Transparency Would Improve JCT’s Dynamic Analysis of the Camp Plan

Download FISCAL FACT No. 417: Transparency Would Improve JCT’s Dynamic Analysis of the Camp Plan

Key Findings

• Rep. Dave Camp deserves credit for introducing dynamic macroeconomic analysis into 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. reform discussion by requesting a dynamic score of his plan from the Joint Committee on Taxation (JCT).
• According to the JCT’s macroeconomic models, the economic growth resulting from Camp’s plan comes from higher labor force participation and hours worked as well as higher consumption.
• JCT’s models also show that Camp’s plan raises the cost of capital due to its heavy tilt toward lowering the tax burden on individuals at the expense of higher taxes on business and investment.
• The JCT analysis overstates the resulting growth because it underestimates the impact of reduced investment on wages and it inappropriately includes consumption responses.
• History tells us that capital is much more responsive than labor to after-tax returns, thus any dollar-for-dollar rise in the tax on capital and reduction in the tax on other sources of income must reduce total inputs of labor and capital and reduce GDP.
• Ultimately, the plan’s effects on reducing capital formation will translate into lower wages for workers, lower economic growth, and, finally, lower tax revenues for the federal government.

With the release of his Tax Reform Act of 2014, Representative Dave Camp (R-MI) deserves credit for requesting a dynamic macroeconomic analysis of the plan from the Joint Committee on Taxation (JCT). The JCT is required by law to conduct a macroeconomic analysis of major tax legislation when requested by the chairman of the House Ways and Means Committee. This is a long overdue step in informing taxpayers and lawmakers alike of the broader economic effects of tax policy. The conventional static method of analyzing tax legislation can tell lawmakers whether or not the plan adds up, but it cannot tell them if the proposed tax changes will improve economic growth or depress growth.

The JCT’s report, Macroeconomic Analysis of the “Tax Reform Act of 2014”, is very instructive in two important ways. First, the report provides an insight into some of the methodological strengths and weaknesses of the JCT’s models. To our knowledge, this is one of the most comprehensive plans that the JCT has scored on a dynamic basis and its economists should be commended for undertaking such a task.

Second, the JCT report also provides an insight into what the architects of Camp’s tax reform plan were thinking as they structured the plan and what economic levers they were trying to press. From a top-line perspective, the Camp plan is tilted toward lowering the burden on individual taxpayers while increasing the burden on business investment. As JCT’s models appear to indicate, this balance has distinct short-term and long-term consequences.

Overall, the Camp plan is very complex and has many moving parts. On net, it reduces individual tax burdens by roughly $580 billion over ten years by restructuring tax rates and tax breaks. It collapses the current seven tax bracketsA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. into three—10, 25, and 35 percent (the latter is considered a “surtax”)—and it expands the standard deduction and child credit while eliminating the personal exemption. The plan also eliminates the individual AMT while modifying or eliminating dozens of tax preferences.

For the business sector overall, the plan amounts to a tax increase of roughly $580 billion over ten years.[1] The plan does lower the top corporate tax rate to 25 percent from 35 percent while eliminating or modifying dozens of tax preferences. The plan also moves the U.S. to a territorial tax system for global businesses but imposes a one-time tax on their deferred profits held abroad and a new 15 percent minimum tax on their intangible income from abroad. The plan also includes a new $86 billion bank excise tax and $76 billion in higher taxes on insurance companies.

The JCT used two different macroeconomic models to produce a range of estimates in its dynamic analysis of the Camp plan, the Macroeconomic Growth model (or MEG) and the Overlapping Generations model (or OLG).[2] The MEG model estimates that the plan would lift the average level of GDP by between 0.1 percent and 0.6 percent compared to its projected level under current law, with more of a rise in the last half of the budget period than in the early years.

By contrast, the OLG model estimates that the plan would raise the average level of GDP by either 1.5 percent or 1.6 percent compared to projected levels in the 2013 through 2023 period. That model shows more of a lift in the first half of the budget window than the second half. In the second half of the period, GDP would be about 1.4 percent higher than the baseline. (These percent changes are in the level of GDP, they are not increases in the annual rates of growth; they do not compound and climb over time.)

