September 6, 1978
Page 27985
Mr. HATHAWAY. My question to the chairman is this: What provision is made for the feedback effect of capital gains in the second resolution?
Mr. MUSKIE. May I say to my colleague that the second resolution contains no specific assumption with respect to capital gains legislation. The resolution does assume $1.2 billion of reductions as an allowance for structural tax changes which could encompass capital gains reductions. However, this allowance of $1.2 billion does not assume any specific level of capital gains changes, nor does it assume any specific behavioral responses of capital gains tax reductions. At this time there is certainly no consensus as to the behavioral feedback effects of recently discussed capital gains tax law changes. I understand the Congressional Budget Office is preparing a study of the revenue effects of such changes, and that the report will be completed by the end of next week prior to Senate consideration of the forthcoming tax bill. Only after I have studied the CBO analysis, and after specific capital gains changes have been reported by the Finance Committee, will I be prepared to give the Senator my view as to the budgetary effects of these capital gains reductions.
In contrast to the still unclear behavioral effects of capital gains changes, the second budget resolution does include additional receipts resulting from the impact of the overall level of reductions assumed in the resolution. These additional receipts from the increased general economic activity resulting from the tax reductions would be derived from either capital gains reductions or general rate reductions that would reduce tax collections directly in fiscal year 1979. Thus, the macroeconomic effects of possible capital gains reductions, as contrasted to the behavioral effects, already are taken into account in the second resolution.
Mr. HATHAWAY. If the Senator will yield further, I am extremely concerned that if we begin making second and third round assumptions about fiscal impact of tax changes then we might as well scrap the budget process.
If we say, "Well, whatever you assume, is the effect, is fine," then I believe we have lost control.
The present revenue estimating is imperfect and imprecise but it is at least consistent. We should not project results on assumed behavior change over time unless there is strong evidence of the results on a gross basis.
In his testimony before the Senate Finance Committee, 2 weeks ago, Secretary Blumenthal discussed feedback effects and revenue estimated. He stated:
Treasury policy to include multiplier effects when overall positions of fiscal policy are being established, as described earlier, is consistent with excluding multiplier effects when alternative programs are being considered that do not markedly alter the desired fiscal posture. The assumption is made that each separate tax proposal being considered is designed to be incorporated into a comprehensive package of proposals, with net tax reductions consistent with the overall fiscal policy. In this framework, it is clearly incorrect to include offsetting multiplier effects in revenue estimates for individual tax proposals. This is because the budget receipt estimates already include the feedback effect of the aggregate change in taxes. To again include feedback effects, as each component of an overall tax package is being considered, would be to double count induced revenue changes and misguide policymakers as to the size of the budget deficit or surplus.
I ask unanimous consent that his full remarks be printed in the RECORD.
There being no objection, the testimony was ordered to be printed in the RECORD, as follows:
APPENDIX: FEEDBACK EFFECTS AND REVENUE ESTIMATION
The term "revenue feedback effect" refers to the fact that the actual change in revenues resulting from a tax revision will depend upon economic responses to that revision. There is general agreement that such feedback effects can be important. To understand more clearly the implications of feedback effects for revenue and receipts estimation, it is useful to separate economic responses into three types.
First, there are short-run responses to changes in spendable income that results from tax increases or reductions. A tax cut, for example, will raise the amounts of after-tax income available to households and to business firms. If there is sufficient additional capacity, higher after-tax incomes will lead to increased consumption and investment which in turn will generate higher incomes and higher revenues. A number of standard macro-economic forecasting models are usually employed to estimate the magnitude of these short-run income effects.
A second type of feedback effect deals with long-run factor-supply responses to tax changes. Taxes alter the after-tax returns for work effort and for saving and thus will influence the supply of labor and capital offered to the market. The size of the capital stock and labor force will in the long run determine economic capacity and, therefore, the income base potentially available for future revenues.
The third type of feedback effect is the behavioral response to price increases or decreases brought about by tax changes. As tax changes alter relative prices, households and business firms tend to shift patterns of consumption and investment away from those activities that have increases in price or cost toward those that have decreases. That is, taxpayers will move into activities which have been granted a tax benefit and away from activities which have lost such a benefit. The result influences the allocation or composition of economic activity and also the volume of Federal revenues.
