Key Issues in Tax Reform: Dynamic Scoring

Key Issues in Tax Reform: Dynamic Scoring

Updated January 9, 2018
Key Issues in Tax Reform: Dynamic Scoring
Dynamic scoring includes, in projections of revenue effects,
tax cuts and decrease it for tax increases, although the
indirect changes in tax collections due to the overall growth
magnitude of the response also depends on the type of tax
effects on the economy. If the economy becomes larger due
change and whether it is more likely to affect spending. The
to the tax revision, tax revenues are larger because of the
effect depends on how close the economy is to full
larger base.
employment, how open the economy is (fiscal stimulus is
less powerful in an open economy), the fundamental
Brief Summary of Current Practices
behavioral effects, and the extent to which the Federal
The estimated revenue effects (i.e., the “score”) of tax
Reserve may take actions to offset the effect. Because the
revisions are prepared by the Joint Committee on Taxation
economy is currently at full employment, a fiscal stimulus
(JCT) and provided to the Congressional Budget Office
is unlikely to produce significant output effects.
(CBO); CBO provides the cost estimates for legislation.
These estimates assume no changes in the overall size of
Demand-side effects are transitory and should fade over
the economy, although they do allow for other behavioral
time. During the first hearings in 1995 on dynamic scoring
effects (such as a change in capital gains realizations).
(Joint Hearing Before the House of Representatives
When legislation is considered, by tradition and norm, these
Committee on the Budget and the Senate Committee on the
JCT and CBO estimates are the basis for determining
Budget, 104th Congress, Review of Congressional Budget
compliance with the budget rules.
Cost Estimating January 10, 1995), many economists
counseled against including these transitory effects in
Beginning in 2003, House rules provided for advisory
dynamic scoring.
estimates of macroeconomic effects, and the JCT usually
provided a range of estimates based on different models and
Supply-Side Effects
assumptions. In most analysis of major legislative changes,
Supply-side effects capture the increases or decreases in
estimates of macroeconomic effects of tax cuts or other
labor and capital that increase or decrease output. Average
changes varied considerably, although none were large
reductions in taxes reduce the supply of labor and capital,
enough to offset a revenue loss estimated by conventional
but marginal reductions (decreases on the last increment of
methods.
supply) increase the supply as the consumption that people
can achieve by working becomes cheaper relative to leisure.
In the 114th Congress, the House adopted rules that required
Similarly, the effect of an increase in the after-tax rate of
a dynamic score for a measure that affected the deficit by
return on saving is theoretically ambiguous.
0.25% of GDP or at the request of the chairman of the
Budget Committee or chair or vice-chair of the JCT (i.e.,
Labor-supply effects can happen relatively quickly, but
the chairman of the Ways and Means Committee). This
capital income effects tend to accumulate more slowly and
provision was incorporated in the budget resolution, which
then settle down into a steady state long-run effect.
extended to the Senate, but only on an advisory basis.
Currently, the House has retained this rule, but it is not in
Both the speed and the size of supply-side effects depend
effect for the Senate. In any case, no law requires the use of
on behavioral responses. Empirical evidence suggests labor
the JCT-CBO score; budget scores are decided by the
supply and savings responses are relatively small, and
Budget Committees, and by tradition, by the chairmen.
models that apply the elasticities from the literature to a
growth model tend to obtain small results. Some models
Uncertainties In Dynamic Scoring
(life-cycle and infinite-horizon) allow individuals to choose
The many macroeconomic analyses by the JCT over the
consumption and leisure over a lifetime taking into account
years as well as macroeconomic analyses of the President’s
future wages and rates of return. In these models, embedded
budget by the CBO have shown a broad range of projected
elasticities are sometimes larger than those suggested by the
effects and illustrated the uncertainties about these
literature (see CRS Report R43381, Dynamic Scoring for
economic projections.
Tax Legislation: A Review of Models, by Jane G. Gravelle).
In the past, the JCT has used both a basic macroeconomic
The projected effects of a tax measure on economic growth
model that can capture all three effects and a dynamic life-
depend on the type of effect considered and the
cycle mode that captures only supply-side effects. The
assumptions surrounding the magnitude of the effect. Three
elasticities used in these two models are similar.
types of effects can be considered.
Supply-side effects also depend on whether the modeling
Demand-Side Effects
takes place in a closed or open economy (with trade and
Short-run demand-side (often termed Keynesian) effects
capital flows). If the economy is open, the effect depends
result from employing additional resources in an
on how substitutable capital is internationally.
underemployed economy. They tend to increase output for
https://crsreports.congress.gov

