CBO & JCT Economic Models
The Congressional Budget Office and the Joint Committee on Taxation have recently published macroeconomic analyses (dynamic) of extending individual provisions of the TaxA Tax is a mandatory payment collected by local, State, and National governments from individuals and businesses to cover the cost of general government goods, services, and activities.
The analysis provides key insights into how their models work and the sort of outputs we can expect from their models as part of next year’s tax debate. The JCT found that permanently extending TCJA individual provisions could provide a measurable economic boost, similar to what we find from our modeling. In contrast, CBO finds the pro-growth aspects of extending the TCJA would be largely offset by increased deficits “crowding out” private investment.JCT’s Three Macro Models
JCT first describes the tax calculators used to generate revenue estimates and marginal tax rates, which feed into their macro models used to estimate economic and dynamic revenue impacts. For several years, JCT has maintained three macro models:
Macroeconomic Equilibrium Growth Model (MEG)
Overlapping Generations Model (OLG)
- Dynamic Stochastic General Equilibrium Model (DSGE)
- In 2018, JCT described some of the differences between the models but noted each uses a neoclassical framework to estimate output as a function of after-tax returns to capital and labor–a core feature of our model as well. JCT uses these models to “get a better idea of the range of possible modeling outcomes, as well as to explore the sensitivity of results to modeling frameworks and parameter assumptions.”
- In JCT’s recent release, they note a few of the improvements made to the models since 2017, including updating the MEG model’s monetary policy reaction, enhancing the OLG model’s household heterogeneity, and adding a partially open economy assumption in its DSGE model (allowing foreign investors to purchase new federal debt issuances).
JCT estimates that extending the TCJA individual provisions would reduce revenue by $3.4 trillion from 2025 to 2034, conventionally measured (without accounting for macroeconomic changes) against current law that allows the tax cuts to expire. Around two-thirds (or $3.4 trillion) of this tax reduction is due to extending current tax brackets and rates. We find very similar results; our total conventional revenue estimate for extending the TCJA individual provisions is within 1 percent of JCT’s.
Running this tax change through their macro models, JCT finds a range of impacts on GDP over the 2025-2034 budget window, from 0.2 percent in the case of the MEG model to 0.9 percent in the case of the DSGE model (the latter from 2030 to 2034). We find similar results in the middle of this range. Specifically, we estimate an initial GDP boost of 0.7 percent in 2026 that falls to 0.6 percent by the end of the budget window, which is driven by lower tax rates increasing labor supply offset over time by less capital formation mainly because of the cap on state and local tax deductions.
Current budget rules (which could be changed in the new Congress) require a point estimate of the macroeconomic effects of major tax legislation. This means JCT will need to average the results of their models together, potentially choosing to weight the models differently depending on “the specific strengths and weaknesses of each model concerning the proposal being analyzed.”
Weighting the results equally, JCT finds an average GDP gain of 0.5 percent over the budget window. This results in a dynamic feedback estimate of $372 Billion, reducing the cost to extend the TCJA individual provision to $3.0 Trillion over the budget window. This is within 1 percentage points of our dynamic revenue estimation. While JCT estimates economic growth reduces the cost of TCJA extension by 11 percent; we estimate economic growth reduces the cost by 12.5 percent.
CBO’s Crowd-Out Effect
CBO analyzed the same policy from the perspective of how it would impact CBO’s baseline economic forecast, noting it is JCT’s responsibility to officially score tax legislation. It is still interesting to see the differences in the model results. CBO finds extending the TCJA individual provisions would boost GDP by about 0.3 percent in the first few years, mainly by lowering marginal tax rates on labor and increasing aggregate demand, but this is offset by a crowd-out effect that grows to about a 0.4 percent reduction in GDP by 2034.
However, CBO’s published work in this area indicates studies come to differing conclusions about the size of crowd-out effects with many estimates pointing to small or negligible crowd-out effects particularly in the case of tax cuts.
In a working paper from 2014, CBO describes crowd-out effects as follows: “Increases in federal budget deficits affect the economy in the long run by reducing national saving (the total amount of saving by households, businesses, and governments) and hence the funds that are available for private investment in productive capital. CBO describes crowd-out effects in a working paper from 2014 as follows: “Increases in federal budget deficits affect the economy on the long term by reducing national saving (the total amount of savings by households, businesses, and governments) and therefore funds that are available for private investment in productive capital. . . . CBO, noting a “high degree of uncertainty,” offers a small estimate of 15 cents and a large estimate of 50 cents per dollar of deficit increase. However, noting a “high degree of uncertainty,” CBO offers a small estimate of 15 cents and a large estimate of 50 cents per dollar of deficit increase.
The studies CBO reviews find a wide range of effects, with about half the studies finding zero or small crowd-out effects particularly in the case of tax cuts, and the other half of studies finding more substantial crowd-out effects particularly in the case of spending increases.
Two of the studies cited by CBO find approximately zero crowd-out effects due to the combination of increases in private saving and net inflows of foreign capital.
Two other studies cited by CBO focus on private saving responses to tax and spending changes separately, finding small or zero crowd-out effects in the case of tax cuts but large crowd-out effects in the case of spending increases. One study found that private saving responses offset up to 97 percent (50 to 100 percent) of the crowd-out effects in the case for tax cuts. This was compared to 10 to 50% in the case for spending increases. Another study finds tax changes are “almost fully offset” by private saving responses, versus about one-third to one-half offset in the case of spending changes.
Evidently, CBO has not updated its estimates of crowd-out effects to account for more recent studies, including one that finds evidence of “crowd in” of private investment in the case of reduced capital income taxes or increased government investment.
CBO has used these estimates to analyze, for instance, the impact of increased federal investment, finding that if the spending is deficit-financed, the crowd-out effect is sufficiently large that by the end of the budget window, it can fully offset any positive effects on GDP. CBO also finds that federal borrowing has a negative impact on GNP (a measure that accounts for foreign ownership of assets) due to increased interest payments. This is because of the increase in interest payments made to foreign owners. Our research casts doubt on the assumption that a large crowding-out effect is present in tax policy changes. Instead, we find a strong theoretical basis and empirical evidence for differentiating the impacts of various types of tax and expenditure changes. Crowd-out effects are small to negligible when pro-growth income taxes are cut, as this increases private income directly and indirectly, by improving savings incentives. This is particularly true for business income tax cuts, which are more pro-growth in general than individual income tax cuts. In contrast, crowd-out effects should be large for spending increases that are not pro-growth, such as government consumption.
Additionally, crowd-out effects are generally diminished by the fact that the US is an open economy with deep financial markets connected to savers worldwide, and foreigners historically represent a large share of the worldwide demand for Treasury debt. Foreign demand for Treasury debt and other US assets, including shares in US businesses, increases for tax (or other) changes that are relatively pro-growth, potentially offsetting a large portion of the crowd-out effect for these changes.
Under an open economy, deficits would have a small impact on GDP. However, they would have a large impact on GNP due to increased interest payments to foreign owners of Treasury debt, similar to CBO’s results.
There are many reasons to be concerned about the federal government’s fiscal trajectory. It is unsustainable, and it must be addressed sooner rather than later. This evidence suggests that lawmakers should pursue pro-growth tax cuts next year offset by spending reforms, including reductions in what is effectively spending through the tax code via tax credits and other preferences. This evidence indicates lawmakers should pursue pro-growth tax cuts next year offset by spending reforms, including reductions in what is effectively spending through the tax code via tax credits and other preferences.
Stay informed on the tax policies impacting you.
Subscribe to get insights from our trusted experts delivered straight to your inbox.
Subscribe to our Newsletter
Share this article
