Camp Tax Reform Proposal Would Result in Economic Growth, JCT Estimates

The following analysis uses both an overlapping generations lifecycle model and the Joint Committee staff's Macroeconomic Equilibrium Growth model to simulate the macroeconomic effects of the proposal. In general, the lower effective marginal tax rates resulting from the combination of lower statutory tax rates and changes to the definition of taxable income provide an incentive for increased labor effort, and under some modeling assumptions for some years, increased business investment. Relative to present law, the policy provides an incentive for increased consumer purchases of goods and services by increasing after-tax income of households. This effect can be important when the economy is operating below full capacity. The extent of both supply and demand effects depends on the sensitivity of individual labor choices to changing effective marginal rates, the responsiveness of individual savings choices to changes in the after-tax return on earnings from investment, and the responsiveness of businesses to changing incentives for overall investment and the location of investment and taxable profits in the United States. In addition, the projected impacts of the proposal on the economy depend on assumptions about the monetary policy response by the Federal Reserve Board. In general, under most modeling assumptions, the proposal is projected to increase overall economic activity as measured by changes in gross domestic product ("GDP") relative to the present law baseline over the 10-year budget period.

           Table 1. -- Statutory Individual Income Tax Rates

   Table 2. -- Changes in Miscellaneous Statutory Tax Rates Between

Both the individual and corporate income tax frameworks include many different deductions, credits, and other special treatment of certain types of income and expenses of businesses. This proposal repeals or modifies a number of them. Some of the larger changes include eliminating the modified accelerated cost recovery system ("MACRS") and lengthening depreciable lives for depreciation of property placed in service after December 31, 2015, and requiring amortization instead of expensing of research and experimental expenditures and certain advertising expenses beginning in 2015. The repeal of MACRS is accompanied by indexing of depreciable basis to chained CPI-U. The proposal also repeals the 20-percent tax on minimum alternative taxable income of corporations.

Present law includes rules (commonly referred to as subpart F) to tax certain items of passive or mobile foreign subsidiary income when that income is earned rather than when it is repatriated. The proposal substantially modifies the subpart F rules, chiefly by providing broad taxation of all intangible income of foreign subsidiaries when the income is earned, with intangible income from serving foreign markets taxed at a reduced rate of 15 percent once the proposal is fully phased in. The proposal provides the same reduced rate of tax on foreign intangible income of U.S. parent companies. The proposal includes a one-time transition tax, subject to a foreign tax credit, on all previously untaxed foreign earnings and profits of foreign subsidiaries of U.S. corporations. The proposal also includes thin capitalization rules that restrict the deduction for interest expense of U.S. parent companies when, among other requirements, the U.S. members of the worldwide group are more heavily leveraged than the overall group. The net effect of the proposed changes to taxation of U.S. multinational corporations is to increase their U.S. income tax liability.

In the MEG model, monetary policy conducted by the Federal Reserve Board is explicitly modeled, with lagged price adjustments allowing for the economy to be temporarily out of equilibrium in response to fiscal and monetary policy changes. Labor supply decisions are modeled separately for four groups: low income primary earners, low income secondary earners, other primary earners, and other secondary earners. Firms make investment decisions based on an expected after-tax rate of return. Individuals in the MEG model do not anticipate future changes in the economy or government finances; thus, this type of model is often referred to as a "myopic" behavior model. This feature of the MEG model allows the simulation of tax and government expenditure policy that may result in an unsustainable growth path. Specifically, policies that result in the Federal debt increasing or decreasing at a faster rate than the growth of GDP can be modeled.

In the OLG model, individuals are assumed to make consumption and labor supply decisions in order to maximize their lifetime well-being given the resources they can foresee will be available to them. They are assumed to have complete information, or "perfect foresight," about economic conditions, such as wages, prices, interest rates, tax rates, and government spending, over their lifetimes. Economic decisions are modeled separately for each of 55 adult-age cohorts. Firms' investment decisions respond to the effects of tax policy on the expected future value of the firm. Changes in marginal tax rates on firm profits, and changes in the value of deductions for investment affect this future valuation. The version of OLG used in this analysis includes a separate multinational corporation ("MNC") sector that uses both capital and intellectual property in the production of goods and services.

We analyze the proposal using varying assumptions about several types of taxpayer and Federal Reserve Board response to the proposed tax changes. We rely on information from various JCT tax models⁵ used in the production of conventional revenue estimates to obtain information about the effects of the proposal on individual and business average and effective marginal tax rates, and on after-tax returns to capital and labor to characterize the tax proposal within the MEG and OLG models. Changes in both statutory tax rates and the definition of taxable income can impact effective marginal tax rates as well as average tax rates.

The MEG model is used to examine the importance of different assumptions about Federal Reserve policy. Under the "Aggressive Fed" policy, it is assumed that the Federal Reserve Board would work to counteract any demand incentives resulting from fiscal policy. For this proposal, since the policy results in a net decrease in income tax paid by individuals, providing them with more take home income for consumption purposes, the aggressive Fed simulation would include an immediate increase in interest rates to counteract these demand effects. The "Neutral Fed" simulations assume that the Federal Reserve Board targets a fixed monetary growth rate, and does not try to counteract fiscal policy.

