Executive Summary
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 uses and maintains a General Equilibrium Model, known as our Taxes and Growth (TAG) Model to simulate the effects of government tax and spending policies on the economy and on government revenues and budgets. The model can produce both conventional and dynamic revenue estimates of tax policy. The model can also produce estimates of how policies impact macroeconomic aggregates such as gross domestic product (GDP), wages, employment, the capital stock, investment, consumption, saving, and the trade deficit. Lastly, it can produce estimates of how different tax policies impact the distribution of the federal tax burden. The model can analyze the effects of most types of taxes. It can estimate the effects of changes to the rate and the base of the 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. , the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. , payroll taxes, taxes on wealth like estate and gift taxes, and excise taxes.
The Tax Foundation model has three main components that work together to produce estimates. The first component is a tax simulator, which produces conventional revenue and distributional estimates as well as estimates of marginal tax rates on different sources of personal and business income. The second component is a neoclassical production function, which estimates long-run changes in the level of output based on changes in the capital stock and labor force in response to policy. The last component is an allocation model, which takes outputs from the tax and production models and combines with aggregate accounting identities and saving responses to forecast the different components of GDP, the balance between saving and investment, the international account, wealth, and gross national product (GNP).
The Tax Foundation model produces estimates of the long-run impact of tax policy as well as the year-by-year path of the economic adjustment and the impact of tax policy on the government budget over the usual 10-year budget window.
Frequently Asked Questions
Tax Foundation produces comparative statics or estimates of the long-run impact of tax policy by comparing a baseline tax policy to a simulation tax policy. It’s like estimating what the economy would look like today if an alternative tax policy had always been in place. But responses to most tax policy changes, especially changes that affect investment, can’t happen instantaneously.
For example, if a tax policy change increases the incentive to invest in the United States, it will take time for businesses to respond as they plan, permit, build, and then put new assets into use. To simulate how investment is built out over time, we assume an adjustment path for the capital stock consistent with recent empirical analysis. We assume about 84 percent of the capital stock adjustment occurs by the 10th year and about 98 percent by the 20th year after a policy change.
If a tax policy increases (or decreases) the tax burden on labor, we assume a much faster response, largely occurring within the first year using a weighted average labor supply elasticity of 0.3.
Gross domestic product (GDP) is a measure of the size of US economic output. It measures the value of final goods and services residents and foreigners produce within the US. GDP is important because what a country can produce is closely related to what a country can consume. Countries with higher GDP per capita can purchase life’s essentials like food and shelter, as well as higher-quality medical care, discretionary consumer goods, and more expansive social services.
Gross national product (GNP) is a measure of American incomes. It is closely related to GDP but differs because it measures the incomes Americans earn from production of goods and services produced within the United States and abroad.
To see how this works in practice, consider a German-owned company that opens a factory in Tennessee. All the productive output of that factory counts toward US GDP. Most of that output counts toward US GNP too (think of the salaries paid to the US workers at the plant), but the portion of profits paid back to the factory’s German owners does not count toward GNP.
The inverse is also helpful. Consider an American-owned company that opens a factory in Germany. From GDP’s perspective, all the output of that factory is German, so none of it counts toward US GDP. But the profits from that factory flow back to American shareholders and count toward US GNP.
Tax policy can change the size of the economy and American incomes by changing whether (and how much) people work and invest in the US.
People respond to incentives on the margin when making decisions to work or invest. As the after-tax returns to additional work or investment fall, people work and invest less. Investment and work opportunities that would have broken even before are no longer viable to pursue.
Less work and lower investment reduce the long-run size of the American economy, American incomes, the capital stock, and the number of full-time equivalent jobs.
Some tax changes can create a wedge between GDP (American output) and GNP (American incomes). Taxes levied on domestic saving, such as capital gains taxes, would reduce the return to saving, and, in response, people would save less, which would reduce the ownership of American investment by residents. Because the US economy is open to international investment, foreign investors who are not subject to the tax may provide additional funds to finance domestic investments.
While increased international investment reduces the effect of the tax change on GDP, it would change who owns assets, resulting in less ownership of US assets by Americans and a decrease in national income as the profits flow to foreign owners instead.
The capital stock is a measure of the level of fixed assets in the economy, including government-owned and private-owned. The private stock consists of four main asset types: equipment, nonresidential structures, residential structures, and intellectual property.
The capital stock is one of the main inputs of the US economy. More equipment, structures, and intellectual property lead to higher output and wages over time. A farmer can harvest more land in an hour with a larger combine, and a second silo lets him store more produce. Changes in tax policy can lead to changes in the size of the capital stock, driving changes in productivity, incomes for workers and business owners, and output.
Conventional revenue estimates estimate the revenue change from a policy without considering a policy’s effect on the size of the aggregate economy. Conventional revenue estimates often include adjustments for how a policy change may influence behavior in an isolated sense. For instance, a lower corporate tax rate may lead some corporations that report their profits abroad in low-tax countries to instead bring them back to the US, expanding the corporate tax base to which the lower corporate tax rate applies. Conventional revenue estimates may also consider how a tax change interacts with other parts of the tax code.
Dynamic revenue estimates incorporate how a policy’s impact on the size of the aggregate economy would change revenue collections. For example, a lower corporate tax rate may increase investment in the United States. Investment drives productivity growth, which drives wage growth, and higher wages translate to higher individual income tax collections.
Congress is required by law to use a 10-year window for budgeting, including for estimating the effects of tax policy changes, which is why Tax Foundation provides revenue scores over the same horizon. Ten-year revenue estimates are effectively an industry standard for comparability across estimates.
Tax Foundation’s distributional tables measure how tax policy changes would affect the income of tax units, or tax returns. However, not all tax units are single individual filers; tax units also include joint filers and head of household filers, both of which can claim dependents. Accordingly, we adjust each tax unit for household size. The adjustment means it’s difficult to exactly interpret the dollar thresholds across the income groups, because it doesn’t translate exactly to the income each tax unit receives.
Quintile Break Points for Market Income, 2025
| 20% | $17,185 |
| 40% | $37,326 |
| 60% | $71,353 |
| 80% | $125,885 |
| 90% | $182,027 |
| 95% | $257,711 |
| 99% | $592,036 |
Source: Tax Foundation General Equilibrium Model.
February 2025 Update
Key Improvements to Our Model
- 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 tax 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).
- 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.
- 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.
Download the PDF below to see the full overview of the Tax Foundation’s General Equilibrium Model.
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