JCT Table 3. Percent Change in Real GDP Relative to Present Law

	Fiscal Years 2014-2018	Fiscal Years 2019-2023	Fiscal Years 2014-2023
MEG
High Labor Eelasticity	Aggressive Fed	0.2%	0.2%	0.2%
	Neutral Fed	0.1%	0.8%	0.5%
Low Labor Elasticity	Aggressive Fed	0.2%	0.1%	0.1%
	Neutral Fed	0.1%	0.7%	0.4%
MEG, reduced investment response to taxation of multinationals
High Labor Elasticity	Aggressive Fed	0.3%	0.3%	0.3%
	Neutral Fed	0.3%	0.8%	0.6%
OLG
Default IP Elasticities	1.8%	1.4%	1.5%
Reduced IP Elasticities	1.8%	1.4%	1.6%

In nearly all the cases examined, most of the short-term improvement in GDP, and all of the long-term gain, is anticipated to come from higher labor force participation and hours worked due to lower average and marginal tax rates on individuals (a positive supply-side effect), and to higher consumption as higher after-tax incomes raise the demand for goods and services (pumping up demand). It does not come from increased investment in plant, equipment, and structures; indeed, the plan is expected to raise the cost of capital, and the capital of domestic firms is expected to have declined, or to be declining, by the second half of the period.

The JCT report states:

The reduction in statutory tax rates on corporate and non-corporate business income increases the after-tax return to investment for some businesses that do not make use of many of the business deductions under present law. For those businesses that do make use of accelerated 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. , expensing of research and experimentation expenses, or other business tax expenditures, the elimination of these provisions is expected to reduce the after-tax return on investment. Overall, the proposal is expected to increase the cost of capital for domestic firms, thus reducing the incentive for investment in domestic capital stock.[3]

Indeed, Table 4 in the JCT report illustrates the significant drop-off in business capital in the second half of the period as a result of the plan’s effect on increasing the cost of capital. This has to dampen the plan’s effect on growth in the long run.

JCT Table 4. Percent Change in Business Capital Relative to Present Law

	Fiscal Years 2014-2018	Fiscal Years 2019-2023	Fiscal Years 2014-2023
MEG
High Labor Elasticity	Aggressive Fed	0.1%	-1.0%	-0.5%
	Neutral Fed	0.0%	-0.5%	-0.3%
Low Labor Elasticity	Aggressive Fed	0.1%	-1.0%	-0.6%
	Neutral Fed	0.0%	-0.6%	-0.3%
MEG, reduced investment response to taxation of multinationals
High Labor Elasticity	Aggressive Fed	0.3%	-0.6%	-0.2%
	Neutral Fed	0.2%	-0.2%	0.0%
OLG
Default IP Elasticities	0.2%	0.0%	0.1%
Reduced IP Elasticities	0.0%	-0.3%	-0.2%

Thus, all of the growth of GDP that the JCT forecasts from the tax reform proposal must come from sources other than an expansion of the capital stock. The JCT’s conclusion reveals its reliance on labor supply and consumption effects to generate its net growth forecast:

Broadening of the individual and 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. bases through elimination of many preferences in the form of deductions, exemptions, and tax credits allows for a reduction in average and marginal tax rates for most individual taxpayers, which provides both an incentive for increased labor effort, and an increase in demand for goods and services. These changes also reduce the after-tax return to investment under many modeling assumptions, providing an incentive for a reduction in the U.S. domestic, capital stock. On net, these changes are expected to result in an increase in economic output relative to present law.[4]

Unfortunately, there is reason to doubt the labor force effects and the demand-side consumption growth effects in the JCT models.

JCT is right to conclude that the labor force participation rate and hours worked should respond positively to higher after-tax wages. The JCT gets a major portion of its growth from assuming a reduction in the average and marginal tax rate on labor and a resulting increase in labor force participation and hours worked.

