively small changes in the tax system. It would be, for all intents and purposes, essentially impossible to create 11 million new jobs in the U.S. through tax changes alone.

The immigration reforms are the most economically consequential part of the budget and the most consequential part of the analysis; this time, taxes take a back seat.


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