Order Code RL32502
CRS Report for Congress
Received through the CRS Web
What Effects Have the Recent Tax Cuts Had on
the Economy?
July 30, 2004
Marc Labonte
Analyst in Macroeconomics
Government & Finance Division
Congressional Research Service ˜ The Library of Congress

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What Effects Have the Recent Tax Cuts Had on the
Economy?
Summary
Congress enacted major tax cuts in 2001, 2002, and 2003. The acts reduced
marginal income tax rates; reduced taxes on married couples, dividends, capital
gains, and on estates and gifts; increased the child tax credit; and accelerated
depreciation for business investment. The tax cuts resulted in an estimated revenue
loss of 0.4% of GDP in 2001, 1.1% in 2002, and 1.6% in 2003. Most of the tax cuts
are scheduled to expire after 10 years, but proponents intended that they be
permanent. Since government spending rose as taxes were cut, the cuts can be
characterized as deficit financed.
It is hard to be certain what effects the tax cuts have had on the economy
because there is no way to compare actual events to the counterfactual case where the
tax cuts were not enacted. The most common method of estimating a tax cut’s effect
is to feed it into a macroeconomic model of the economy and see what the model
predicts. Note that this is typically done before the fact: economic estimates of the
tax cut’s effect are not based on actual ex post data. These estimates are highly
uncertain since there is no one macroeconomic model that adequately captures all of
the economy’s dynamics, no consensus among macroeconomists as to which one
model is most suitable for policy simulations, and no model with a strong track
record in accurately projecting economic events.
Most estimates predict that the tax cuts will increase economic growth in the
short term and reduce it in the long run. For example, the Joint Committee on
Taxation predicts that the 2003 tax cut will increase GDP by an average of 0.2 to
0.5% in the first five years and decrease it by -0.1 to -0.2% over the next five years.
Keynesian models find the largest positive short-term effect of the tax cuts on the
economy. But these effects are completely temporary because they focus on how tax
cuts boost aggregate spending; in the long run, prices adjust, and production rather
than spending determines the level of output. In neo-classical (Solow) growth
models, deficit-financed tax cuts reduce national saving, thereby reducing national
income because capital investment can only be financed through national saving or
foreign borrowing. If the latter occurs, the result will be an increased trade deficit.
In intertemporal models, a deficit-financed tax cut is unsustainable: it must be offset
in the future by a tax increase or spending cut to prevent the national debt from
growing indefinitely. Thus, in these models tax cuts followed by tax increases lead
individuals to shift work and saving into the low-tax period, increasing growth, and
out of the high-tax period, reducing growth.
The period encompassing the tax cuts featured a recession of average duration
but below-average depth, an initially sluggish recovery, a deep and unusually long
decline in employment, a small decline in hours worked, a sharp and long lasting
contraction in investment spending, a significant decline in national saving, and an
unusually large trade deficit. Opponents see this as evidence that the tax cuts were
ineffective; proponents argue that the economy would have performed worse in their
absence. One should also consider that some, perhaps most, of the recovery was due
to monetary rather than fiscal stimulus. (This report will not be updated.)

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Contents
A Brief Description of the Tax Cuts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Pitfalls in Estimating the Economic Effects of Tax Cuts . . . . . . . . . . . . . . . . . . . 4
A Tax Cut’s Predicted Effects Depend on the Model Used . . . . . . . . . . . . . . . . . 6
Demand Side Effects of a Tax Cut in a Keynesian Model . . . . . . . . . . . . . . 6
Economic Growth and Employment . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
“Bang for The Buck” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
How Much Stimulus Was Attributable to Monetary Policy? . . . . . . . 11
Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Consumption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Effects of a Tax Cut in Long-Term Growth Models . . . . . . . . . . . . . . . . . . 14
Neoclassical Solow Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Saving and Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
The Trade Deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Supply Side Effects of a Tax Cut on Labor and Saving . . . . . . . . . . . . . . . 17
Intertemporal Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Overview of Simulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Simulations of EGTRRA’s Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Macroeconomic Advisers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
DRI-WEFA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Auerbach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Gale and Potter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Economic Effects of the 2001 Rebate . . . . . . . . . . . . . . . . . . . . . . . . . 24
Simulations of JGTRRA’s Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
JCT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
CBO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Macroeconomic Advisers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Global Insight . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
List of Figures
Figure 1: Consumption and Investment Growth, 2000-2002 . . . . . . . . . . . . . . . 13
List of Tables
Table 1: Estimated Revenue Loss from the Tax Cuts . . . . . . . . . . . . . . . . . . . . . . 2
Table 2: Average Marginal Tax Rates Under EGTRRA/JGTRRA in 2011 . . . . . 3
Table 3: GDP Growth in Historical Recessions . . . . . . . . . . . . . . . . . . . . . . . . . . 8

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Table 4: Decline in Employment during the Post-War Recessions and
Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Table 5: Lowest Federal Funds Rate in Each Recessionary Episode,
1958-2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Table 6: Budget Deficits, Trade Deficits, Saving, and Investment . . . . . . . . . . . 16
Table 7: Labor Supply and Saving Indicators, 2000-2003 . . . . . . . . . . . . . . . . . . 19

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What Effects Have the Recent Tax Cuts
Had on the Economy?
Proponents of the tax cuts passed in 2001, 2002, and 2003 stressed their
purportedly salutary effects on the economy. Particular emphasis was placed on
economic stimulus in the short term. Now that some time has elapsed since the tax
cuts were implemented, some Members of Congress has expressed interest in looking
back to see what effects the tax cuts have had on economic activity.
This report will trace out the channels through which the tax cuts are thought
to affect the economy, and assess the performance of those economic indicators,
including gross domestic product (GDP), employment, interest rates, inflation, labor
supply, saving, capital investment, and the trade deficit. The report uses data to
evaluate the tax cuts’ effects to date, and uses theory to predict their future effects.
The report will also offer an overview of the forecasts of their effects made at the
time the tax cuts were passed. Most estimates predicted that the tax cuts would
increase economic growth in the short term and reduce it in the long run. Despite the
wide diversity of the models used, all of the results are relatively small, as would be
expected of tax cuts that are relatively small in relation to GDP in the years
considered.
A Brief Description of the Tax Cuts
Three tax cuts have been signed into law in recent years. This report will focus
on provisions of those bills that caused significant revenue loss from 2001 to 2004.
In 2001, the Economic Growth and Tax Relief Reconciliation Act was signed into
law (EGTRRA, P.L. 107-16). Its major provisions for 2001-2004 were a reduction
in marginal income tax rates, an increase in the child tax credit, “marriage penalty”
tax relief, and elimination of the estate tax. All of these provisions were phased in
gradually over several years, and then scheduled to expire due to budget rules
(although it was the framers’ stated intent that they become permanent).1 In 2002,
the Job Creation and Worker Assistance Act (JCWAA, P.L. 107-147) was signed
into law. Its major revenue-side provision was accelerated depreciation for business
investment. In 2003, the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA,
P.L. 108-27) was signed into law. It accelerated the phase in of the main EGTRRA
provisions, with the exception of the estate tax provisions, and extended and
expanded the accelerated depreciation in JCWAA. It also reduced the tax rates on
dividend and capital gains income.
1Proposals to make part or all of EGTRRA/JGTRRA permanent can be found in the
Administration’s budget proposal for FY2005 and several dozen Congressional bills.

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CRS-2
Table 1 gives the estimated revenue loss of the tax cuts and their key provisions
as scored by the Joint Committee on Taxation at the time the tax cuts were enacted.
Estimates of the cost of the tax cuts based on ex post data do not exist.2 EGTRRA
was the largest of the tax cuts and most of EGTRRA’s costs are to occur in the out
years. Most of the costs of JGTRRA and JCWAA occurred in the short term. In
fact, since accelerated depreciation is a revenue loser in the short term and revenue
raiser in the medium term, the 10-year cost of JCWAA is smaller than the short-term
cost. In the long run, it was by far the smallest of the three, but of comparable size
in the time period considered here. JGTRRA’s costs are mainly short term because
it mostly accelerates tax cuts that would have occurred later under EGTRRA. All of
the tax cuts are temporary and scheduled to expire, although it was the intention of
their supporters that EGTRRA/JGTRRA be permanent.
Table 1: Estimated Revenue Loss from the Tax Cuts
(billions of dollars)
10 Year
2001
2002
2003
2004
Total
Tax Acts:
EGTRRA, 2001
40
71
91
102
1,349
JCWAA, 2002
-
42
39
29
30
JGTRRA, 2003
-
-
50
135
320
Provisions :
(cumulative totals for all tax acts)
Marginal Rate
40
55
61
69
875
Reductions
Child Tax Credit
1
9
24
17
204
Marriage Penalty Relief
0
0
6
26
98
Estate and Gift Tax
0
0
7
6
138
Reductions
Dividend and Capital
-
-
4
17
148
Gains Tax Reduction
Accelerated
-
35
44
65
26
Depreciation
Source: Joint Committee on Taxation
Notes: Estimates do not include outlay provisions or cost of additional debt service. Table omits
effects of date shifting on yearly revenue loss. Cumulative costs for JCWAA and accelerated
depreciation provisions are lower than the years shown because of revenue offsets in outyears.
2Actual tax receipts fell significantly more than predicted by the ex ante scores, even after
controlling for economic conditions. This suggests that the tax cuts may have resulted in
more revenue loss than predicted. See CRS Report RS21786, The Federal Budget Deficit:
A Discussion of Recent Trends, by Gregg Esenwein, Marc Labonte, and Philip Winters.

