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Dynamic Analysis, Welfare, and Implications for Tax Reform Jason Furman Chairman, Council of Economic Advisers National Bureau of Economic Research Tax Policy and the Economy Conference Washington, DC September 22, 2016 Dynamic Analysis is Not Welfare Analysis: Efficiency Issues Illustrative Welfare Analysis of a Reduction in Labor Taxes (Assuming a Representative Worker to Whom Tax Revenues Are Rebated Lump Sum) Baseline (30% Labor Tax) Social Benefit (Change in Output) Hourly Wage Hours Worked per Week Output per Week Change in Output Social Cost (Change in Value of Leisure) Hourly Value of Leisure Leisure Hours per Week Value of Leisure per Week Change in Value of Leisure Net Social Benefits Alternative (20% Labor Tax) 20 40 800 20 45 900 100 15 80 1,200 15 75 1,125 -75 25 Source: CEA calculations. 1 Dynamic Analysis is Not Welfare Analysis: Distributional Issues Illustrative Welfare Analysis of Changes in the Distribution of Income Individual Incomes Person 1 Person 2 Person 3 Aggregate Welfare Mean Income Mean Log Income Mean CRRA Transformation of Income with θ = 21 Percent Change Baseline Alternative 100 200 10,000 85 195 10,500 -15.0 -2.5 5.0 3,433 6.37 0.99 3,593 6.32 0.99 4.7 -0.7 -0.1 Source: CEA calculations. 1 CRRA refers to the constant relative risk aversion functional form: (y^(1-θ)-1)/(1-θ). 2 An Illustrative Application: Replacing Labor Taxes with Lump-Sum Taxes • Baseline policy is proportional 25% income tax, no exemptions • Policy change cuts labor income tax to 22.5% and collects a $900 per family lump-sum tax • Aggregate economic impacts based on Mankiw-Weinzierl Ramsey model and parameters • Microsimulation using 2010 IRS Public Use File 3 Representative Agent Results • Before-tax income up 1% • Consumption-equivalent utility up 0.5% • Taxes unchanged, but a 12% dynamic offset 4 Distributional Results Economic Effects of Shifting from a Hypothetical 25% Proportional Income Tax to a 22.5% Labor Income Tax, 25% Capital Income Tax, and $900 Lump-Sum Tax Income Class Bottom Quintile Second Quintile Middle Quintile Fourth Quintile Top Quintile All Percent of Families Static Percent Change in Tax Income Without Financing Dynamic After- With Financing Percent Change Percent Change in Pre-Tax in After-Tax Income Income Percent Change in Utility (Consumption Equivalent)1 20.0 20.0 20.0 20.0 20.0 2.9 2.7 2.5 2.4 2.3 -12.3 -3.2 -0.9 0.3 1.4 1.0 0.9 0.8 0.8 0.9 -11.4 -2.3 -0.1 1.1 2.3 -22.4 -2.9 -0.6 0.7 1.8 100.0 2.3 0.3 0.9 1.1 -4.7 Source: CEA calculations. Note: Aggregate economic impacts are computed using the macroeconomic model of Mankiw and Weinzierl (2004, 2006). Values for individual families are assumed to change by the same percentage as the aggregate values. The distribution of income is derived from the 2010 IRS Statistics of Income Public Use File. See text for additional details. 1 At the family level, the consumption equivalent utility increase is the percent change in consumption (assuming labor supply remains unchanged at the baseline level) that would yield the utility level realized in the alternative policy scenario. Percent change for an income class is the simple average of the percent change across families. Utility is computed as log(after-tax income) - n^(1+1/σ), where n is the value of labor supply generated by the Mankiw-Weinzierl model (assuming an isoelastic specification of labor disutility). 5 Winners/Losers Analysis Economic Effects of Shifting from a Hypothetical 25% Proportional Income Tax to a 22.5% Labor Income Tax, 25% Capital Income Tax, and $900 Lump-Sum Tax Percent with Increase Percent with Decrease Static After-Tax Income 36.3 63.7 Dynamic Taxes Pre-Tax Income Leisure After-Tax Income Utility1 67.3 96.4 0.0 46.2 40.8 32.7 0.0 87.7 53.8 59.2 Source: CEA calculations. Note: Aggregate economic impacts are computed using the macroeconomic model of Mankiw and Weinzierl (2004, 2006). Values for individual families are assumed to change by the same percentage as the aggregate values. The distribution of income is derived from the 2010 IRS Statistics of Income Public Use File. See text for additional details. 