The MEG model is also used to present results using differing assumptions about the responsiveness of labor to changes in effective marginal tax rates and average taxes for each proposal. The "High Labor Elasticity" simulations use labor supply responsiveness parameters that are consistent with the upper range of measured response levels from empirical studies. The "Low Labor Elasticity" simulations reduce the responsiveness to changes in effective marginal tax rates by 50 percent.

Both the MEG and OLG models are used to explore the impact of varying assumptions about the responsiveness of capital investment and international capital flows to tax policy changes. In the MEG model, there is no explicit distinction between domestic and multinational corporations. International capital flows respond to changes in the after-tax rate of return on capital between the United States and the rest of the world, as well as to changes in the relative attractiveness of imports and exports. In contrast, the OLG model has several different types of businesses, including a multinational corporate ("MNC") sector with foreign subsidiaries. The addition of foreign subsidiaries presents the MNC with the ability to optimize over both the location of investments (both highly mobile intellectual property ("IP") and capital), as well as some ability to shift profits from the U.S. parent to low tax subsidiaries. The ability of MNC to shift profits from the United States to low tax jurisdictions is meant to capture the many ways that firms can shift their profit overseas, including transfer pricing, debt leveraging, interest stripping, and hybrid instruments. The OLG model treats all of these different types of profit shifting strategies the same and limits the amount of shifting to the extra-normal returns to IP.⁶

This analysis presents two OLG simulations that vary the degree of responsiveness of this MNC sector to changes in tax policy. In particular, we vary the responsiveness of MNCs to shifting intellectual property and profits. The "default IP elasticities" simulation reflects the calibration of the model to hit estimates for cross-border capital movements under present law, with the relatively mobile intellectual property estimated to be roughly 8.5 times more responsive than capital. Profit shifting is calibrated to be about 20 percent of the corporate tax base in 2013, consistent with the middle point of estimates of this shifting under present law. We present an additional simulation ("reduced IP elasticities") in which the IP responsiveness is assumed to be the same as that of capital, and the profit shifting elasticity is reduced by about one third.

One important difference between the MEG and OLG models is in their treatment of Federal fiscal policy. In the MEG model, it is possible to simulate structural Federal budget deficits as forecast in the CBO baseline and to allow for increases or decreases in the deficit in simulating proposals. In contrast, the OLG model cannot simulate either the present law fiscal baseline or policy proposals that incorporate unsustainable Federal budget deficits or surpluses. The MEG model assumes individuals cannot foresee future unsustainable Federal budget conditions, while the OLG model assumes that individuals have perfect foresight about the economy, including unsustainable Federal budget conditions. Thus, in the OLG model there is no equilibrium solution when Federal budget conditions appear unsustainable in the long run. It is necessary to create counterfactual stable ratios of debt to GDP within both the baseline and policy simulations of the OLG model.

Because both present-law fiscal conditions and the path of the budget deficit are necessarily modeled differently within the OLG and MEG models, it is difficult to compare the results between the two models directly, as they are essentially modeling different types of economies. Because the MEG model simulates the effects of the actual proposed law, its results are of interest. Because the MEG model assumes people are unable to foresee the probable effects of the proposed law change, while the OLG model assumes that people can foresee these effects, the OLG model provides a useful alternative perspective on the economy.

The OLG simulations presented here include an assumption in the base (present law) simulation that average tax rates are higher and transfer payments are lower than they actually are. To the extent that the policy simulation changes the path of debt growth, it is necessary to include a fiscal policy reaction function so that the debt to GDP ratio does not change significantly in the policy simulation. The specific changes in tax and spending that are used to provide fiscal balance can affect results. Because this proposal results in increased economic growth and decreasing deficits, the fiscal balance reaction to the policy requires either an increase in government outlays or a decrease in taxes. These simulations adjust transfer payments, thereby allowing us to analyze the specific tax policy in the proposal.

Following is a series of tables that show the effects of this proposal on real (inflation adjusted) gross domestic product, business capital stock, employment, and consumption. Results from each policy simulation for each variable are presented as percentage changes from the present-law baseline forecast values for the variables in each of Tables 3-7 below. The Joint Committee staff configures the present-law baseline forecasts for Federal government receipts and spending in the MEG model to approximate the February 2013 forecast of the CBO⁷ as closely as possible.

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The level of economic activity also responds to changes in the after-tax income of individuals under certain assumptions about the current state of the baseline economy and Federal Reserve policy. During periods when the economy is operating below its full employment capacity -- when not all available labor or capital is employed -- increases in after-tax income increase demand for goods and services, leading to more economic growth.