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CRS-3
Consistent with the goal of short-term stimulus, this report will focus on the
effects of the tax cuts to date. Certain provisions that are large in the long run are
small to date and will not be explored, most notably the repeal of the estate tax.
Other provisions, such as accelerated depreciation, were large in the short run, but
not in the long run. While the costs of the tax cuts are large as a fraction of total
receipts, particularly in the out years, the costs as a percentage of gross domestic
product (GDP) in the years of interest are small. The small size of the tax cuts places
a low ceiling on their potential economic effects. This is especially the case when
evaluating demand-side effects, where their incremental increase from year to year,
rather than their absolute value, is the relevant figure. In 2001, the tax cuts (revenue
provisions only) were equal to 0.4% of GDP, all of which occurred in the second half
of the year. In 2002, they increased 0.7 percentage points to 1.1% of GDP. In 2003,
they increased 0.5 percentage points to 1.6% of GDP. In 2004, they increased 0.7
percentage points to a projected 2.3% of GDP.
As discussed below, when considering the effects of tax cuts on labor supply
and saving, the key measure is marginal tax rates. As seen in Table 2, the change in
average marginal tax rates under EGTRRA and JGTRRA is modest for wages and
interest income when fully phased in; however, EGTRRA/JGTRRA leads to a larger
decline in marginal rates on capital gains income and a more than 50% decline in
marginal rates on dividend income.
Table 2: Average Marginal Tax Rates Under
EGTRRA/JGTRRA in 2011
(percent)
Dividend
Capital Gains
Wage Income
Interest Income
Income
Income
Prior Law
26.0
25.3
28.8
19.9
EGTRRA/
24.4
23.2
13.2
15.5
JGTRRA
Source: CRS calculations based on data from Office of Tax Analysis and Joint Committee on
Taxation.
Notes: Marginal tax rates under EGTRRA/JGTRRA vary by year as various provisions are phased
in and out. The table shows marginal tax rates in 2011 when the tax cuts are fully phased in. Marginal
tax rates include only the individual income tax system; they do not include marginal rates on, for
example, wages from the payroll tax system or the corporate tax system. Marginal rates on capital
income do not apply to capital income held in tax preferred accounts.
Since government spending rose as a percentage of GDP in the years when taxes
were cut, these tax cuts can be characterized as wholly deficit-financed tax cuts
(financed by increasing the deficit or decreasing the surplus). This is important to
note since deficit-financed tax cuts have a different economic effect than tax cuts
financed by reducing spending or raising other taxes in the models described below.

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CRS-4
Pitfalls in Estimating the Economic Effects
of Tax Cuts
It may be surprising to learn that there is no straightforward way to evaluate
how a tax cut has affected the economy. Economists can observe how the economy
performed after a tax cut, but because they cannot observe the counterfactual — how
the economy would have performed in the absence of a tax cut — there is no direct
way to tell what contribution the tax cut made to the economy’s performance. If the
economy boomed after a tax cut, there is no way of telling whether the economy
would have boomed even if the tax cut had not been passed. If the economy grew
sluggishly after a tax cut, there is no way of telling whether the economy would have
grown even more slowly without a tax cut.
Econometric research is based on observing variation between data observations
to determine correlation between variables. For studies of individual behavior,
variations in the tax cut that individuals receive can be used to establish correlation.
If recipients of a tax cut systematically behave differently than non-recipients, all else
equal, it can be deduced that the tax cut caused that behavior. Unfortunately, in the
case of tax cuts, variation between individuals is not independent of other control
variables needed to hold all else equal. The size and eligibility of a tax cut is based
on criteria that may strongly influence an individual’s behavior. For example, the
size of the marginal tax rate reduction received under EGTRRA is determined by
factors such as income. Yet if the experience of individuals in one income cohort is
systematically different than in a different cohort, a tax cut could be erroneously
attributed as the cause when some other factor was the cause. For example, income
inequality has been growing in the United States in recent decades because the
income of upper-income cohorts has been rising more quickly than lower-income
cohorts. Since EGTRRA gave larger tax cuts to upper-income cohorts on average,3
the portion of faster income growth caused by growing inequality, unless properly
controlled for, would be spuriously attributed to the larger tax cut.4
For economy-wide studies, the variation studied is typically over time rather
than across individuals. In the case of a tax cut, this would entail comparing how the
economy performed in periods with the tax cut compared to periods without the tax
cut. But because other factors are also changing over time, different control variables
are not independent, and causation runs in both directions, it is very difficult to
isolate the effect of tax cuts. For example, consider a tax cut implemented to
stimulate the economy in response to a downturn. Comparing economic activity
before and during the tax cut, simple correlation could lead to the conclusion that tax
cuts cause recessions since the timing of the tax cut is associated with a decline in
3Distributional analysis for all recent tax cuts have been estimated by the Tax Policy Center,
[http://www.taxpolicycenter.org/TaxModel/tmdb/TMTemplate.cfm]. Distributional analysis
for some tax cuts are also available online from the U.S. Treasury’s website at
[http://www.treas.gov/press/taxes.html].
4Austan Goolsbee, “It’s Not About the Money,” in Joel Slemrod, ed., Does Atlas Shrug?
The Economic Consequences of Taxing the Rich, (Cambridge, MA: Harvard University
Press, 2000), p. 143.

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CRS-5
growth. Some other factor is necessary to control for this “endogeneity” problem.
Some econometric methods can overcome the endogeneity problem, but greatly limit
the number of control variables that can be employed because of insufficient “degrees
of freedom.” Some time series analysis has been criticized for assuming that
individuals do not change their reactions in response to changes in the behavior of
policymakers (known as the “Lucas critique”). And since there have been relatively
few major tax cuts or increases in recent history, there are relatively few observations
to consider.5
In this situation, economists typically predict a tax cut’s economic effects by
building econometric forecasting models, calibrating the models to match actual
economic data, and then running the model with and without a tax cut. The
difference between the two outcomes is said to be the tax cut’s economic effects.
Notice that this approach does not rely on actual, after the fact data to determine the
tax cuts’ effects. These simulations are typically run before the tax cut is
implemented, and it is rare for the modeler to go back after the fact and test the
accuracy of the prediction. As will be seen in the section below, none of the
predictions made for EGTRRA and JGTRRA were based on actual ex-post data.
(Using ex-post data would improve the accuracy of the results, but not avoid all of
the problems discussed above.)
This method of estimating a tax cut’s effects would be less problematic if there
were widespread consensus that one particular econometric model could accurately
predict economic activity. In fact, econometric models are sometimes poor
predictors of economic activity, even over short periods of time. While some models
have proven capable of making reasonably accurate short-term projections during
expansions, no model has proven able to correctly predict turning points in the
business cycle on a regular basis. For example, every month the company Blue Chip
surveys 50 private forecasters. Not one of the 50 forecasters predicted the 2001
recession until April 2001 — a month after the recession had started. There is little
consensus over the correct approach in theory to modeling macroeconomic activity,
so there are many competing models that radically differ in basic and fundamental
ways. The Congressional Budget Office (CBO) and Joint Committee on Taxation
(JCT) have responded to this problem by using several different models to offer a
range of predictions of a proposal’s effects. As we will see below, these models
predict that tax cuts will have widely different — sometimes contradictory —
economic outcomes. Given these circumstances, it is difficult to argue that model-
based predictions offer a reliable proxy for the tax cuts’ actual effects.
5An endogenous variable is one that simultaneously affects other variables and is affected
by those variables. Degrees of freedom are calculated as the number of observations minus
the number of explanatory variables. It must be positive for statistical inference. Higher
degrees of freedom lead to more robust analysis.

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CRS-6
A Tax Cut’s Predicted Effects Depend on
the Model Used
As discussed above, there is no consensus as to which type of macroeconomic
model best describes reality. Each model captures certain aspects of economic
behavior well, but no model adequately synthesizes all the different aspects at once.
Since economists differ on which aspects of economic behavior are most important,
they differ on which model is preferable for evaluating policy. No model described
below is right or wrong; each has unique strengths and weaknesses.6 But the
predicted effects of a tax cut will be highly sensitive to the assumptions of the model
used to evaluate it. Because the models are not integrated, a major problem with the
estimates is that if there are effects caused by properties that the model being used
neglects, the effects will be incorrectly attributed to other properties that are included
in the model being used. For example, if a tax cut boosted aggregate demand, a
supply side model would attribute the rise in output to an increase in labor or saving,
even though the increase would not necessarily be induced by incentives, would not
necessarily be permanent, nor would it necessarily be replicable at a different point
in the business cycle.
Demand Side Effects of a Tax Cut in a Keynesian Model
Keynesian models focus on aggregate demand, or the spending side of the
economy, rather than the aggregate supply, or the production side of the economy.
Since recessions are typically thought to be shortfalls in aggregate spending relative
to potential supply (production if all of the economy’s labor and capital resources
were fully employed), Keynesian models are popular for short-term policymaking
and forecasting purposes. Professional forecasters, including CBO, Office of
Management and Budget (OMB), the Federal Reserve, Global Insight, and
Macroeconomic Advisers, use models with Keynesian attributes in the short run to
predict economic activity. However, the richness of the models’ development of the
demand side of the economy comes at the expense of their ability to explain the
supply side. This makes these models of more limited usefulness for explaining and
prescribing policies when the economy is fully employed. Since aggregate demand
can fall below aggregate supply only in the short run, before prices adjust, Keynesian
models are also of limited usefulness in explaining the long run.
Economic Growth and Employment. Using fiscal policy to boost
aggregate spending is often popularly referred to as “stimulating the economy,” and
evaluating a “stimulus package” is best done by looking at its effects on aggregate
spending using a Keynesian model. In these models, the government can boost
spending in the economy by increasing the budget deficit. If the deficit is the result
of increased government spending, aggregate spending is boosted directly since
government spending is a component of aggregate demand. Since the deficit is
financed by borrowing from the public, resources that were previously being saved
6Commercial forecasting models, such as Global Insight and Macroeconomic Advisers,
incorporate aspects of supply side and Solow Growth models in their results, but Keynesian
effects dominate the results over the first few years of the projection.

