Congressional Budget Office and Tax Foundation Modeling Show That Some Tax Hikes Are More Damaging Than Others

March 26, 2021

A recent working paper by economists at the Congressional Budget Office (CBO) shows that not all taxes are created equalprogressive taxes on labor income and taxes on capital income would have a negative impact on the economy, capital investment, and jobs, especially when compared to flatter taxes on labor income. Policymakers should consider these results as they debate ways to fund additional spending. There are many ways to raise an additional dollar of revenue, but some methods do more damage to long-run growth by undermining incentives to work and invest.

The CBO examined three tax increases to raise 5 percent or 10 percent of GDP in additional revenue: a flat tax on labor earnings, a flat tax on income from labor and capital, and a progressive income tax.

A tax on labor income is like levying an additional payroll tax on wages and self-employment earnings, while taxes on capital income apply to income sources like capital gains and dividends. To measure the effect of progressive taxes, the CBO also modeled a proportionate increase in tax rates on labor combined with a flat tax on capital income.

The authors find that labor taxes are less economically harmful than taxes on capital, as capital is more mobile and sensitive to taxation. For example, a labor tax raising 5 percent of GDP in revenue would reduce GDP by 3.2 percent in 2030, while a progressive income tax would reduce GDP by 4.5 percent. Progressive income taxes are more damaging to growth because “high-productivity workers reduce their hours worked and because higher taxes on asset income reduce the incentive to save and invest relatively more than under the two flat taxes.”

We find broadly similar results when using the Tax Foundation General Equilibrium model, namely that progressive income taxes are the most economically damaging of the three options. We find that a progressive income tax of 5 percent of GDP would reduce long-run GDP by 3.4 percent, shrink American incomes (GNP) by 3.8 percent, and eliminate about 3.6 million jobs. We find that a flat labor tax of 5 percent of GDP would reduce long-run GDP and GNP by 2.2 percent and eliminate about 2.4 million jobs.

Some Tax Hikes Are More Damaging Than Others

Table 1. Long-Run Economic Effects of Stylized Options to Raise 5 Percent of GDP in Revenue 
  Flat Labor Tax of 5% of GDP Flat Income Tax of 5% of GDP Progressive Income Tax of 5% of GDP
Gross Domestic Product (GDP) -2.2% -2.8% -3.4%
Gross National Product (GNP) -2.2% -3.2% -3.8%
Capital Stock -2.4% -3.6% -4.5%
Full-Time Equivalent Jobs -2,425,000 -3,000,000 -3,550,000

Source: Tax Foundation General Equilibrium Model, March 2021.

Note: Tax Foundation results are not directly comparable to the CBO estimates (CBO uses an overlapping-generations model, while Tax Foundation uses a comparative statics approach using an individual income tax calculator).

For our results, a “flat labor tax” applies a payroll tax to labor income while not impacting investment income. A flat income tax imposes a flat surtax onto each tax bracket for ordinary income and long-term capital gains and dividends, while the progressive income tax applies proportionate increases to ordinary income tax rates and long-term capital gains and dividends rates.

Tax increases on labor reduce total hours worked by reducing the after-tax return to labor, while capital income taxes harm investment incentives. As the CBO states, “the less a tax distorts people’s decisions to work, save, and invest, the smaller the economic effects are per dollar of revenues raised. As any tax rate increases, the size of the resulting economic distortion grows.”

Raising taxes to increase revenue by 10 percent of GDP would have larger economic effects. According to Tax Foundation modeling, a progressive income tax is the most damaging option, reducing GDP by 6.5 percent, shrinking American incomes (GNP) by 7.3 percent, and eliminating about 6.7 million jobs. We find that a flat labor tax of 10 percent of GDP would reduce long-run GDP by 4.4 percent and GNP by 4.5 percent and eliminate about 5 million jobs.

Table 2. Long-Run Economic Effect of Stylized Options to Raise 10 Percent of GDP in Revenue 
  Flat Labor Tax of 10% of GDP Flat Income Tax of 10% of GDP Progressive Income Tax of 10% of GDP
Gross Domestic Product (GDP) -4.4% -5.4% -6.5%
Gross National Product (GNP) -4.5% -6.1% -7.3%
Capital Stock -4.9% -6.9% -8.6%
Full-Time Equivalent Jobs -5,000,000 -5,700,000 -6,725,000

Source: Tax Foundation General Equilibrium Model, March 2021.

Note: Tax Foundation results are not directly comparable to the CBO estimates (CBO uses an overlapping-generations model, while Tax Foundation uses a comparative statics approach using an individual income tax calculator).

For our results, a “flat labor tax” applies a payroll tax to labor income while not impacting investment income. A flat income tax imposes a flat surtax onto each tax bracket for ordinary income and long-term capital gains and dividends, while the progressive income tax applies proportionate increases to ordinary income tax rates and long-term capital gains and dividends rates.

Using the Tax Foundation’s model to simulate a higher corporate income tax indicates that this would be more damaging to economic growth than the three options above. For example, raising the corporate income tax to generate 5 percent of GDP in additional revenue would reduce long-run GDP by 11.3 percent.

The results from the CBO and Tax Foundation models show that, independent of spending, the type of tax used to finance the spending matters. Policymakers should consider how damaging a given tax increase would be for economic growth and American jobs, not just its impact to the Treasury. Selecting less damaging revenue sources and avoiding dramatic tax increases will contribute to a successful U.S. economic recovery over the coming year.

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A 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.

A 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 23.05 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue.

A progressive tax is one where the average tax burden increases with income. High-income families pay a disproportionate share of the tax burden, while low- and middle-income taxpayers shoulder a relatively small tax burden.

An 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. Individual income taxes are the largest source of tax revenue in the U.S.

A 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.