Therefore, to estimate all potential revenue feedbacks requires determination of (1) the increase or reduction in spending due to changes in income, (2) the changes in economic capacity due to changes in the supply of labor and capital, and (3) the substitution of lower cost for higher cost activities. In general, estimating procedures currently used by the Treasury do incorporate such feedback effects. Budget receipts for each fiscal year include the impact of tax changes on aggregate demand. Longer-run receipt projections allow for the likelihood of tax-induced changes in the capacity of the economy. Furthermore, whenever it is reasonable to do so, the allocation effects of price changes resulting from tax revisions are incorporated into revenue estimates. Each of the three types of feedbacks is discussed in more detail below.
MACRO-ECONOMIC RESPONSES
According to the macro-economic models, tax law changes which reduce government revenues will, over time, increase demand, resulting in higher GNP, personal incomes and corporate profits and higher tax receipts. Consequently, estimates which do not take into account these short-run multiplier effects tend to overstate revenue losses resulting from proposals which reduce tax rates or narrow the tax base and overstate revenue increases resulting from proposals to raise taxes. Treasury estimates are alleged to suffer from this defect.
However, this criticism is based on a misunderstanding of the longstanding Treasury practice to provide two types of revenue estimates for proposed changes in tax law. The first type of estimate is made for the complete program of tax changes in the President's budget. Feedback effects on incomes and tax receipts resulting from short-run multiplier effects are always incorporated in these figures to show the actual impact of the President's program on the economy.
For example, Treasury estimates of total tax receipts during the 1963–1968 period incorporated such feedback effects. The stimulative effects of the Kennedy tax cut along with anticipated growth in the population, the labor force, prices and productivity were more than enough to fully offset the reduced revenues resulting directly from lower income tax rates. While total receipts were projected to rise over this period, it is generally agreed that the 1964 tax cut by itself, could not have induced an economic response sufficient to restore the initial revenue loss. The figures in Table 1 demonstrate that Treasury anticipated the feedback revenues. The estimating errors taken from the annual budget documents for that period ran about 4½ percent, far too close to the mark for estimates which did not accurately include short-run feedback effects.
In the context of the current tax debate, Table 2 illustrates the impact on receipts of short-run multiplier effects resulting from the President's proposed $20 billion tax reduction program. The Mid-session Review of the 1979 Budget shows estimated unified budget receipts of $448.2 billion in 1979 and $507.3 billion in 1980. These figures include proposed tax reductions of $14.1 billion and $21.8 billion, respectively. However, in the absence of these proposed tax reductions, revenues are estimated to be $459.3 billion in 1979 and $521.1 billion in 1980. Thus, the net cost to the Treasury of the President's proposed program is $11.1 billion in 1979 and $13.8 billion in 1980. These net tax program figures include $3 billion and $8 billion of offsetting revenues attributed to short-run multiplier effects. These feedback revenues are included in the receipt totals but are not separately identified in the published Mid-session Budget Review.
The estimation of multiplier effects requires making a number of critical assumptions, including actions the Federal Reserve may take to adjust the money supply and interest rates. These assumptions can influence the multiplier effects on the economy and the resulting revenue feedback. However, there are no plausible assumptions under which induced feedback effects from tax cuts will lead to an increase in tax receipts over what they otherwise would have been. In fact, none of the macro-economic models of the United States economy predict revenue feedback sufficient to offset the initial revenue loss.
The second kind of estimate made by Treasury involves the revenue change from specific proposals without feedback effects (except to the extent Treasury is able to estimate price effects as described below). This kind of estimate is also appropriate for the kind of policy questions which may arise. For example, great attention is focused on the distribution of tax changes among taxpayers at different income levels. For distributional analysis policymakers should look at the direct impact on taxpayers engaged in a particular activity, such as paying private school tuition, or on those receiving a particular source of income, such as capital gains.
In contrast to the tax side of the Budget, there is general agreement that feedback effects are not appropriate for the expenditure side of the budget. Congressional decisions concerning the expenditure side of the budget are also properly made on the basis of gross expenditures. We should not estimate, for example, that a dam, highway, harbor, or even aircraft carrier costs only 60 percent of its initial outlay on the argument that the Federal government recoups the rest in the form of higher revenues. A dollar of outlay costs a dollar in resources used up and a dollar of tax reduction releases a dollar for use in the private sector. The macro-economic feedback effects of both of these changes are important, but it is also important, to evaluate the initial impacts correctly.
