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The Tax Foundation’s Taxes and Growth Model

6 min read

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 has developed a General Equilibrium Model to simulate the effects of tax 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 measures of economic performance such as GDP, wages, and employment. Lastly, it can produce estimates of how different tax policies impact the distribution of the federal tax burden on both a conventional and dynamic basis.

The General Equilibrium model improves upon on the previous Tax Foundation model in two significant ways. First, it places economic results in a broader context by providing estimates of how tax changes impact economic aggregates such as consumption, savings, investment, and the trade balance. Second, it can provide more detailed annual estimates of how the economy adjusts to changes in tax policies, allowing for more detailed dynamic results.

The Tax Foundation General Equilibrium Model has three main components that work together to produce estimates: a tax simulator, a neoclassical production function, and an allocation or demand function. The Tax Foundation model can produce two types of estimates: comparative statics (i.e., long-run estimates), and year-by-year estimates over the 10-year budget window.

Tax Calculator

The starting point for Tax Foundation estimates is the output from the tax simulator. The tax simulator includes a detailed 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. calculator and tax models for 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. , the 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. , value-added taxes, excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. es, 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. , and miscellaneous taxes and fees. The tax model produces estimates of federal tax revenues, marginal and effective tax rates on different sources of income, and the distribution of the tax burden.

The main data source for the tax calculator is the Internal Revenue Service’s 2011 Public Use File (PUF), the latest available information. The PUF is a representative sample of U.S. taxpayers and contains more than 150,000 sample tax returns that represent the population of more than 150 million taxpayers. This allows the tax calculator to estimate how different proposals impact individual income tax revenue. The tax model also relies heavily on data from the Bureau of Economic Analysis, the Federal Reserve, and the Congressional Budget Office to make projections for other federal taxes.

The tax calculator produces two types of distributional tables: conventional and dynamic. Conventional distributional tables are constructed using many of the same methods and assumptions employed by the U.S. Treasury, the Joint Committee on Taxation, and the Congressional Budget Office. The dynamic table uses many of the same assumptions in the conventional tables (with a few key exceptions), but it also includes the impact of the economy on taxpayer income.

Production Model

The production model uses marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. s estimated in the tax calculator to estimate changes in long-run output. The estimate of economic output includes GDP, compensation of employees, the labor supply (in hours worked), and the capital stock. The outputs of the production model are also used to produce income growth factors, which are used in the tax model to produce both dynamic revenue and distributional estimates.

The production model employs a standard Cobb-Douglas production function. The model is constructed by separating the economy into four sectors: private business, households and institutions, government enterprises, and general government. The first three each have their own production functions. The general government sector is exogenous. Output in the first three sectors is a function of each sector’s supply of labor and the supply of capital. The supply of labor and capital is determined by their respective prices: the after-tax wage and the service price of capital.

The production model employs four underlying assumptions. First, the real after-tax rate of return on physical capital is constant in the long run. Second, labor’s share of factor income is constant in the long-run. Third, the supply of labor is somewhat inelastic. In modeling the response of workers to changes in their after-tax wage, we assume a labor supply elasticity of 0.3. Lastly, in our modeling we assume that the Federal Reserve holds the price level constant. This allows us to focus on the effect of tax policy rather than some combination of a tax policy change with an accompanying monetary change.

Allocation Model

The allocation model takes estimates of the change in economic output from the production model and attempts to forecast how people allocate their incomes. The allocation model reports on more features of the economy than a simple production model. It puts production into a broader context, beginning with a starting endowment of time, valued at the after-tax wage, and initial wealth. Each period, people choose to allocate time between labor and leisure. They choose to increase or reduce wealth by consuming or saving, and they decide whether to hold wealth as physical assets such as equipment and real estate, or as financial wealth as government debt or domestic or foreign stocks and bonds.

Determining these behaviors helps to answer questions such as:

  • “How will changes in the government deficit and private investment be funded?”
  • “What will happen to consumption and saving?”
  • “What will be the effect of the policy changes on the trade and current account balances, and international capital flows?”
  • “Given the availability of and demands on domestic saving and foreign capital flows to fund the government deficit and investment, how fast will the changes to capital formation occur, and how long will it take to complete all the economic adjustments to the changes in tax and spending policies?”

Producing Estimates

The three main components of the Tax Foundation General Equilibrium Model work together to produce revenue and economic estimates. The Tax Foundation model can produce two types of estimates: comparative statics (i.e., long-run estimates), and year-by-year estimates over the 10-year budget window.

Using the comparative statics framework, the model estimates the long-run impact of tax policy by comparing a baseline tax policy and economy to an economy with an alternate tax policy. The comparative statics model does not attempt to model economic and budgetary transitional impacts. It essentially tries to answer the question: what would today’s economy look like if an alternative tax policy had always been in place?

In addition to long-run estimates, the Tax Foundation model can create estimates of federal revenues, GDP, wages, investment, capital stock, employment, consumption, and other measures of economic output for each year over a 10-year period. The procedure for estimating policies over the 10-year budget window is similar to the procedure for comparative statics estimates. We compare baseline economic and tax parameters to alternative economic and tax parameters to estimate changes in economic output and tax revenue. However, rather than comparing baseline and simulation parameters for two periods (current year and a simulation year), we compare baseline and simulation parameters for each year over the budget window. This allows us to account for short-run economic effects and transitional revenue effects such as temporary tax policies, phase-ins, and phaseouts.