The Macro Effects of Camp’s Tax Reform

William G. Gale and
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

Donald Marron
Donald Marron Urban Institute

March 5, 2014

When House Ways & Means Chairman Dave Camp rolled out his tax reform last week, the Joint Committee on Taxation (JCT) evaluated its macroeconomic impacts. Using two different models, the nonpartisan JCT found the plan would boost gross domestic product between 0.1 percent and 1.6 percent over the next ten years, which would increase federal revenue by between $50 billion and $700 billion.

That’s an important finding, particularly since JCT’s official estimate, ignoring macroeconomic effects, is that the plan would raise roughly the same amount of money as the current tax code (about $40 trillion over the next decade). But the analysis also raises big questions: How would Camp’s plan increase growth, and why is the range of estimates so wide?

To start, remember that tax changes can affect both the demand and supply sides of the economy. On the demand side, lower taxes put more money in people’s pockets and thus encourage higher spending in the short run. You might not expect this to be much of a factor for Camp’s proposal, since it is revenue-neutral over the next ten years. But JCT believes that the combination of tax changes—tax cuts for households, tax increases for businesses—will, on net, boost demand.

On the supply side, lower tax rates raise the net return to working, saving, investing, and risk-taking and thus encourage people to do more of them. However, lower taxes also mean people can achieve the same standard of living by working or saving less—what economists call an “income effect.” The net effect of tax rate reductions can thus go either way. But Camp’s plan eliminates tax breaks to pay for lower tax rates. Eliminating deductions and credits may improve the allocation of resources throughout the economy. It also works to offset the income effect from the tax rate cuts. On the other hand, a variety of phase-outs and bubbles raise effective marginal rates at some income levels. On net, the combination of all of these factors is estimated to encourage more economic activity.

Four other aspects of the analysis are particularly noteworthy.

First, JCT illustrates how hard it is to model the link between taxes and the economy. Indeed, it offers eight different estimates, reflecting various assumptions about the sensitivity of labor to tax rates, the international mobility of physical capital, the international mobility of intellectual property (a topic on which there is relatively little evidence), the degree of foresight by economic actors, and the potential response of the Federal Reserve. That explains its wide range of GDP growth estimates, from 0.1 percent to 1.6 percent over 2014-2023, and a similar range in employment gains, from 0.4 percent to 1.5 percent.

Second, JCT concludes the plan would boost employment while slightly reducing private business investment. That happens because the proposal would reduce the effective tax rate on labor, but increase it on capital, something of a surprise for a Republican tax reform. That likely reflects the tradeoffs necessary to reduce individual and corporate tax rates while maintaining roughly the same revenue levels and distributional effects of the current system. One implication, not discussed by JCT, is that workers would have slightly less capital to work with, on average. That would make them less productive, reducing pre-tax wages slightly, even as the tax reductions increase them after-tax.

Third, JCT appears to conclude that the Federal Reserve’s response to the tax reform could affect growth as far in the future as 2019-2023. This is a puzzling result to us since Camp’s reform is roughly revenue- and distributionally-neutral, so there should be little if any persistent change in aggregate demand and, if there were, the Fed would have ample time to respond before then. Most projections have the economy at or very near full employment by 2019. It is hard to understand how the Federal Reserve can (positively) affect growth rates for sustained periods in that situation.

Fourth, like almost all dynamic analyses, the JCT analysis assumes that other nations do not respond by cutting their own corporate tax rates or otherwise making changes to attract investment capital. If some nations do respond, as they did after enactment of the Tax Reform Act of 1986, that would likely reduce the potential benefits of the plan.

The JCT report is an important contribution. It demonstrates both the insights that macro dynamic analysis can provide and its uncertainties and limitations. Overall, the estimates strengthen the case that a base-broadening, rate-reducing, distributionally- and revenue-neutral tax reform can increase the size of our economy. Still, it is worth noting that the previous reform most like Camp’s proposal was the Tax Reform Act of 1986, which appears to have done little to stimulate growth (Auerbach and Slemrod 1997).

The above was originally published on the Tax Policy Center’s Tax Vox blog.