Key Issues in Tax Reform: Dynamic Scoring
Dynamic models cannot account for demand-side effects,
23% for the individual rate cut, 21% for the corporate rate
and those with perfect foresight cannot allow for crowding
cut, and 15% for the increase in the personal exemption
out discussed below (or at least cannot allow for indefinite
increase.
and growing crowding out). If a tax revision cuts taxes and
results in a deficit (and thus a growing debt), the simulation
Current Tax Reform Proposals
of a tax cut model must be accompanied by some other
The House-passed version of the tax proposal (H.R. 1) was
policy to stabilize the debt. The projected effects of the
estimated to cost $1.436 trillion from FY2018 to FY2027.
model on growth depend on the nature of the accompanying
The JCT estimated a cost, after macroeconomic effects, of
policy and when it happens. For example, if a tax cut is in
$1.001 trillion, with $55 billion due to additional interest,
each period offset by a lump-sum payment, it will negate
indicating a feedback effect of 34%. JCT projected an
the contractionary income effects from the tax cut and
average increase in GDP of 0.7% (not an annual growth
cause a larger growth effect; an offset for government
rate but an average change in level). Two estimates were
spending that does not affect individual choice will not.
prepared by outside groups. The Urban-Brookings Tax
Crowding-out effects can, however, still occur, if the
Policy Center (TPC), using a model similar to that used by
stabilizing measure is in the future.
JCT in 2005, found a feedback effect of 10%. Its model
projected average GDP growth of 0.4%. The University of
Crowding-Out Effects
Pennsylvania’s Wharton School, using a life-cycle model,
If a tax change reduces revenues, the deficit must be
found feedback effects from 8% to 20%. Including the
financed by borrowing, which reduces funds available for
interest costs from debt, the total effect on the deficit
investment. The magnitude of this crowding-out effect
exceeded the static revenue cost. Wharton projected growth
depends on how open the economy is. If some of the deficit
of between 0.4% and 0.8%. For both models, eventually the
can be financed by borrowing from abroad, less investment
economy would contract due to crowding out.
will be crowed out. The crowding-out effect grows
continually, unlike demand-side effects that are transitory
The Senate bill was estimated to cost $1.414 trillion before
or supply-side effects that reach a steady state level. Any
macroeconomic effects. To address budget rules, some
growing level of debt will eventually contract the economy.
individual provisions of the bill expire after 2025. The JCT
estimated a cost after feedback of $1.007 trillion to the debt,
Variations in Effects
with about $50 billion due to additional interest costs, a
A revenue-neutral tax reform would not have crowding-out
revenue feedback effect of 32%. The economy was
effects, but it could have demand-side effects if it cut taxes
projected to grow by 0.8%. The analysis suggested that
of lower-income households likely to spend and increased
demand-side effects would be largely offset by the Federal
taxes on corporations and higher-income individuals less
Reserve because the economy is at full employment. The
likely to spend. It would have supply-side effects if it
TPC estimated average GDP growth of 0.5% and a
lowered marginal tax rates on wages or returns to capital.
feedback of 13%, whereas Wharton projected growth of
0.5% to 1% and a feedback of 13% to 26%.
When the JCT was providing advisory estimates, it
performed sensitivity analysis that isolated various effects.
The JCT estimated a $1.456 trillion loss before
For example, in its in-house model simulation of the 2014
macroeconomic effects for the bill as enacted (P.L. 115-97),
tax reform proposal of the then-chairman of the Ways and
costing $1.071 trillion after feedback and adding $66 billion
Means Committee, most of the effect in the budget window
in interest payments. Average growth was 0.7%.
was due to demand-side effects. In the first 10 years, the
economy grew by 0.1% to 0.2% (depending on the labor
The JCT feedback effect is higher than the TPC and
supply elasticity used). When demand-side effects were
Wharton models and the JCT 2005 results. The larger effect
added, the growth rate was 0.4% to 0.5%. (JCT,
in the JCT estimate appears to reflect, in part, the reliance
“Macroeconomic Analysis of the Tax Reform Act of 2014,”
on life-cycle and infinite-horizon models, which tend to
JCX-22-14, February 26, 2014.)
produce larger effects, for 60% of the input into the
estimate. They also reflect shifts of capital from abroad.
In 2005, the JCT analyzed the effect of a tax cut of
The effects also reflect the temporary expensing for
$500 billion over 10 years in the form of an individual rate
equipment for the first five years in the proposal, which
cut, a corporate rate cut or an increase in the personal
shifts investment into the present in these models (also an
exemption. The estimates basically showed that the
issue in the Wharton model) and, in the Senate bill, the
demand-side effects dominated the effects in the short run
expiration of the individual tax cuts, causing an
and in the budget window, whereas in the long run
intertemporal shift in labor supply into the period when the
crowding out eventually led to a negative growth effect if
tax cuts are in place. The result is a more rapid growth than
crowding out is allowed. (JCT, Macroeconomic Analysis of
would be the case with permanent provisions.
Various Proposals to Provide $500 billion in Tax Relief,
JCX-4-05, March 1, 2005.)
This In Focus is part of a series of short CRS Products on
tax reform. For more information, visit the “Taxes, Budget,
In the first 10 years, without demand-side effects, the
& the Economy” Issue Area page at www.crs.gov.
reduction in revenue loss due to dynamic effects was 8% to
10% for the individual rate cut, 13% for the corporate rate
Jane G. Gravelle, Senior Specialist in Economic Policy
cut, and 0.5% for the personal exemption. With the
demand-side effects as well, the feedback effect was 22% to
IF10632
https://crsreports.congress.gov

Key Issues in Tax Reform: Dynamic Scoring

Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff to
congressional committees and Members of Congress. It operates solely at the behest of and under the direction of Congress.
Information in a CRS Report should not be relied upon for purposes other than public understanding of information that has
been provided by CRS to Members of Congress in connection with CRS’s institutional role. CRS Reports, as a work of the
United States Government, are not subject to copyright protection in the United States. Any CRS Report may be
reproduced and distributed in its entirety without permission from CRS. However, as a CRS Report may include
copyrighted images or material from a third party, you may need to obtain the permission of the copyright holder if you
wish to copy or otherwise use copyrighted material.

https://crsreports.congress.gov | IF10632 · VERSION 7 · UPDATED