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The Congressional Budget Office (CBO) and the Joint Committee on Taxation (JCT) recently published macroeconomic (dynamic) analyses of extending the individual provisions of the TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
Cuts and Jobs Act (TCJA), which are due to expire at the end of 2025. The analysis provides key insights into how their models work and the sort of outputs we can expect from their models as part of next year’s tax debate.
JCT finds permanently extending the TCJA individual provisions would provide a measurable boost to the economy, similar in magnitude to what we find in our modeling. In contrast, CBO finds the pro-growth aspects of extending the TCJA would be largely offset by increased deficits “crowding out” private investment.
JCT’s Three Macro Models
JCT first describes the tax calculators used to generate revenue estimates and marginal tax rates, which feed into their macro models used to estimate economic and dynamic revenue impacts. For several years, JCT has maintained three macro models:
- Macroeconomic Equilibrium Growth Model (MEG)
- Overlapping Generations Model (OLG)
- Dynamic Stochastic General Equilibrium Model (DSGE)
In 2018, JCT described some of the differences between the models but noted each uses a neoclassical framework to estimate output as a function of after-tax returns to capital and labor—a core feature of our model as well. JCT uses these models to “get a better idea of the range of possible modeling outcomes, as well as to explore the sensitivity of results to modeling frameworks and parameter assumptions.”
In JCT’s recent release, they note a few of the improvements made to the models since 2017, including updating the MEG model’s monetary policy reaction, enhancing the OLG model’s household heterogeneity, and adding a partially open economy assumption in its DSGE model (allowing foreign investors to purchase new federal debt issuances).
JCT estimates that extending the TCJA individual provisions would reduce revenue by $3.4 trillion from 2025 to 2034, conventionally measured (without accounting for macroeconomic changes) against current law that allows the tax cuts to expire. About two-thirds of this tax cut is from extending the current tax rates and brackets. We find very similar results; our total conventional revenue estimate for extending the TCJA individual provisions is within 1 percent of JCT’s.
Running this tax change through their macro models, JCT finds a range of impacts on GDP over the 2025-2034 budget window, from 0.2 percent in the case of the MEG model to 0.9 percent in the case of the DSGE model (the latter from 2030 to 2034). We find similar effects in the middle of this range. Specifically, we estimate an initial GDP boost of 0.7 percent in 2026 that falls to 0.6 percent by the end of the budget window, which is driven by lower tax rates increasing labor supply offset over time by less capital formation mainly because of the cap on state and local tax deductions.
Current budget rules (which could be changed in the new Congress) require a point estimate of the macroeconomic effects of major tax legislation. This means JCT will need to average the results of their models together, potentially choosing to weight the models differently depending on “the specific strengths and weaknesses of each model concerning the proposal being analyzed.”
Weighting the results equally, JCT finds an average GDP gain of 0.5 percent over the budget window. This leads to a dynamic revenue feedback estimate of $372 billion, reducing the cost of extending the TCJA individual provisions to $3.0 trillion over the budget window. This is within 1 percent of our dynamic revenue estimate. While JCT estimates economic growth reduces the cost of TCJA extension by 11 percent; we estimate economic growth reduces the cost by 12.5 percent.
CBO’s Crowd-Out Effect
CBO analyzed the same policy from the perspective of how it would impact CBO’s baseline economic forecast, noting it is JCT’s responsibility to officially score tax legislation. Nonetheless, it is instructive to see how the model results differ.
The main difference is CBO assumes a much larger crowd-out effect from deficits: the effect is so large that it offsets all of TCJA’s pro-growth impacts by the end of the budget window. CBO finds extending the TCJA individual provisions would boost GDP by about 0.3 percent in the first few years, mainly by lowering marginal tax rates on labor and increasing aggregate demand, but this is offset by a crowd-out effect that grows to about a 0.4 percent reduction in GDP by 2034.
However, CBO’s published work in this area indicates studies come to differing conclusions about the size of crowd-out effects with many estimates pointing to small or negligible crowd-out effects particularly in the case of tax cuts.