Treasury policy to include multiplier effects when overall positions of fiscal policy are being established, as described earlier, is consistent with excluding multiplier effects when alternative programs are being considered that do not markedly alter the desired fiscal posture. The assumption is made that each separate tax proposal being considered is designed to be incorporated into a comprehensive package of proposals, with net tax reductions consistent with the overall fiscal policy. In this framework, it is clearly incorrect to include offsetting multiplier effects in the revenue estimates for individual tax proposals. This is because the budget receipt estimates already include the feedback effect of the aggregate change in taxes. To again include feedback effects, as each component of an overall tax package is being considered, would be to double the count induced revenue changes and misguide policy makers as to the size of the budget deficit or surplus.
CAPACITY RESPONSES
Much attention has recently been focused on the potential for increasing economic capacity by reducing rates of tax. Since income taxes necessarily reduce the reward from additional work effort or from adding to savings or investment, reductions in rates of income taxes — especially reductions of the highest marginal rates — would increase significantly the aggregate amount of work effort and capital supplied in the economy. This increased work effort and larger capital stock would provide increased capacity to produce income that is subject to tax, offsetting at least some of the initial revenue lost by tax reduction.
The fundamental logic of this argument is sound, but there are a number of practical considerations that recommend against regularly reporting separate estimates of these aggregate capacity, or "supply side", effects of tax changes. There are presently no economic models that fully incorporate supply effects and that have also developed a track record over a period of years. In fact neither the magnitude nor the timing of such effects is well known and there is consequently wide professional disagreement about their importance. For example, some advocates of the Roth-Kemp tax reductions claim that induced supply responses would be so large that general rate reductions would bring about higher revenues than would occur without them. Some of these advocates argue that the responses would be so rapid that revenue increases from induced supply would occur in the first year. Other analysts, including those who have developed the well-known econometric forecasting models, predict that in the first few years following a tax change, there will be no significant increases in economic capacity resulting from higher wages or increased returns to saving.
In the case of induced labor supply even the direction of change is at issue. Historically, there has been a tendency, as incomes have increased, for the average worker to work shorter hours and to retire at an earlier age. When taxes on labor income are reduced, the positive response to higher after-tax earnings will be offset, perhaps completely, by this tendency to take some of the increased potential earnings in the form of increased leisure.
The greatest weight of professional opinion is that increased capacity in response to reduced tax rates will take effect much more slowly than the demand effects induced by higher incomes. Any tendency for labor supply to respond to increases in after-tax wages will be translated into increased economic capacity only over a period of years. In part, this is because it takes time for households to adjust — to seek out a second job, to arrange for child care, to take more schooling, and the like. More important, however, is that it takes time for businesses to make the additional investment necessary to accommodate the increased labor supply.
Nevertheless, these long-run supply effects are very important since they will help to determine the underlying growth and composition of employment and output in the future. Significant supply side factors are not ignored in deriving the long range receipts projections that are included in the budget. These projections show the path of Federal receipts through time that are consistent with attainable increases in capacity and aggregate demand.
The Treasury has been devoting substantial resources to understanding and estimating supply effects. We also closely monitor new research in this area. Analysis of the longer-run implications of tax policy will build upon new research findings as they become available.
Price Effects
Tax policy changes have consequences for economic behavior other than their aggregate demand effects and supply side responses. A further important effect of tax policy changes is that they alter the relative prices or costs of particular types of consumption and investment goods. As a consequence, households and firms respond by changing their consumption and investment patterns. Not all tax changes have significant price effects. Changes in exemptions, the standard deduction, and even across-the-board cuts in tax rates do not bring about significant changes in relative prices. However, when such relative price effects do occur and when there is broad agreement as to both the magnitude and the direction of these impacts, revenue estimates incorporate the behavioral responses to the relative price changes. There are numerous examples of such behavioral responses. They include:
[Table omitted]
The taxable bond option, where it is assumed that some fraction of municipal debt will be issued on a taxable basis as a result of the lower interest costs of issuing subsidized taxable debt compared to the prevailing rate on tax-exempts.
The automobile efficiency tax, where consumers are assumed to modify their pattern of automobile purchases in response to the increased prices of gas-inefficient vehicles.
Residential and business thermal efficiency and solar tax credits, where the reduction in prices of the subsidized activities are assumed to induce households and firms to install more insulation and to use lower cost sources of energy.
Any new program such as subsidies for exports (DISC) or for new retirement programs (IRA) where the revenue estimate depends upon the extent to which the new provision will be used.