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CRS-7
are now being used to finance government purchase or production of goods and
services. If the deficit is the result of tax cuts, aggregate spending is boosted by the
tax cut’s recipient to the extent that the tax cut is spent (not saved or invested in
financial securities).7 In this case, resources that were previously being saved are
now at the disposal of the tax cut recipient, and to the extent that the recipient decides
to increase his consumption, aggregate spending will rise.
In this model, the increase in aggregate spending does not stop there. When
spending increases, idle labor and capital resources are brought back into use, leading
to an increase in employment and decrease in unemployment. This generates new
production, and income accrues to those previously idle resources, which can then
be spent by the worker or owner of capital. This process is repeated, producing a
“multiplier effect” so that the eventual increase in aggregate spending exceeds the
initial increase in the budget deficit. It is assumed that it will take some time for the
full effects of the stimulus to be felt. Keynesian models suggest most of the effects
will be felt within two years; neoclassical economists, who believe in rapid price
adjustment, argue that the effects will occur more quickly.
The effects of fiscal stimulus can be visualized in terms of a simple supply and
demand diagram, where the boost in demand brings the economy to a new, higher
equilibrium with supply. Because the supply curve is sloped upward, the ultimate
increase in output is less than the boost in demand; if the supply curve were vertical
the boost in demand would ultimately lead to zero increase in output. Economists
cannot directly observe distinct supply and demand curves; they can observe only the
single point of equilibrium between them, and this is recorded as gross domestic
product. Thus, there is no direct way to determine whether a change in GDP is
demand or supply driven. Simple Keynesian models assume, in essence, that all
changes in GDP are demand-side phenomena and can be explained by the process
above. (The other models considered below assume that all changes in GDP are
supply-side phenomena.) In recessions, this assumption is often valid (unless the
recession is caused by a “supply shock,” such as an increase in the price of oil). In
expansions, the assumption is problematic, because aggregate spending already
matches potential production, and the process described above may be a poor guide
for explaining reality. Thus, the same tax cut implemented at full employment will
result in a significantly smaller boost to aggregate spending and employment than
during a recession.
Since the 2001 tax cuts took place during a recession and the 2002-2003 tax cuts
took place during a period of sluggish recovery characterized by an economy
operating below full employment, the Keynesian framework is a valid one to capture,
at least in part, the effects of these tax cuts on the economy. In this framework, these
tax cuts would be predicted to stimulate aggregate demand, which would be
manifested in the data as an increase in GDP growth. The size of the stimulus would
7A tax cut that was financed by lower government spending would not stimulate aggregate
spending because the increase in private spending among the tax cut’s recipients would be
offset by the decrease in government spending. In the Keynesian model, the key to a
stimulus is the larger deficit, not the tax cut.

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CRS-8
be small relative to GDP since the incremental increase in the budget deficit was
small (less than 1% of GDP) each year.
How did the economy react following the tax cuts? In evaluating the effect of
the tax cuts on aggregate demand, the unusual nature of the economic recession and
recovery poses a serious problem. Keynesian models predict that tax cuts will boost
GDP growth and employment (and other measures of capacity utilization).
Beginning in the fourth quarter of 2001, growth and employment moved in opposite
directions.
Based on GDP data, this recession and subsequent recovery was characterized
by its mildness: the decline in GDP during the recession was relatively brief and
shallow, and economic output returned to its previous peak quickly — although
growth was not initially rapid in the recovery, GDP was not far below its peak. This
is illustrated in Table 3. Based on these data, one could make the argument that
EGTRRA prevented a deeper and longer recession from taking place. Alternatively,
one could argue that, despite very large tax cuts, the recession was a comparable
length to (although it was clearly shallower than) other recessions in which taxes
were not cut.
Furthermore, there is the question of whether the later tax cuts were useful in
stimulating aggregate spending, even if one believes that the earlier ones were.
Historical experience shows that eventually recessions end on their own through
market adjustment and monetary expansion. Every recession in the post-war period
has lasted less than a year and a half. By the time JGTRRA was implemented — two
years after the recession had ended — it can be argued that the economy was in little
need of further stimulus. And unlike most recoveries, GDP growth was sluggish for
the first six quarters of this recovery, despite three tax cuts. This view would lead
one to conclude that the tax cuts, particularly the latter two, made no impression on
the normal market forces that determine expansion and contraction. The counter-
argument would stress the initially sluggish nature of the recovery as evidence that
further stimulus was required.
Table 3: GDP Growth in Historical Recessions
Quarters After
GDP Growth
Duration of
Percent Decline
Recession Until
in First Four
Period
Recession
in GDP
GDP Reached
Quarters of
(months)
(cumulative)
Previous Peak
Recovery
1949:1 - 1949:4
8
-1.6
1
13.4
1953:3 - 1954:1
10
-2.7
1
6.2
1957:4 - 1958:1
8
-3.7
3
7.3
1960:2 - 1960:4
10
-1.6
2
6.3
1969:4 - 1970:1
11
-0.6
2
0.2
1973:3 - 1975:1
16
-3.0
3
6.4
1980:1 - 1980:3
6
-1.9
2
4.3

---

CRS-9
Quarters After
GDP Growth
Duration of
Percent Decline
Recession Until
in First Four
Period
Recession
in GDP
GDP Reached
Quarters of
(months)
(cumulative)
Previous Peak
Recovery
1981:4 - 1982:3
16
-2.9
3
5.5
1990:3 - 1991:1
9
-1.5
3
2.3
2001:1 - 2001:3
9
-0.5
2
3.3
Source: National Bureau of Economic Research, Bureau of Economic Analysis
Based on employment, unemployment, capacity utilization rates, and related
measures, the recent recession was deep and extremely long, and the recovery was
unusually sluggish, as shown in Table 4. Of the 10 post-war recessions, the 2001
recession had the seventh largest employment decline during the recession. But if the
employment decline after the recession ended is included, it becomes the fifth largest,
and the second largest in the past four decades. The unemployment rate did not begin
to fall until mid-2003. Altogether, this was the longest period of employment in the
post-war period. Likewise, the industrial capacity utilization rate was still below
average through 2003.
Table 4: Decline in Employment during the Post-War
Recessions and Recoveries
Number of
Percent Decline
Date
Percent Decline
Months That
in Employment
Employment
Recession Dates
in Employment
Employment
After Recession
Surpassed
During Recession
Declined After
Ended
Previous Peak
Recession Ended
Nov. 1948-Oct. 1949
6.2
0.0
0
Aug. 1950
July 1953-May 1954
3.8
0.5
3
July 1955
Aug. 1957-Apr. 1958
4.9
0.4
2
July 1959
Apr. 1960-Feb. 1961
2.1
0.0
0
Feb. 1962
Dec. 1969-Nov. 1970
1.8
0.0
0
Dec. 1971
Nov. 1973-Mar. 1975
2.7
0.4
1
June 1976
Jan. 1980-July 1980
1.4
0.0
0
Feb. 1981
July 1981-Nov. 1982
3.4
a
1
Oct. 1983
July 1990-Mar. 1991
1.3
0.6
11
May 1993
Mar. 2001-Nov. 2001
1.9
1.2
21
—
Source: U.S. Bureau of Labor Statistics data from the establishment survey for non-farm private sector
employment; recessions dated by NBER.
a. less than 0.1%.

---

CRS-10
By these measures, making the case that the tax cuts boosted aggregate spending
is more difficult. At best, one could argue that the tax cuts prevented the decline in
aggregate spending from being even longer and deeper. But why would this
recession have been worse than others in the tax cuts’ absence? To make this case,
one would have to identify circumstances in this recession that made it unique. Some
recent events can be used to make this case, such as the September 11 attacks and the
stock market crash. However, this case is weakened by the role of monetary policy.
The depth and duration of the “double dip” recessions of the early 1980s are widely
attributed to the monetary contraction that preceded them; in recent years, monetary
policy has played the opposite role, sharply mitigating any recessionary forces, as
discussed below.
Does the employment or GDP data give a more accurate picture of the
recession’s depth and breadth? While no single data set gives a complete picture of
the economy, there is one compelling argument that the GDP data understate the
recession’s severity. The strong growth in productivity throughout the recession and
recovery suggests that the higher rates of productivity growth first registered in the
late 1990s have continued to the present. If this is the case, then the economy’s long-
term sustainable growth rate has risen, in which case the 0.5% and 2.2% GDP growth
rates achieved in 2001 and 2002, respectively, place the economy farther below full
employment than would be the case if the economy grew at similar rates in earlier
downturns.
“Bang for The Buck”. As discussed above, the key to evaluating a tax cut’s
effect as a stimulus is the extent to which it boosts aggregate spending. By
definition, to boost aggregate demand, a stimulus package must lead to spending
rather than saving. Any policy-induced increase in the deficit would lead to some
increase in aggregate spending, all else equal. But one criticism that was made about
the recent tax cuts was that they would deliver relatively little “bang for the buck” as
a stimulus measure. That is, while they would boost aggregate spending in the
economy, because of their design they would have a very low multiplier effect
relative to alternative policy options.
Several arguments have been made for why the recent tax cuts provided
relatively little “bang for the buck” compared to the alternatives.8 First, government
spending has a greater multiplier effect than tax cuts because some portion of a tax
cut is saved rather than spent. Second, it is believed that tax cuts for upper income
cohorts — the primary recipients of the recent tax cuts — provide less bang for the
buck than tax cuts for lower income cohorts because upper income cohorts have
higher saving rates. Third, some argue that more of a tax cut will be saved if it is
temporary rather than permanent. By law, major parts of EGTRRA and JGTRRA are
scheduled to expire after 10 years. However, this factor may be inconsequential
because individuals may view the tax cuts as permanent since the legislators who
supported the tax cuts indicated their intention to make them permanent. Finally,
8See CRS Report RS21126, Tax Cuts and Economic Stimulus: How Effective Are the
Alternatives?, by Jane Gravelle; CRS Report RS21136, Government Spending and Tax
Reduction: Which Might Add More Stimulus to the Economy?, by Marc Labonte; and Mark
Zandi, “Fiscal Stimulus,” Economy.com Regional Financial Review, Feb. 2003.

