Macroeconomic Effects of a 10% Cut in Statutory Marginal Income Tax Rates on Ordinary Income

By DeBacker, Jason; W. Evans, Richard et al. | AEI Paper & Studies, December 2015 | Go to article overview

Macroeconomic Effects of a 10% Cut in Statutory Marginal Income Tax Rates on Ordinary Income


DeBacker, Jason, W. Evans, Richard, L. Phillips, Kerk, AEI Paper & Studies


5 A 10% Reduction in Income Tax Rates

The policy change we consider is a reduction in the marginal statutory rates on individual filers ordinary income. The changes in tax policy are summaries in Table 4.

5.1 The Static Revenue Effects

Using the web application for the Tax-Calculator at www.ospc.org/TaxBrain, we calculate the revenue effects of the proposal to reduce the statutory marginal tax rate by 10% for each tax bracket. The static revenue effects as displaying on the Tax Brain webpage are about -$1.25 trillion over 10 years (2015-2024).

5.2 The Macroeconomic Effects

Table 6 displays the percentage changes in aggregate quantities and prices over the budget window and in the long-run steady state. These are computed through the DGE model described above, using the estimated tax functions for the baseline and policy tax parameters. The parameters of the estimated tax functions are given in Table 5.

6 Discussion

Qualitatively, the results of the macro model are consistent with economic theory. The reduction in marginal tax rates increases the incentives to work and save. We subsequently see increases aggregate hours worked and investment. As a result, both GDP and consumption increase. That the increases in the capital stock are larger than the increase in hours worked, means that the marginal product of capital falls, while the marginal product of labor rises. Given our assumption of a competitive production sector, this results in lower real interest rates and higher wages.

Total tax revenue decreases due to the lower tax rates, but the increase in aggregate income that results from the additional investment and labor supply offset the revenue losses to some extent. Consider that the static score suggests revenue losses on the order of 4% of total tax revenue. These losses are between 2% and 3% when accounting for the macroeconomic effects of the tax policy.

A few caveats about the limitations of the model are in order. Of first order importance in determining the macroeconomic effects of changes in tax policy are the assumptions about how such tax changes are financed. The DGE model used here has a simple balanced budget requirement for the government. This means that tax cuts, as we consider here, are financed by immediate reductions in the lump sum transfers the government makes to all households. The assumption is the most conducive to reductions in taxes providing positive macroeconomic effects. If these tax cuts were temporary and financed by future tax increases, the stimulative effects of such cuts would be substantially reduced.

Not considered in this model but also important in determining the macroeconomic effects of fiscal policy are the policy responses of the central bank. Implicit in the results presented here is that the central bank does not respond to fiscal policy. If, for example, the central bank responded by holding interest rates constant, the supply side effects would be smaller and their would be less of a change in the macroeconomic aggregates.

Finally, one should note that while the levels of the macroeconomic aggregates change in the steady state as a result of tax policy, that long run growth rates do not. These long run growth rates are governed by exogenous changes in population growth and factor productivity. Thus these long run growth rates, in this framework, are not dependent on tax policy.

References

Auerbach, Alan J. and Lawrence J. Kotlikoff, Dynamic Fiscal Policy, Cambridge University Press, 1987.

Census Bureau, "Annual Estimates of the Resident Population for Selected Age Groups by Sex for the United States, States, Counties, and Puerto Rico Commonwealth and Municipios: April 1, 2010 to July 1, 2013," Technical Report, U.S. Census Bureau, Population Division June 2014.

Center for Disease Control, "National Vital Statistics Reports," Technical Report, Center for Disease Control 2010. …

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