In a working paper from 2014, CBO describes crowd-out effects as follows: “Increases in federal budget deficits affect the economy in the long run by reducing national saving (the total amount of saving by households, businesses, and governments) and hence the funds that are available for private investment in productive capital. Deficits thus ‘crowd out’ private domestic investment in the long run. . . . The amount of crowding out caused by an increase in the federal budget deficit depends on the magnitude of the resulting increases in private saving and in net inflows of foreign capital (foreign purchases of U.S. assets minus U.S. purchases of foreign assets).”
In the same paper, CBO provides a review of eight empirical studies, finding as a central estimate that for each dollar that the federal deficit increases, domestic private investment falls by 33 cents. However, noting a “high degree of uncertainty,” CBO offers a small estimate of 15 cents and a large estimate of 50 cents per dollar of deficit increase.
The studies CBO reviews find a wide range of effects, with about half the studies finding zero or small crowd-out effects particularly in the case of tax cuts, and the other half of studies finding more substantial crowd-out effects particularly in the case of spending increases.
Two of the studies cited by CBO find approximately zero crowd-out effects due to the combination of increases in private saving and net inflows of foreign capital.
Two other studies cited by CBO focus on private saving responses to tax and spending changes separately, finding small or zero crowd-out effects in the case of tax cuts but large crowd-out effects in the case of spending increases. Specifically, one study finds that 50 to 97 percent of the crowd-out effect is offset by increases in private saving in the case of tax cuts, versus about a 10 to 50 percent offset in the case of spending increases. Another study finds tax changes are “almost fully offset” by private saving responses, versus about one-third to one-half offset in the case of spending changes.
Evidently, CBO has not updated its estimates of crowd-out effects to account for more recent studies, including one that finds evidence of “crowd in” of private investment in the case of reduced capital income taxes or increased government investment.
CBO has used these estimates to analyze, for instance, the impact of increased federal investment, finding that if the spending is deficit-financed, the crowd-out effect is sufficiently large that by the end of the budget window, it can fully offset any positive effects on GDP. Further, CBO finds that the negative impacts of federal borrowing are still greater for GNP (a measure of US income that accounts for cross-border ownership of assets), due to increases in interest payments to foreign owners of the debt.
In another study from 2022, CBO found that changes to spending and taxes have differing effects on the economy and debt burden such that stabilizing the debt-to-GDP ratio via reductions in government benefit payments (mostly Social Security, Medicare, and Medicaid) leads to stabilization at a lower level of debt as compared to increases in income taxes.
These studies indicate CBO’s modeling reflects a substantial negative incentive effect of income taxes but does not apparently include any differential effect on crowd-out of deficits caused by changes in taxes versus spending.
Our research casts doubt on assuming a large crowd-out effect in modeling tax policy changes, and instead finds a strong theoretical and empirical basis for distinguishing the impacts of different types of tax and spending changes. Specifically, crowd-out effects should be small to negligible for pro-growth income tax cuts, since this boosts private saving directly by increasing private income and indirectly by improving incentives to save. This is especially so for cuts to business income taxes, since these are generally more pro-growth than cuts to individual income taxes. In contrast, crowd-out effects should be large for spending increases that are not pro-growth, such as government consumption.
Additionally, crowd-out effects are generally diminished by the fact that the US is an open economy with deep financial markets connected to savers worldwide, and foreigners historically represent a large share of the worldwide demand for Treasury debt. Foreign demand for Treasury debt and other US assets, including shares in US businesses, increases for tax (or other) changes that are relatively pro-growth, potentially offsetting a large portion of the crowd-out effect for these changes.
Under an open economy, deficits would have a small impact on GDP. However, they would have a large impact on GNP due to increased interest payments to foreign owners of Treasury debt, similar to CBO’s results.
There are many reasons to be concerned about the federal government’s fiscal trajectory. It is unsustainable and must eventually be reckoned with, ideally sooner rather than later. However, studies of crowd-out effects as well as of fiscal consolidation episodes throughout the world indicate debt reduction is most effectively accomplished primarily by spending adjustments that do relatively little damage to the economy. This evidence indicates lawmakers should pursue pro-growth tax cuts next year offset by spending reforms, including reductions in what is effectively spending through the tax code via tax credits and other preferences.
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