---

CRS-11
certain provisions of the recent tax cuts are intended to promote saving rather than
spending, such as the reduction in the taxation of dividends and the elimination of the
estate tax. By definition, these provisions would not be stimulative.
While the tax cuts could have been designed to have a larger bang for the buck
for the reasons listed above, it is an open question as to whether the difference would
have been substantial or negligible. Econometric models are typically not detailed
enough in the modeling of fiscal policy to answer this question definitively. Further
complicating the question, the alternative economic models discussed below predict
different — in some cases, contradictory — factors that would make a tax cut more
effective. For example, in the Solow growth model, a tax cut that promoted saving
and discouraged consumption would have a more positive effect on growth. In any
case, it is fair to say that the most important factor in determining the effect of fiscal
stimulus on the economy is its size (the incremental increase in the budget deficit),
not the specific form that the stimulus takes.
How Much Stimulus Was Attributable to Monetary Policy? When
considering the short-run effects of the tax cuts on GDP, one should also net out the
stimulative effects of changes in monetary policy. Most economists believe that
monetary policy has a strong effect on aggregate demand growth in the short run, and
that lower interest rates were a more important factor than tax cuts in tempering the
depth and length of the recession. Indeed, there was a large decline in the federal
funds rate from 2000 to 2003. As can be seen in Table 5, in 2003 the federal funds
rate reached its lowest nominal level since the 1957-1958 recession. (Federal funds
rate data are not available for earlier recessions.)
However, this easing of policy is not unusually large by other measures.
Adjusting the federal funds rate for inflation (ex-post) reveals that real interest rates
were lower in three of the previous seven recessions than in 2003. And the recent
decline in interest rates was smaller than any other recession in the previous three
decades. Thus, monetary policy did not play a more prominent role than usual in
mitigating the recession. Nor did monetary policy play a large role in causing the
recession: short-term interest rates were raised by 1.75 percentage points between
1999 and 2000. This is much smaller than the episodes of significant monetary
tightening in 1969, 1973, and 1980-1981, which are credited with contributing to the
subsequent recessions.
Table 5: Lowest Federal Funds Rate in Each Recessionary
Episode, 1958-2003
Rate Change:
Date of Lowest Rate
Nominal Interest Rate
Real Interest Rate
Peak to Trough
(percentage points)
May 1958
0.6%
-2.8%
2.9
July 1961
1.2%
-0.1%
2.8
February 1971
3.7%
-1.0%
5.5
May 1975
5.2%
-4.1%
6.8a

---

CRS-12
Rate Change:
Date of Lowest Rate
Nominal Interest Rate
Real Interest Rate
Peak to Trough
(percentage points)
July 1980
9.0%
-4.2%
8.6
February 1983
8.5%
5.0%
10.5
December 1992
2.9%
-0.1%
7.0
June 2003
1.0%
-1.2%
5.5
Source: CRS calculations based on Federal Reserve and BLS data
Note: Real interest rates calculated by subtracting nominal rates less inflation over previous 12
months. Interest rates measured as a monthly average. Rate change calculated on a nominal basis.
a. In the 1973-1975 recession, interest rates peaked nearly one year into the recession.
Inflation. In Keynesian models, the inflation rate is determined by the
interaction of aggregate demand and supply. When aggregate demand exceeds
supply, inflation rises because there is “too much money chasing too few goods;”
when spending is inadequate to maintain full employment, inflation falls. Keynesian
models are based on the assumption of “price stickiness”: prices are slow to adjust
to changes in aggregate supply and demand.
A tax cut pushes up inflation by increasing aggregate demand, all else equal.
Because of sticky prices, the entire increase in prices does not occur instantaneously.
When the economy is already near full employment, the increase in inflation is likely
to be quick and substantial (relative to the tax cut) because production is incapable
of being increased enough to match the increase in spending. When the economy is
below full employment, the increase in inflation would likely be smaller and slower
because there can be a greater increase in production to meet the increase in
spending.
When considering the effects of fiscal policy on inflation, it is highly unlikely
that all else will remain equal in reality. Inflation is ultimately determined by the
Federal Reserve’s manipulation of the money supply, and the Fed has shown a strong
preference in recent decades for maintaining a relatively low and stable inflation rate.
When evaluating the effects of a change in fiscal policy, the most realistic
assumption to make is that the Federal Reserve would take steps to offset any
inflationary effects that the policy change may have. Thus, the most realistic
assumption to make about a tax cut in the abstract is that it will lead to higher short
term interest rates (via tighter monetary policy) rather than higher inflation. This is
particularly true if the tax cut takes place when the economy is near full employment,
in which case the monetary response will negate most of the tax cut’s effect on
aggregate spending. If the economy is in a recession, inflationary pressures are less
likely to be a concern, and the Federal Reserve is less likely to allow interest rates to
rise (i.e., it will accommodate the fiscal expansion).
In the case of the recent tax cuts, inflation was extremely low. As measured by
the consumer price index, it fell from 3.4% in 2000 to 1.6% in 2002, and then rose
to 2.3% in 2003. With the federal funds rate declining by 5.5 percentage points from

---

CRS-13
2000-2003, there was no tightening of monetary policy to offset the inflationary
effects of fiscal policy. At most, the easing of monetary policy that occurred would
have been larger in the absence of the tax cut — but the Fed was limited by how
much further monetary policy could have been eased under traditional methods since
short-term interest rates were brought down to 1%, close to the zero bound.
Consumption. It is often assumed that insufficient aggregate spending, the
source of recessions in Keynesian models, refers to personal consumption spending.
In fact, aggregate spending is composed of personal consumption, private investment,
government spending, and net exports, and a shortfall in any of these components can
cause a recession.
In 2001-2002, consumption growth was slightly below normal, but was
consistently the strongest component of GDP growth, as seen in Figure 1. Thus, it
would be inaccurate to characterize the 2001 recession as being caused by
insufficient consumer spending. By far, the weakest component of the economy was
private investment spending, as will be discussed below. This is not unusual: in all
of the post-war recessions, investment spending growth was lower than GDP growth,
and consumer spending was higher than GDP growth.9 At most, consumption
spending indirectly caused the recession if businesses responded to sub-par
consumption spending by reducing investment spending.
Figure 1: Consumption and Investment Growth, 2000-2002
15
10
GDP
5
0
nge
a
Consumption
h -5
C -10
%
Fixed
-15



Inves tment
-I
-III
-I
-III
-I
-III
000
001
002
2
000
001
002
2
2
2
2
2
Source: BEA.
The tax cuts may have helped sustain personal consumption by increasing after-
tax disposable income. But other factors were also at work. The fastest growing
quarter for consumption, the fourth quarter of 2001, seems to have been dominated
by one-time automobile sales incentives, however. Expansionary monetary policy
may also have played a role in sustaining consumption since much of the growth in
9See CRS Report RL31237, The 2001 Recession: How Long, How Deep, and How Different
From the Past?, by Marc Labonte and Gail Makinen.

---

CRS-14
spending was concentrated in interest-sensitive durable goods. Note that the
argument that tax cuts boosted consumption spending is mutually exclusive with the
supply-side argument, described below, that tax cuts will boost national saving.10
Effects of a Tax Cut in Long-Term Growth Models
While Keynesian models are useful for understanding short-term fluctuations
in the business cycle, they provide little insight into the causes of long-term growth
when the economy is already at full employment. In other words, Keynesian models
emphasize movements in aggregate demand, and de-emphasize changes in aggregate
supply. Although the short term might appear to be a more worthy goal of fiscal
policy than the long term, many economists would argue that the short-term effects
of fiscal policy have been over-emphasized, and the long-term effects neglected.
That is because the Federal Reserve and market forces have proven able to keep the
economy growing steadily for sustained periods of time without relying on activist
fiscal policy. In which case, when the economy is not in a recession, the advice
derived from Keynesian models will be based on factors that are not particularly
relevant at that point in time.

Since the 2001 tax cuts were enacted during a recession, Keynesian models are
probably the single best guide for evaluating its effects at the time. Yet by the time
the 2003 tax cuts were passed, the economy had nearly returned to full employment
(at least based on GDP data). Furthermore, going forward into the future, these tax
cuts (if made permanent) will continue to have an effect on the supply side of the
economy, but no effect on the demand side of the economy. Thus, growth models
can play a valuable role in evaluating the long-run effects of these tax cuts. And
when evaluating tax cuts in the abstract, it may be most sensible to assume that the
economy is at full employment — since recessions are rare — and omit demand-side
effects from the analysis.
Neoclassical Solow Growth Model
The standard neoclassical growth model developed by Nobel Laureate Robert
Solow explains growth in terms of the input of resources into production that lead to
greater output. In the basic model, inputs are labor and physical capital (plant and
equipment). Any increase in production that is not attributable to these two inputs
(e.g., improved business practices) is caused by productivity growth.11 Output cannot
be influenced by changes in spending, as in Keynesian models, and there is typically
no monetary sector in the model. The government can only indirectly influence labor
inputs and productivity through policies which promote the two. But it can directly
affect capital inputs.
10The Keynesian prediction of higher consumption is also in contrast to intertemporal
models with Ricardian equivalence (described below), which predict that consumption
would fall in response to a deficit financed tax cut.
11The analogous measure recorded by the Bureau of Labor Statistics is called total factor
productivity growth.