This proposal reduces the overall effective marginal tax rate on labor, providing an incentive for people to work, supplying more labor to the economy. The importance of this effect depends on how responsive labor is to these changes. The proposal also increases the after-tax income of individuals by reducing individual tax rates overall, thus increasing demand for goods and services. Because the economy is currently operating below full employment levels, this increased demand can be expected to lead to an increase in economic output, to the extent that Federal Reserve policy does not take action to counteract this effect.

The proposal reduces effective marginal tax rates on interest and rental income and business profits of corporations and pass-through entities relative to present law, which increases the after-tax return to capital. But it also reduces a number of credits and deductions, the largest of which are inventory and depreciation deductions, which reduces the after-tax return to capital relative to present law. On net, the after-tax return to business capital is reduced relative to present law by these changes overall.

The proposal is projected to result in increases in economic activity relative to that projected under present law, as measured by changes in real GDP. The increase in projected economic activity is projected to increase revenues relative to the conventional revenue estimate by $50 to $700 billion, depending on which modeling assumptions are used, over the 10-year budget period.

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

In the standard MEG model simulations, the larger growth effects occur in simulations that assume more labor response to reductions in effective marginal tax rates, and in which the Federal Reserve Board is assumed not to moderate increases in demand arising from higher after-tax income.

An additional modeling assumption affecting the projected effects of this proposal is the extent to which changes in the taxation of foreign income and income from intellectual property are expected to provide an incentive for more investment and profit reporting within the United States. The MEG model is not designed to model specifically the difference between IP and capital or the effects of shifting of reported profits between countries to take advantage of differences in relative tax rates. The conventional revenue estimate accounts for the effects of the latter behavior on revenues, but not on economic activity. In the OLG model, the ability to shift profits to minimize tax liability without shifting economic activity results in increased economic activity within the United States. To approximate the separate modeling of these effects using the MEG model, we assume that the various tax increasing portions of the changes on taxation of multinational corporations and intellectual property do not affect their investment incentives, as shown in the "MEG, reduced investment response to taxation of multinationals" simulations. In these simulations, anticipated GDP growth is higher than in the base MEG simulations.

Table 4 shows the expected change in business capital relative to what was projected to occur under the present law baseline, but does not indicate a reduction in capital stock over time. In other words, the negative numbers in these tables result from a projected slower rate of growth in capital due to the proposal. Investment in capital is generally projected to increase slightly relative to present law in the first half of the budget period, and decrease relative to present law in the second half. The repeal of accelerated depreciation does not occur until 2016, thus delaying the negative influence of this provision, at the same time that reduced tax rates on income from capital are providing an incentive for increased investment. Over time, the cumulative effects of the repeal of MACRS and amortization of intellectual property begin to outweigh the positive incentives from reduced rates in standard MEG simulations.

As mentioned above, a crucial modeling assumption for analyzing this proposal is predicting the extent to which the changes in the taxation of foreign capital will provide an incentive for both U.S. multinational and foreign corporations to shift investment and profits to the United States. Because the proposal treats domestic investment in intellectual property less favorably and earnings on some foreign income more favorably than under present law, in the simulations with reduced sensitivity of the location of intellectual property to changes in taxation, the effects of reducing responsiveness to incentives for foreign-based capital investment, particularly in intellectual property, are shown to reverse or dampen (depending on the degree of responsiveness assumed) the negative effects on capital stock generated by the increased cost of domestic capital.

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

  Table 5. -- Percent Change in Labor Force Participation Relative to

  Table 6. -- Percent Change in Private Sector Employment Relative to

   Table 7. -- Percent Change in Consumption Relative to Present Law

         Table A.1-Key Parameter Assumptions in the MEG Model

² Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2013-2023, February 5, 2013.

³ A detailed description of the MEG model and its behavioral parameters may be found in: Joint Committee on Taxation, Macroeconomic Analysis of Various Proposals to Provide $500 Billion in Tax Relief, (JCX-4-05), March 1, 2005, and Joint Committee on Taxation, Overview of the Work of the Staff of the Joint Committee on Taxation to Model the Macroeconomic Effects of Proposed Tax Legislation to Comply with House Rule XIII.3(h)(2), (JCX-105-03), December 22, 2003.

⁴ The OLG model used in this analysis was leased from Tax Policy Advisers. Information about this model may be found in John W. Diamond and George R. Zodrow, Description of the Tax Policy Advisers Model, unpublished document, 2013.

⁵ Descriptions of the JCT conventional estimating models may be found in JCX-46-11, Testimony of the Staff of the Joint Committee on Taxation before the House Committee on Ways and Means Regarding Economic Modeling, September 21, 2011 and other documents at www.jct.gov under "Estimating Methodology."

⁶ The MNC modeling follows the work in M.P. Devereux and R. de Mooij in "An applied analysis of ACE and CBIT reforms in the EU," International Tax and Public Finance, 18(1), 2011, 93-120 and M.P. Devereux, L. Bettendorf, A. van der Horst, S. Loretz. And R. de Mooij, "Corporate tax harmonization in the EU," Economic Policy, 63, 2010, 537-590.

⁷ Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2013-2023, February 5, 2013.