Comparing the Static and Dynamic Effects of Tax Reform on After-Tax Incomes

There are different ways of assessing the benefits of tax reform. The conventional approach is to simply calculate how much families will save in taxes. While this is certainly what taxpayers are most interested in, the sheer dollar amount of a tax cut doesn’t tell us much about the long-term effect a tax plan has on the economy and what impact, if any, the plan has on boosting real wages and living standards.

Measuring the long-term economic effects of changes in tax policy requires a tool such as the Tax Foundation’s Taxes and Growth (TAG) Macroeconomic Tax Model. The TAG model measures how changes in tax policy affect the incentives to work and to invest which, in turn, determines whether a tax plan will increase the amount of labor and capital in the economy. The more labor and capital in the economy, the larger GDP will be. If there is less labor and capital in the economy, GDP will shrink.

To illustrate this point, we used the TAG model to simulate the impact of a 1 percent across-the-board rate cut for individual taxpayers. Table 1 displays how this modest rate cut affects taxpayers’ after-tax incomes in static, or simple dollar terms. We can see that this tax cut provides barely $1 in relief for taxpayers earning under $12,521, $381 in relief for taxpayers in the middle, and $5,224 in relief for the highest earners.

However, because the rate cut will increase incentives for people to work a bit more and for pass-through businesses to invest a bit more, the model estimates that the tax change will boost the level of GDP by 0.5 percent and wages by 0.1 percent. After we account for these economic gains, we can see that the dynamic changes in after-tax incomes are many times that of the static estimate.

We can see similar results to an even larger degree with a comprehensive tax reform plan such as the GOP Better Way Blueprint drafted by Ways and Means Chairman Kevin Brady (R-TX). The plan combines tax cuts and tax simplification for individuals with a sweeping reform of business taxes.

As the Tax Foundation’s analysis of the Blueprint shows, the plan would boost the long-term level of GDP by 9.1 percent, capital investment by 28 percent, and after-tax incomes by an average of 8.7 percent.

Table 2 below shows the stark differences in the static and dynamic estimates of how the plan improves after-tax incomes. For low-income taxpayers, who pay very little in taxes to begin with, the benefits of the plan are very small in simple dollar terms, just $22. But, when we account for the plan’s impact on the economy and wages, their after-tax incomes will rise by more than $600, many times the static change.

Similarly, for a family earning roughly $55,000, the static change in their take-home pay is rather modest. However, when we account for the effects of the Better Way tax plan on productivity, wages, and economic growth, a family earning $55,000 will see their after-tax incomes rise by $4,672. It is important to note that this change in after-tax incomes marks a permanent change in this family’s standard of living.

Far too often, we see debates over tax policy get hyper-focused on comparing the raw dollar amount of tax relief that a plan delivers to taxpayers at different income levels. This sort of static, or accountants, view of tax policy misses the crucial aim of a well-crafted tax reform plan—raising real wages and living standards. Estimating these effects requires more sophisticated tools than a desk calculator, such as the Tax Foundation’s TAG Model, but value in judging the true benefits of a tax reform plan cannot be overstated.