---

CRS-15
Saving and Investment. By identity, capital investment is exactly equal to
national saving, and saving can be undertaken by individuals, businesses (through
retained earnings), or the government. When the government runs a budget surplus,
it increases national saving; when it runs a deficit, it decreases national saving
because it must borrow to finance expenditures in excess of revenues. Thus, deficit-
financed tax cuts of the type the U.S. has pursued in the past few years reduce
economic growth in Solow growth models by reducing national saving, which in turn
lowers private investment.12 As national saving falls, interest rates — the cost of
borrowing — rise as firms bid for a shrinking pot of resources to finance their
investment spending. This is often referred to as the “crowding out” effect.13
The decline in growth caused by the budget deficit predicted by the Solow
model is based on two assumptions. First, private saving (at the household or
corporate level) does not rise to offset the fall in government saving. This possibility
will be explored in the section below on supply-side effects. Second, investment is
not financed from abroad to offset the fall in government saving, which will be
considered in the next section.
Table 6 shows what has happened to saving and investment in recent years.
The budget deficit has shifted by 6.2 percentage points of GDP between 2000 and
2003. Of this, about 2.3 percentage points of the shift can be attributed to the tax
cuts, according to official estimates. Over the same period, private saving did not
rise nearly enough to offset the decline in public saving of 6.2 percentage points of
GDP — national saving fell by 4.5 percentage points and private saving rose by 1.7
percentage points of GDP. Some of this rise in saving may be for precautionary
reasons related to the recession, and not continue into the expansion, however. At
the same time, the recession and stock market decline caused investment demand to
decline by 3.9 percentage points of GDP. This explains why interest rates did not
rise as a result of the budget deficit — interest rates are determined by supply and
demand, and the supply of saving and the demand for investment happened to fall
simultaneously for unrelated reasons. As the current economic expansion heats up,
the demand for investment will continue to recover. Unless private saving rises or
the budget deficit is reduced, there will be only three quarters as much national
saving available to finance investment spending as there was in 2000.
12More precisely, growth in Solow models declines in the medium run when the rate of
capital formation declines. In the steady state, changes in the rate of capital formation have
no effect on growth.
13A similar effect occurs in Keynesian models, for different reasons. In the Keynesian
model, the rise in aggregate spending resulting from the budget deficit causes the demand
for money to rise. To restore equilibrium in money markets, interest rates must rise. When
interest rates rise, investment spending and interest-sensitive spending declines. The
primary difference between the Solow model and Keynesian model is that growth cannot
fall as the result of a deficit in the Keynesian model, as it does in the Solow model. That
is because interest rates only rise if aggregate spending rises. At most, the crowding out of
investment can entirely offset the rise in aggregate spending, so that growth does not rise,
but it cannot cause growth to fall.

---

CRS-16
Table 6: Budget Deficits, Trade Deficits, Saving, and Investment
(as a % of GDP)
Trade
Budget
Investment
National
Private
Deficit (Net
Surplus/
Spending
Saving
Saving
Foreign
Deficit (-)
Borrowing)
1995-1999
19.1
17.3
-0.3
15.4
1.8
2000
22.1
18.0
2.4
13.6
4.0
2001
20.2
16.4
0.7
13.7
3.7
2002
19.1
14.7
-2.3
15.0
4.4
2003
18.2
13.5
-3.8
15.3
4.7
Source: Bureau of Economic Analysis
Note: Investment spending includes private and public investment.
The decline in investment spending is pertinent because certain provisions of
JCWAA and JGTRRA were specifically aimed at boosting capital investment.
JCWAA contained temporary accelerated depreciation provisions for certain types
of capital investment (structures were a notable exception) and this provision was
extended and expanded under JGTRRA. JGTRRA also temporarily increased the
amount of investment that an unincorporated businesses can expense.14
The effectiveness of these provisions depends on whether they caused capital
investment to be higher than it otherwise would have been. In fact, capital
investment fell by 2.0 percentage points of GDP between 2001 and 2003. As with
any tax cut, evaluating the efficacy of these provisions is hindered by uncertainty
concerning how much lower capital investment would have been without the
provisions. The efficacy of the provisions may have been partly offset because they
were deficit financed, due to the crowding out effect.
In addition to influencing the overall level of investment spending, these
provisions may have distorted the form of capital investment since not all types of
investment were eligible. This may explain why the decline in capital investment
was so concentrated in structures, which were not generally eligible under the
provisions. Between 2001 and 2003, investment in equipment fell by 3%, while
investment in structures fell by 24%. This pattern is unusual: investment in
structures contracted more than investment in equipment in only two other post-war
recessions.
The Trade Deficit. Domestic investment spending can be financed by
Americans or foreigners. If the entire decline in public saving caused by the deficit
is offset by an inflow of foreign saving, then there will be no increase in interest rates
14See CRS Report RL32034, The Jobs and Growth Tax Revenue and Reconciliation Act of
2003 and Business Investment, by Gary Guenther.

---

CRS-17
and no crowding out of private investment. The deficit will have other
consequences, however. Even if foreign borrowing can be used to finance American
investment, the return from that capital will accrue to foreigners, not Americans.
U.S. output will exceed national income because some income will accrue to foreign
lenders.
Furthermore, to purchase U.S. financial securities, foreigners must first buy U.S.
dollars, and this pushes up the value of the dollar. As the dollar appreciates, U.S.
exports and import-competing goods become less competitive. This causes exports
to fall and imports to rise, increasing the trade deficit. By definition, the increase in
the trade deficit will be equal to the borrowing from abroad, because the only way the
U.S. can borrow from abroad is if the U.S. purchases more imports than foreigners
purchase U.S. exports.15
As can be seen in Table 6, there is some evidence that the decline in
government saving has been partly offset by foreign borrowing. Even though private
investment fell by nearly four percentage points of GDP between 2000 and 2003,
borrowing from foreigners (the trade deficit) rose by 0.7% of GDP to a record high
of 4.7%.16 As investment spending increases due to the economic recovery, it is
unclear how much further the trade deficit can rise to finance it.
Supply Side Effects of a Tax Cut on Labor and Saving
Some argue that tax cuts boost long-run growth by giving individuals a greater
incentive to work and save. If tax cuts caused individuals to extend their work hours
or join the labor force, this would increase output directly. Likewise, if tax cuts
caused individuals to save more — assuming this had no short-run effects on
aggregate demand — there would be more saving available for investment, and
growth would rise. There are three main problems with this reasoning.
First, capital investment is determined by national saving, not private saving.
National saving consists of personal saving, business saving, and public saving.
When the government runs a budget deficit, public saving is negative and reduces
national saving. Since the recent tax cuts were deficit financed, any increase in
private saving they caused would have to exceed the increase in the budget deficit to
prevent investment spending from falling. Some of the provisions, such as the
15These results are identical in a Keynesian “open economy” model with perfect capital
mobility. In such a model, the stimulative effects of the tax cut are completely offset by a
wider trade deficit. The actual economy is somewhere between the theoretical cases of an
open economy and closed economy since capital does flow in and out of countries in
response to interest rate differentials, but not sufficiently to eliminate differentials entirely.
Thus, the tax cuts will provide some stimulus, but not as much as the “closed economy”
Keynesian model would predict.
16Looking at the current account, there was a significant decline in trade during the
recession. In 2001 the trade deficit increased because exports declined more rapidly than
imports. In 2002, the trade deficit increased because imports grew more rapidly than
exports.

---

CRS-18
dividend tax reduction and repeal of the estate tax, are intended to promote saving,
but others are likely to encourage consumption.
Second, it is not clear theoretically whether tax cuts would increase or decrease
growth. Marginal reductions in income tax rates, elimination of the estate tax, and
dividend tax reductions, have a separate “substitution effect” and “income effect.”
By making work and saving more rewarding, these tax cuts may induce individuals
to undertake more of each. This is called the substitution effect and raises growth.
But there is an opposing income effect that lowers growth. By making individuals
more wealthy on an after-tax basis, tax cuts require less work and saving to achieve
their financial goals. For example, with a lower tax rate, less saving is needed to
reach a target, such as retirement or the purchase of a car or vacation. The net effect
on growth will depend on the strength of the substitution effect relative to the income
effect. But some of the provisions of the recent tax cuts have no substitution effect;
they only have an income effect, and would therefore have a negative effect on
growth. These include the child tax credit and marriage penalty relief for most
taxpayers.
Third, there is the issue of how large these supply side effects are empirically.
Could the substitution effect and income effect cancel each other out so that the
effect on growth is negligible? Even if the substitution effect dominates, how much
more work will be induced by a reduction in the marginal tax rate from, for example,
31% to 28%? Why has the working week first shortened and then stayed relatively
constant over the past century when wages and tax rates were rising?
Empirical research is not conclusive, with some studies finding tax cuts to have
a positive effect on labor supply and some finding a negative effect; most of the
estimates are modest and some are statistically insignificant (not statistically different
from zero). There is little consensus on the effects of tax cuts on personal saving.
Reflecting the empirical literature, the Joint Committee on Taxation assumed in its
macroeconomic model a labor supply substitution elasticity of 0.18 and an income
elasticity of -0.13, so that the two almost cancel out for a very small labor response.
This means that a 10% reduction in after-tax income would lead to a 0.5% increase
in labor supply (and a smaller increase in GDP). It assumes a long-run saving
elasticity of 0.29.17 CBO assumed a labor supply elasticity of 0.07 for primary
earners and a 0.5 elasticity for secondary earners.18 Research suggests that working-
aged males are not very sensitive to changes in tax rates: they tend to work full-time
regardless of the tax rate. Their ability to alter their hours in response to a change in
tax rates may be limited, at least in the short term. Some married women, older
workers, and younger workers may be more sensitive to tax rates because they are
less attached to the workforce, but estimates of their sensitivity vary significantly
from study to study. The dramatic rise in female labor force participation in the post-
war period suggests that cultural factors may be a far more important determinant of
17John Diamond and Pamela Moomau, “Issues in Analyzing the Macroeconomic Effects of
Tax Policy,” National Tax Journal, vol. LVI, no. 3, Sept. 2003, p. 447.
18Congressional Budget Office, How CBO Analyzed the Macroeconomic Effects of the
President’s Budget, July 2003.