1 Utility is computed as log(after-tax income) - n^(1+1/σ), where n is the value of labor supply generated by the Mankiw-Weinzierl model (assuming an isoelastic specification of labor disutility). 6 Aggregate Presentation Economic Effects of Shifting from a Hypothetical 25% Proportional Income Tax to a 22.5% Labor Income Tax, 25% Capital Income Tax, and $900 Lump-Sum Tax Baseline (25% Flat Tax) Income Mean Pre-Tax Income Mean After-Tax Income Log After-Tax Income Welfare Mean Consumption Equivalent Utility Increase1 Mean Utility Mean Log of (Utility + 1) Mean CRRA Transformation of (Utility + 1) with θ = 22 Alternative (22.5% Labor Tax + $900 Lump Sum) 63,122 50,221 10.2 63,690 50,788 10.1 10.00 2.39 0.91 9.89 2.36 0.90 Percent Change 0.9 1.1 -1.0 -4.7 Source: CEA calculations. Note: Aggregate economic impacts are computed using the macroeconomic model of Mankiw and Weinzierl (2004, 2006). Values for individual families are assumed to change by the same percentage as the aggregate values. The distribution of income is derived from the 2010 IRS Statistics of Income Public Use File. Utility is computed as log(after-tax income) - n^(1+1/σ), where n is the value of labor supply generated by the Mankiw-Weinzierl model (assuming an isoelastic specification of labor disutility). See text for additional details. 1 At the family level, the consumption equivalent utility increase is the percent change in consumption (assuming labor supply remains unchanged at the baseline level) that would yield the utility level realized in the alternative policy scenario. 2 CRRA refers to the constant relative risk aversion functional form: (u^(1-θ)-1)/(1-θ). 7 Implications for Real Tax Reform: Growth Select Estimates of the Effect of Tax Reform on the Level of Output Source Policy Change Treasury (2006b) President's Advisory Panel on Tax Reform Simplified Income Tax Growth and Investment Tax Progressive Consumption Tax Treasury (2006a) Altig et al. (2001) Short-Run 0.0 - 0.4 0.1 - 1.9 0.2 - 2.3 Long-Run 0.2 - 0.9 1.4 - 4.8 1.9 - 6.0 Permanent Extension of the 2001/2003 Tax Cuts Financed with Future Spending Cuts Financed with Future Tax Increases 0.5 0.8 0.7 (0.9) Stylized Revenue-Neutral Tax Reforms Proportional Consumption Tax Flat Tax with Transition Relief 6.3 0.5 9.4 1.9 n.r. = Not reported. Red indicates negative values. Note: Output measure is (in order of preference if multiple measures are reported) national income, real gross national product, and real gross domestic product. Time period for short-run effects varies across studies, but (in most cases) is an average over several years in the first decade. Long-run effects typically reflect estimates of the change in the steady state level of output. 8 Implications for Real Tax Reform: Distribution Change in After-Tax Income due to Changes in Average Tax Rates by Income Percentile, 1986 to 2013 Income Percentile 0-20 20-40 40-60 60-80 80-90 90-95 95-99 99-100 Net of Tax Rate, Net of Tax Rate, Percent Change 1986 2013 90.7 85.5 81.9 79.4 77.2 76.5 76.3 75.3 96.7 91.6 87.2 83.0 79.3 77.0 73.7 66.0 6.6 7.1 6.5 4.5 2.7 0.7 -3.4 -12.4 Source: CBO (2016); CEA calculations. Note: Net of tax rate is 100 minus the average tax rate. Change in after-tax income due to changes in average tax rate is the percent change in the net of tax rate. 9 Conclusion 1. Growth is not the same as welfare. 2. Many tax reforms generate their growth effects through reductions in the consumption of non-market goods (e.g., leisure) or through tax increases on more moderate-income workers. 3. When analyzing a change in tax policy, the traditional, static distribution table is often the most useful information for evaluating its welfare impacts. 10 Dynamic Analysis, Welfare, and Implications for Tax Reform Jason Furman Chairman, Council of Economic Advisers National Bureau of Economic Research Tax Policy and the Economy Conference Washington, DC September 22, 2016