However, history tells us that the labor supply response to changes in after-tax wages is much smaller that the response of capital to changes in the after-tax rates of return. Any dollar-for-dollar rise in the tax on capital (if reflected in lower marginal returns) and reduction in the tax on labor (especially if it chiefly lowers the average tax rate on labor, with less reduction at the margin) must reduce total inputs of labor and capital and reduce GDP.

Furthermore, there is reason to be concerned about the presumed reduction in the marginal tax rates on labor income. The proposal contains several surtaxes and phase-outs of major items in the plan, including the surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. on the upper income brackets, the take-back of the 10 percent bracket, the phase-outs of the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. for all taxpayers and the additional standard deduction for single filers, and the phase-out of the child credit.

These create effective 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. “bubbles” that lift income tax rates at high as 40 percent (43.8 percent including the 3.8 percent HI Medicare tax).[5] We will be examining these effects to gauge just how much the marginal tax rates are reduced by the lower statutory rate structure when the claw-backs are taken into account.

The consumption effects found by the JCT models have no place in a long-run growth estimate and are a major weakness in the JCT dynamic modeling methodology. In forecasting a long-run change in economic capacity and output, one must not include short-run counter-cyclical effects on consumer spending from increases in disposable income.

These income effects relate to old-fashioned counter-cyclical pump priming during periods when the economy is at less than full employment, which is presumed to trigger ripple or multiplier effects by giving people money to spend, which can supposedly lift GDP to existing capacity. They do not boost GDP long term, when one assumes the economy is operating at capacity. Indeed, these effects may not even occur in the short run, because, in the absence of Federal Reserve accommodation, the added federal debt issued to cover the net tax reduction absorbs the additional after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize their earnings. , and the additional spending is crowded out.

The avoidance of income effects is even more important in the case of a revenue-neutral tax change. In the case of a revenue-neutral tax change, there should be no net increase in after-tax income in the initial implementation of the reform and no income-related stimulus. Insofar as the JCT models rely on demand-side stimulus to get their result, their growth figures are overstated. This issue regarding income effects is discussed with great clarity in a recent Congressional Research Service analysis.[6]

The CRS analysis also notes that the cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages. changes and the repeal of many of the other business tax expenditure provisions act as implicit tax rate increases, would raise the cost of capital, and in doing so would offset the effect of the portion of the corporate and individual tax rate reductions on capital formation financed in that manner.

Lastly, the absence of any analysis beyond the ten-year window hides much of the negative effects, since buildings and some equipment take more than ten years to build out and impact productivity and wages. A longer-term analysis would show the reduced capital stock eventually overwhelming the positive labor market effects.

Conclusion

The JCT’s dynamic scoring of Representative Camp’s tax reform plan provides many useful insights into the workings of JCT’s models and the thinking that went into the crafting of the proposal. While the Joint Committee should be commended for producing such an analysis of comprehensive tax reform, they did lawmakers a disservice with the way in which they presented their results.

Rather than give lawmakers a clear year-by-year picture of the path of growth over the ten-year period, they obscured these details by summarizing the results with averages for the first five years and second five years. If JCT’s models show that growth is fading to zero by the end of the period, lawmakers need to know this and not have it hidden from view. Transparent information is critical to crafting good, pro-growth tax policy while avoiding harmful changes.

Camp’s tax reform plan tilts heavily toward lowering the tax burden on individuals at the expense of business investment. However, JCT’s models tend to overstate short term labor and consumption effects and understate long term investment effects. Therefore, both models show that Camp’s plan would produce a modest amount of economic growth over the ten-year period in spite of the anti-investment tax tilt.

Nonetheless, even though JCT models tend to understate the negative effects of higher taxes on capital and investment, they clearly show the decline in capital formation over the second half of the ten-year window. We believe the plan’s effects on reducing capital formation ultimately will translate into lower wages for workers, lower economic growth, and, finally, lower tax revenues for the federal government.

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