---

CRS-19
labor supply than tax policy — and, in the case of married women, may have already
run their course.19
Casual observation does not reveal higher labor supply or national saving since
the recent tax cuts have been enacted. As seen in Table 6, private saving has risen
since 2000, but by less than one third as much as public saving has fallen. While less
than half of the decline in public saving is attributed to the tax cuts, the increase in
the deficit caused by the tax cuts alone exceeded the increase in private saving.
Furthermore, some of the increase in private saving could have been motivated by
unrelated factors, such as precautionary saving in response to the recession. Finally,
the composition of the increase in saving casts further doubts on causation. With the
exception of accelerated depreciation, all of the major provisions of the tax cuts
affected individuals. Yet the increase in private saving is entirely attributable to
increased business saving — personal saving actually fell from 1.7% to 1.5% of GDP
between 2000 and 2003, as seen in Table 7.
Since 2000, labor supply has fallen, both in terms of total employment and hours
worked, as seen in Table 7. Of course, this decline is overwhelmingly attributable
to the recession and sluggish recovery. But it suggests that any supply side incentives
to work more were swamped by the weakness of the economy and were not a
significant factor. This might be expected since the provisions with effects at the
margin were small. For example, the reductions in marginal individual tax, estate
tax, and dividend tax rates caused a combined revenue loss of less than 1% of GDP
annually from 2001 to 2004.
Table 7: Labor Supply and Saving Indicators, 2000-2003
Average Weekly Hours
Employment/Population
Personal Saving Rate
(% change)
Ratio
(% of GDP)
1995-1999
0.1%
63.7%
2.8%
(average)
2000
-0.8
64.4
1.7
2001
-1.3
63.7
1.3
2002
-0.4
62.7
1.7
2003
-0.4
62.3
1.5
Source: Bureau of Labor Statistics
It should also be noted that any change in labor supply in response to a tax cut
will be a one-time effect only, as the labor supply moves from the old hours worked
to the new hours worked. After that, labor supply will not continue to grow in
19For an analysis and literature review of these issues, see CRS Report RL31949, Issues in
Dynamic Revenue Estimating, by Jane Gravelle.

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CRS-20
response to the tax cut.20 By contrast, the effects of the deficit on saving are ongoing
(until the economy returns to its steady state). If the deficit-financed tax cuts result
in a decline in national saving, as the data would seem to indicate, then the negative
effect on growth would be ongoing.
While the difference between demand-side effects and supply-side effects are
distinct in theory, it is difficult to disentangle them in practice. Assume taxes are cut
in a recession caused by insufficient consumption, leading to higher aggregate
spending as the tax cuts are spent by individuals. The increase in aggregate spending
would bring involuntarily unemployed workers back into the labor force and increase
the hours of involuntarily underemployed workers. In a supply-side analysis, unless
properly controlled for, it would appear that workers were responding to the
incentives of lower tax rates to voluntarily increase their labor supply, and would be
taken as evidence in favor of supply-side economics. This also suggests that many
workers will not be able to take advantage of supply-side incentives that do exist in
recessions because they will not be able to voluntarily increase their hours at a time
when labor is underutilized.
Intertemporal Models
Beginning in the 1970s, many economists grew discontented with Keynesian
and Solow models because of their ad-hoc, non-theoretical nature.21 They turned to
macroecnomic models based on rational optimization by individuals over time,
referred to here as intertemporal models. Infinite horizon models and overlapping
generation models (such as life-cycle models) are some prominent examples in this
category. In these models, individuals plan their lifetime work, leisure, saving, and
consumption choices at present in order to maximize their lifetime utility (well-
being). The advantage of these highly sophisticated, highly mathematical models is
that every decision made by individuals is rooted in a logical, coherent decision. The
disadvantages are that these models make unrealistically complex assumptions about
how individuals make decisions and the models are more grounded in theory than
evidence — particularly because their theoretical complexity makes empirical
estimation problematic.22 For example, infinite horizon models assume that
20The only ongoing effect from an increase in the labor supply on economic growth comes
from the fact that some of the additional output generated from the one-time increase in
labor supply will be invested, leading to growth in the capital stock.
21See, for example, Robert Lucas and Thomas Sargent, After Keynesian Macroeconomics,
in Federal Reserve Bank of Boston, Conference Series 19, June 1978, p. 49. For a defense
of Keynesian economics against this critique, see Benjamin Friedman, Comment, in Federal
Reserve Bank of Boston, Conference Series 19, June 1978, p. 73. Neo-Keynesian models
have been developed that make similar assumptions about intertemporal optimization, but
feature sticky prices in the short run.
22Intertemporal models have not been without their critics. A group of economists known
as behavioral economists have developed new economic models based on irrational, rule of
thumb, and “bounded rational” behavior. For an overview of behavior economics, see
Richard Thaler and Sendil Mulianathan, Behavioral Economics, National Bureau of
Economic Research, Working Paper 7948, Oct. 2000. For the application of behavioral
(continued...)

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CRS-21
individuals live (and have planned their work, saving, and consumption) forever.
Even if one believes that concern for one’s descendants makes the infinite horizon
close to actual behavior for parents, not everyone has descendants or values their
descendants’ well-being on par with their own. As another example, the models
often do not feature uncertainty (or uncertainty is assumed to cancel out in the
aggregate) about future earnings, prices, rates of return, or government policies when
individuals make decisions today.
Because of the long time-frame taken by these models, a deficit-financed tax cut
cannot be evaluated because it is not a sustainable policy — eventually, a tax cut
must be offset by higher taxes or lower government spending or else the national debt
would become infinitely large.23 Thus, when these models are used to evaluate tax
cuts, some assumption must be made about higher taxes or lower spending at some
point in the future. Although there is no obvious choice for when the policy change
is likely to occur or what form it is likely to take, these choices are unfortunately
critical to the model’s results. The primary reason why saving and labor supply
change in these models when taxes are cut is because of the wedge they create
between after-tax wages and interest rates now relative to the future. For example,
in a life-cycle model individuals are assumed to keep their lifetime consumption
constant. When taxes are cut today and raised in the future, the model predicts that
individuals will work and save more today, when taxes are low, in order to work and
save less when taxes are raised. If the tax cut leads to a seemingly innocuous change
in interest rates, this can affect labor supply today because a higher interest rate
makes the discounted value of leisure in the future greater. As a result, people work
more today so they can save more and work less in the future. If the tax cuts are
instead assumed to be financed through lower future government spending, in many
of these models, there is a smaller labor and saving response induced by the tax cut
since private spending cannot be substituted for government spending.
These models also contain, to varying degrees, effects known as “Ricardian
equivalence.” Ricardian equivalence is the theoretical notion that budget deficits
would not cause interest rates to rise because individuals know the deficits will be
offset by higher taxes or lower government spending in the future. As a result,
private saving rises today to prepare for future consumption losses, and replaces the
fall in public saving, so that there is no net effect on national saving and capital
investment. In infinite horizon models, there is total Ricardian equivalence because
people are assumed to live forever. In overlapping generations models, such as life
cycle models, the Ricardian effect is only applicable to those generations that will
still be alive when taxes are raised or spending is cut, so there is only a partial private
saving offset.
22(...continued)
economics to tax policy, see B. Douglas Bernheim, “Taxation and Saving,” in Alan
Auerbach and Martin Feldstein, eds., Handbook of Public Economics (Amsterdam: Elsevier
Science, 2002), p. 1200.
23Because of interest costs, the future higher taxes or lower government spending will
exceed the size of the original tax cut.

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CRS-22
The theoretical sophistication of intertemporal models comes at the expense of
empirical accuracy. Because the models are so complex, they cannot be empirically
estimated directly. Instead, the models are simulated with certain key parameters
inferred from empirical evidence; some of the parameters must be inferred because
they are also too complex to measure directly. For this reason, the model results
should not be considered direct evidence of a tax cut’s effect.
Most economists believe these models do a poor job of explaining economic
activity in the short run.24 In these models, there are no demand-side effects, such as
involuntary unemployment (i.e., everyone who wants a job can find one) or excess
capacity. There tends to be no modeling of monetary policy since there are no short
term effects. Workers are free to lower or raise their work hours, or even enter or
exit employment, as they desire. Indeed, when these models generate substantial
growth effects in response to a tax cut, it is because they assume that work and saving
patterns (voluntarily) fluctuate greatly because the tax cut changes present and future
economic conditions. While these models may offer certain insights into behavior
over the long run, they are unsuitable for evaluating a tax cut whose purpose is short-
term stimulus in a recession.
Overview of Simulations
Before EGTRRA and JGTRRA were enacted, a number of simulations were
performed that estimated their economic effects using the economic models
discussed above. (No estimates of JCWAA’s effects were found.) As tax cut
proposals move through the policy process, details change, and the estimates
presented here are based on proposals that may differ slightly from the policy that
was eventually enacted. It should be stressed that all of the estimates were made
before the fact, and none have examined the data retrospectively to check the
estimates’ accuracy.
Nearly all of the simulations find the tax cuts to have positive effects in the short
run and negative effects in the long run. Often, the long-run effects have not entirely
materialized by the end of the traditional 10-year forecast window. Thus, the tax cuts
cannot be said to be unambiguously good or bad; the merits of this tradeoff depend
on a policymaker’s preferences over time.
Simulations of EGTRRA’s Effects
Macroeconomic Advisers. The private forecasting firm Macroeconomic
Advisers (MA) uses a model with Keynesian properties for the first few years after
a tax cut. Thus, the tax cut mainly affects the economy by boosting aggregate
demand — including large multiplier effects — not supply side effects. In the long
run, the model has neo-classical properties. MA estimated that EGTRRA would
boost growth by 1.2 percentage points in the second half of 2001 (in other words, 0.6
24Real business cycle models are dynamic optimization models used to analyze short-run
cyclical fluctuations. They are not analyzed here because they are not typically used to
assess the effects of tax cuts.

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CRS-23
percentage points for the entire year) and 0.3 percentage points in 2002. In 2002,
MA projected that the Fed would keep interest rates 0.75 percentage points higher
as a result of the tax cut. MA did not offer information on the tax cut’s long term
effects.25

DRI-WEFA. The private forecasting firm DRI-WEFA (now Global Insight)
also uses a model with Keynesian properties and multiplier effects for the first few
years after a tax cut, and neo-classical properties over the long run. While they did
not do a full analysis of EGTRRA’s effects, they did predict that EGTRRA would
increase growth in the second half of 2001 by 0.4 percentage points through a boost
to aggregate spending.26
Auerbach. Alan Auerbach of University of California-Berkley used the
Auerbach-Kotlikoff model, an intertemporal life-cycle model, to evaluate the
economic effects of EGTRRA over the next 150 years. This model does not contain
short-term business cycle properties Like all intertemporal models, a permanent
deficit-financed tax cut is inconsistent with the model since it would cause the
national debt to grow indefinitely. Auerbach assumes that the tax cut results in
higher taxes at some point in the future, and runs simulations in which either the tax
on labor or the tax on capital is raised; an increase in the wage tax reduce output
more than an increase in the capital tax. Faced with lower tax rates in the short run
and higher tax rates in the long run, the model assumes that individuals work and
save more while the tax cut is in place, and work and save less while the permanently
higher tax rates are in place. As a result, saving rates and output are increased while
the lower tax rates are in place, and lowered while the permanently higher tax rates
are in place. The eventual increase in taxes reduces GDP; the longer the tax increase
is postponed, the more long run GDP falls. The tax cuts cause output to rise by about
1% by 2004. In the first year of the tax increase, output declines by enough to leave
it below the baseline level, and in the long run output is 1-2.5% lower.27
Gale and Potter. William Gale and Samara Potter of Brookings Institution
use a neo-classical Solow model with supply side effects to estimate the effects of
EGTRRA.28 While this model will not capture short-run business cycle dynamics,
it can be useful for estimating the tax cut’s long run effect on the economy. They
estimate that the tax cut will reduce GNP by 0.68% in 2011. That is because the
crowding out effect of budget deficits is estimated to reduce GNP by 1.63%. This
is partly offset, they believe, by incentive effects on labor and private saving (0.95
percentage points).29
25Macroeconomic Advisers, Economic Outlook, vol. 19, no. 5. June 2001, p. 5.
26DRI-WEFA, Economic Outlook, May 2001, p. 2.
27Alan Auerbach, “The Bush Tax Cut and National Saving,” National Tax Journal, vol. LV,
no. 3, Sept. 2002, p. 387.
28William Gale and Samantha Potter, “An Economic Evaluation of the Economic Growth
and Tax Relief Reconciliation Act of 2001,” National Tax Journal, vol. LV, no. 1, Mar.
2002, p. 133.
29When considering the welfare effects of a tax cut in a model with capital flows, it may be
(continued...)

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CRS-24
Economic Effects of the 2001 Rebate. One provision of EGTRRA
provided what was referred to as a “rebate” of up to $600 as an advanced tax credit
in lieu of the 10% tax bracket.30 Some studies have looked specifically at the effects
of this credit on consumption and saving. Unlike the other studies summarized here,
these studies were not based on simulations using macroeconomic models.
David Johnson, Jonathon Parker, Nicholas Souleles use regression analysis to
determine whether the rebate affected the consumption of non-durable goods.31 They
find that 23%-37% of the rebate check was spent on higher non-durable consumption
within the first three months of receipt. If the remainder of the rebate was saved,
then the effect on aggregate demand is likely to be modest; however, it may have
been spent on services, durable goods, or investment goods, which the study did not
include. They find evidence that most of the remaining rebate was spent within the
next two quarters, although these findings are not statistically significant.
Econometric studies of this type are hampered by several factors, including self-
reporting errors (a problem with most economic data), random fluctuations in high
frequency data, insufficient variation in the data over time because most of the rebate
checks were received within two months, and omitted variable bias, both because the
study did not control for other factors influencing consumption over time (e.g.,
macroeconomic conditions) and because the control group of rebate non-recipients
may have differed in important ways (e.g., income and marital status) that influenced
consumption, thereby attributing the influence of those omitted variables to the
rebates. When non-recipients are excluded from their calculations, the results
become statistically insignificant.
Joel Slemrod and Matthew Shapiro of the University of Michigan analyzed the
results of telephone surveys before and after the rebate was sent which asked
individuals whether they planned to/had mostly spent the rebate, saved the rebate, or
use the rebate to pay down debt. (From an economic perspective, the last two
choices are both a form of saving, and only the first response would lead to an
increase in aggregate spending.) In both surveys, about one quarter planned to
mostly spend the rebate and about three quarters planned to save it or used it to pay
down debt, which does not suggest the rebate had strong stimulative effects. Survey
results need to be considered with caution because it is well known among
researchers that survey responses often differ systematically from actual behavior.
29(...continued)
more useful to look at GNP, which measures the output of Americans, than GDP, which
measures the output in the United States. That is because the GDP growth stemming from
capital inflows accumulates to foreigners rather than Americans. Gale and Potter estimate
that GDP would be 0.37 percentage points higher than GNP.
30See CRS Report RS21171, The Rate Reduction Tax Credit: A Brief Explanation, by Gregg
Esenwein and Steven Maguire.
31David Johnson, Jonathon Parker, Nicholas Souleles, The Response of Consumer Spending
to the Randomized Income Tax Rebates of 2001, Working Paper, Feb. 2004.

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CRS-25
But the authors argue that the sharp increase in the personal saving rate in the months
that the rebate was sent out supports their findings.32
Simulations of JGTRRA’s Effects
JCT. The Joint Committee on Taxation estimated the economic effects of
JGTRRA as it was passed using three different models.33 Thus, they assume that
JGTRRA will be allowed to expire in 2013, as scheduled, and the tax cuts (with the
exception of new dividend and capital gains tax cuts) are an acceleration of tax cuts
that, in the baseline, would have already gone into effect in future years.
The JCT used two models with Keynesian short-term properties and neo-
classical long-term properties, a proprietary model and the Global Insight model.
Assuming that the Federal Reserve (Fed) responds aggressively to keep inflation
stable — consistent with their actual behavior in recent years — the proprietary
model predicts that GDP will be increased by a cumulative total of 0.2% after five
years. With a less aggressive Fed, the Global Insight model predicts that GDP will
be increased by a cumulative total of 0.9% after five years. In both models, GDP
would be reduced by a cumulative total of 0.1% over the next five years, primarily
due to crowding out. The third model is an intertemporal life cycle model, which,
as discussed previously, requires one to assume that taxes will be raised or spending
cut in the future to finance the tax cut. The life cycle model predicts that GDP will
be increased by a cumulative total of 0.2% over the first five years, and decreased by
a cumulative total over the next five years by 0.1% if the tax cuts are financed by
reduced government transfer payments (e.g., Social Security) after 2013 and reduced
0.2% if financed by higher taxes after 2013. In other words, the negative effects on
growth begin even before taxes are raised or spending is cut.
Because the dividend tax cuts and accelerated depreciation create an incentive
to invest in capital equipment, the models predict that investment in residential
housing will decline as investors shift from investment in housing to equipment.
CBO. CBO evaluated the economic effects of the President’s overall budget
proposal for FY2004.34 This differs from JGTRRA because it includes other
spending and revenue proposals, and the analysis is based on the tax cut that was
proposed by the President, not what he signed into law. Still, the tax cut was
arguably the most significant budgetary proposal in FY2004, and the President’s
proposal was close to the version enacted, so CBO’s analysis is pertinent. (One
important difference between the President’s proposal and JGTRRA was that the
President proposed to make EGTRRA/JGTRRA permanent.) Because of the
uncertainty and complexity surrounding macroeconomic modeling, CBO employs
32Joel Slemrod and Matthew Shapiro, Did the 2001 Rebate Stimulate Spending? National
Bureau of Economic Research, Working Paper 9308, Oct. 2002.
33Joint Committee on Taxation, “Macroeconomic Analysis of H.R. 2,” Congressional
Record, Doc 2003-11771, May 8, 2003.
34Congressional Budget Office, An Analysis of the President’s Budgetary Proposals for
FY2004, Mar. 2004.

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CRS-26
five different econometric models and nine different scenarios to make its
projections. While the results varied by model and scenario, all were modest relative
to GDP. All of the models predict that the tax cuts will increase interest rates, except
under the open economy assumption where borrowing from abroad completely
compensates for the fall in national saving.35
Using a Solow growth model, the President’s budget proposals were projected
to decrease GDP by an average of 0.2% from 2004 to 2008 and an average of 0.7%
from 2009 to 2013. The tax cuts reduce growth because the increase in labor supply
is not sufficient to offset the decrease in the capital stock caused by the larger budget
deficit. In this model, CBO assumes that labor supply would increase and 65% of the
decline in public saving caused by government borrowing would be offset by higher
private saving and borrowing from abroad; without these ad hoc offsets (which are
not empirically estimated), the decline in GDP would be greater.
CBO has six different results based on intertemporal models. Since
intertemporal models require that the budget eventually return to balance, CBO has
different scenarios where lump-sum taxes are raised or spending is cut after ten
years.36 It produces results with an infinite horizon model and a life cycle model,
both under an open economy (i.e., the U.S. can borrow from abroad) and closed
economy assumption. It estimates that the budget proposals would reduce GNP if
financed by lower government spending after 2013 (GNP would change 0.2% to -
0.8% from 2004 to 2008 and -0.6 to -2.0 from 2009 to 2013) but increase GNP if
financed by higher taxes after 2013 (GNP would increase by 0.3% to 0.9% from 2004
to 2008 and 0.3% to 1.4% from 2009 to 2013).37 It may sound counter-intuitive that
higher future taxes are better for the economy than lower government spending, but
that is because of the oddities of the intertemporal models.38 Because individuals are
assumed not to value government spending — a highly unrealistic assumption —
there is less incentive to work and save more in the first 10 years in response to the
tax cuts when they are financed through lower government spending. By contrast,
when the tax cuts are financed through higher future taxes, these models assume that
there is a large incentive to work and save more now, in order to work and save less
once taxes are raised.
CBO also estimated the economic effects of the budget proposals using two
Keynesian models, the MA model and the Global Insight (GI) model. For these
35Congressional Budget Office, How CBO Analyzed the Macroeconomic Effects of the
President’s Budget, July 2003. The increase in interest rates were largest in the Keynesian
simulations and lowest in the intertemporal simulations.
36CBO’s assumption that the President’s Budget proposals would be financed through higher
future lump sum taxes (e.g., a head tax) is curious since the government does not currently
collect any lump sum taxes. CBO reports that if it had instead assumed that the Budget
proposals were financed with marginal tax increases, the increase in GDP would have been
smaller.
37The results for GDP are equal to the GNP results for closed economy models. In the open
economy variation, GDP is slightly higher because it includes the income accruing to
foreigners as a result of net capital inflows.
38Higher taxes reduce GDP in the model outside the reported 10 year projection window.

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CRS-27
models, CBO estimated results only for five years since the models are designed to
capture only short-run phenomena. CBO added larger labor supply responses to the
models than the original modelers intended. On average, the proposals would
increase GDP by 0.2% in the MA model and 1.4% in the GI model. In both models,
the supply side effects are negative and the demand side effects are positive over five
years: GDP rises only because of the stimulus to aggregate spending. The increase
in GDP is possible only if the Fed does not offset it, which it may do to keep inflation
from rising. In the MA model, GDP is higher for the first three and lower for the
next three years. In the GI model, GDP is higher for every year of the projection.
Macroeconomic Advisers. As mentioned above, the Macroeconomic
Advisers (MA) model has Keynesian properties for the first couple of years of a
simulation, and neo-classical properties in the long run. MA, a private forecasting
firm, projected JGTRRA will boost growth by 0.5 percentage points in 2003 and 1.0
percentage points in 2004. They projected JGTRRA will reduce growth in later
years, leaving GDP 0.3% lower by 2017. (The long-run effects are largely the result
of the Administration’s proposal to make EGTRRA permanent; a provision that was
not included in the version of JGTRRA signed into law.) Because the economy was
already close to full employment, JGTRRA causes inflation and interest rates to rise
quickly. As a result, while JGTRRA reduces unemployment from 2003 to 2006, it
increases unemployment from 2006 through the rest of the decade. JGTRRA is
projected to raise long-term interest rates by an average of 0.34 percentage points
over five years and 0.75 percentage points in the long run due to crowding out.39
One important assumption MA makes is that the acceleration of tax cuts already
scheduled to take place as a result of EGTRRA are modeled as new tax cuts, rather
than accelerated tax cuts; if individuals did not treat them as new, their effect on
aggregate demand would be smaller.40
Global Insight. As mentioned above, the Global Insight (formerly DRI-
WEFA) model has Keynesian properties for the first couple of years of a simulation,
and neo-classical properties in the long run.41 Global Insight’s model projected that
JGTRRA, as proposed by the Bush Administration, would increase growth by 0.2
percentage points in 2003, 0.9 percentage points in 2004, and 0.1 percentage points
in 2005, primarily by stimulating aggregate demand. After that point, JGTRRA
39Macroeconomic Advisers, “A Preliminary Analysis of the President’s Jobs and Growth
Proposals,” mimeo, Jan. 2003.
40Estimates of a tax cut’s effects are sensitive not only to the model used, but the
assumptions entered into the model. The Heritage Foundation also used the Global Insight
model to estimate the effects of JGTRRA and found more favorable results by using more
favorable assumptions. However, even using more favorable assumptions, they estimated
that the tax cut would have a negligible effect on GDP growth after the first two years. Over
ten years, they estimates that on average the tax cut would have no effect on economic
growth. William Beach et al., The Economic and Fiscal Effects of the President’s Growth
Package, Heritage Center for Data Analysis, Apr. 2003.
41The model has been criticized for having extremely long lasting Keynesian effects. For
example, even at the end of the 10-year projection, JGTRRA still causes aggregate demand
to exceed the baseline in their model.

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CRS-28
would reduce economic growth by 0.5 percentage points in 2006, and smaller
amounts for a couple of years after that, primarily through the crowding out effect of
the budget deficit. JGTRRA was also projected to increase inflation by 0.2-0.3
percentage points per year through 2006, with the inflation rate remaining 0.1
percentage points higher for the remainder of the 10-year projection. Interest rates
are about 0.25 percentage points higher for most of the 10-year projection, which
leads to a stronger dollar and larger current account deficit. The dividend tax cut is
projected to initially boost stock prices by 5%, but prices fall slightly by the end of
the projection.42
Conclusions
This report studies the macroeconomic effects of the tax cuts passed between
2001 and 2003. There is no direct way to determine the effects of a tax cut on the
economy because there is no way to observe the counterfactual case where the tax cut
did not occur. Estimates are made by comparing the results of macroeconomic
models with and without the tax cuts. These estimates were made before the tax cut
occurred, and are not based on actual ex-post data. Unfortunately, there is no
consensus among macroeconomists as to which one model is most suitable for policy
simulations, and no model with a strong track record in accurately projecting
economic events. The different models vary in fundamental ways, and no one model
incorporates every key aspect of economic behavior. Keynesian models focus on the
business cycle but neglect the determinants of long-run growth. Neoclassical growth
models and intertemporal models concentrate on long-run growth, but do not feature
involuntary unemployment or monetary sectors. The results generated by
intertemporal models are based on assumptions about behavior that most people
would find highly unrealistic. Despite the wide diversity of the models used, all of
the results are relatively small, as would be expected of tax cuts that are relatively
small in relation to GDP in the years considered.
Economic Growth in a Keynesian Model. Keynesian models predict that
deficit-financed tax cuts will boost output during a recession by increasing spending
so that slack labor and capital resources are brought back into production. For the
individual income tax cuts, higher consumption in response to higher after-tax
income is the channel through which spending is boosted. This boost in growth is
temporary because the growth rate of spending cannot exceed potential production
over time. Keynesian macroeconomic models are the only popular model that allows
for short-run business cycle fluctuations. The effect of growth in other
macroeconomic models is considered next.
The economy was in a recession of mild depth and average contraction when
EGTRRA was passed. The recovery was unusually sluggish for the first six quarters,
during which JCWAA and JGTRRA were passed, before a more normal growth rate
took root. Proponents point to the short and mild recession as evidence that
EGTRRA boosted growth. Opponents point to the sluggish recovery as a sign that
42Cynthia Latta, “The 2003 Stimulus and Growth Plans Compared,” Global Insight, U.S.
Economic Outlook, Feb. 2003.

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CRS-29
the tax cuts were ineffective, and credit monetary expansion and normal market
forces for the mild recession. Opponents also point to the performance of labor
markets as evidence that the tax cuts did not stimulate spending.
Investment, National Saving, Interest Rates, and Growth in the
Solow Model. Deficit-financed tax cuts reduce public saving; unless this is offset
by higher private saving or borrowing from abroad, national saving will be reduced
and interest rates will rise. Most empirical estimates suggest that the offset will be
only partial (because some of the tax cut is not saved), and national saving will fall.
The neoclassical Solow growth model predicts that a reduction in national saving will
reduce economic growth over the medium term by reducing capital investment.
Empirical evidence suggests that marginal tax cuts create incentives to work and save
more (referred to as “supply side effects”), but the increases in work and saving are
too small to offset the reduction in capital accumulation caused by the budget deficit.
Thus, on net, the neoclassical model predicts that growth will be reduced by deficit-
financed tax cuts. National saving fell from 2000-2003, but this did not lead to
higher interest rates because investment demand fell even more sharply.
Accelerated depreciation, which was the major provision in JCWAA and was
extended and expanded in JGTRRA, was intended to stimulate capital investment
spending. Investment spending sharply contracted during and following the
recession. This is not unusual, but it is difficult to make the case that investment
spending would have been even lower in the absence of the tax cuts. JCWAA may
have distorted investment decisions toward equipment, which qualified for
accelerated depreciation, and away from structures, which generally did not qualify.
Equipment spending contracted by 3% from 2001 to 2003, while spending on
structures contracted by 24%.
Trade Deficit. Deficit-financed tax cuts can be financed through national
saving or by borrowing from abroad. Net borrowing from abroad must take the form
of a trade deficit. This option will mitigate the rise in interest rates and the
“crowding out” of capital investment, but will lead to dollar appreciation that causes
exports and import-competing goods to be “crowded out.”
There is some evidence that this has occurred, as the trade deficit increased from
4% in 2000 to 4.7% in 2003. Typically, the trade deficit declines when growth has
been low.
Employment and Unemployment in a Keynesian Model. For a mild
recession, the contraction in employment and rise in unemployment was unusually
long lasting — the longest period of employment decline since the Great Depression.
Employment declined throughout and for 21 months after the recession — a post-war
record by 10 months. Since the employment contraction was so prolonged, it is
difficult to argue it would have been even longer in the absence of the tax cuts.
In Keynesian models, tax cuts boost employment and reduce unemployment by
boosting aggregate spending. The other macroeconomic models do not feature
involuntary unemployment, and make no prediction that tax cuts will affect
unemployment.

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Supply Side Effects on Labor Supply and Private Saving, and
Growth in the Intertemporal Models. “Supply-siders” focus on the incentives
that tax cuts provide to work and save more. However, marginal tax cuts could
theoretically lead to more or less work since tax cuts also reduce the labor and saving
required to meet income targets. (Tax cuts without marginal effects, such as the child
tax credit, unambiguously reduce work and saving.) It is an empirical question as to
the size and direction of these effects. Most estimates for labor supply are positive
and very small for primary earners, and somewhat larger for secondary earners.
There is no evidence of supply-side effects from the tax cuts thus far. Hours
worked and labor force participation have both declined since the tax cuts passed.
This is likely due to cyclical factors, which suggests that supply side effects are not
large enough to outweigh other factors. Private sector saving increased after the tax
cuts, but this was due to an increase in business saving. Supply-side analysis predicts
that reductions in individual income taxes will lead to higher personal saving by
individuals, but personal saving fell between 2000 and 2003.
Intertemporal models are based on the assumption that policy changes affect
individuals’ lifetime plans for work, consumption, and saving. Since these plans
span the lifetime, the models can only analyze a deficit-financed tax cut if they
assume it is offset by higher taxes or lower government spending in the future.
Growth rises in the short run in the estimates using these models because people
choose to work and save more in the low tax period and less in the future high tax
period. Growth rises because of the parameters chosen when the model is calibrated,
but many of these parameters are highly uncertain and cannot be directly observed.

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