Integration of corporate and personal taxes, where an increase in corporate dividends would be expected to accompany the reduction in the combined level of personal and corporate taxes on these dividends.
In all of these cases, there may be disagreement over the magnitude of the behavioral responses. Nevertheless, a good faith effort is made to incorporate behavioral responses into the revenue estimates where the behavioral responses will obviously occur and they are believed to be substantial. But we do not try to estimate feedback effects where the predominant responses are unpredictable or where there is no objective basis for making a judgment.
Two specific cases of tax induced price changes are currently of particular interest. They are the cuts of capital gains taxes and the reduction of top marginal tax rates. It has been alleged in both cases that the price effects of the tax change will induce a flood of new revenues to the Treasury, outweighing the initial revenue loss. In the case of capital gains cuts, the claim is made that the increased realizations will be so large as to yield an increase in tax receipts on capital gains. In the case of a reduction in the top marginal tax rates, the switch of investment from sheltered to unsheltered activities along with a vast increase in work effort are the alleged sources of the higher tax receipts.
Claims have been made that solid empirical analysis underlies both behavioral responses. But these claims are greatly overstated. The empirical work to date concerning the response of gains realizations to changes in capital gains tax rates has not distinguished between short-run transitional effects and long-term effects. Further, if the results are interpreted as estimates of permanent long-run effects, they imply such enormous reductions in the average holding periods of assets as to be totally at variance with the observed historical stability of these holding periods. Also, the estimates assume that every investor has an unlimited amount of unrealized accrued gains just waiting to be realized at lower tax rates, an assumption surely contrary to the facts. Moreover, it may be very difficult to separate statistically the effect of the marginal tax rates from the effect of high itemized deductions for medical expenses or casualty losses. Higher realizations of capital gains may be due to high itemized deductions rather than to low marginal rates themselves.
Attempts to adduce the likely responses of high income taxpayers to reductions in their marginal tax rates by examining historical data for the years before and after the 1964 tax cut also are seriously deficient. While it may be true that at substantially lower marginal tax rates individuals would find tax shelters of much diminished economic advantage and would therefore tend to invest more in fully taxed assets, the likelihood and magnitude of such a response cannot be determined by merely looking at the income taxes paid by those in the upper income classes before and after the tax cuts of 1964. The upper income group did, in fact, pay more in taxes after their marginal rates were cut, but all income classes experienced tax cuts and all realized significant increases in incomes along with the general expansion of the economy in 1964-66. The share of before-tax income reported by the highest income classes was remarkably stable over the entire period from 1952 through 1972. In addition, it should be pointed out that most of the increased taxable income in these income groups was from higher realized capital gains. But the 1964 Revenue Act did not change the 25 percent alternative tax on capital gains. Thus while it may be desirable to reduce marginal tax rates to provide additional incentives to work and to save, there is little evidence for claiming large revenue gains to the Federal Treasury as a result of tax-induced price effects.
CONCLUSION
First, estimates of aggregate budget receipts do include the additional receipts resulting from the impact of tax changes on aggregate demand. However, estimates for particular tax changes, just like estimates for particular expenditure changes, do not include feedback effects. To do so when they are already in the aggregate estimates would be double counting.
Second, projections of long-run budgetary figures also accommodate the impacts of tax changes on economic capacity. As research sheds more light on the nature of these effects, it may be possible to incorporate them more formally into longer-run projections.
Third, Treasury does incorporate estimates of changes in specific types of investment or consumption induced by relative price changes whenever it appears the effects are important and it is possible to make reasonable estimates.
Mr. HATHAWAY. Mr. President, I am troubled by the idea that there is such a concept as a "free lunch." Of course, we know otherwise.
I hope that the Budget Committee and its excellent staff will review the Revenue Act of 1978 when reported by the Finance Committee in light of the mandate in section 311(b) of the Budget Act, and assure the Senate that the bill is in compliance with the second resolution or, if necessary, to challenge the assumptions and the revenue effects.
I say that as a member of the Finance Committee.
Mr. MUSKIE. I appreciate the Senator's concern and interest. He is, of course, correct, that under section 311 of the Budget Act, the Budget Committee has the responsibility to estimate the revenue effects of tax legislation to determine whether the legislation is consistent with the revenue floor in the concurrent budget resolution binding upon Congress. Thus, the views of the committee on the revenue effects of capital gains legislation and other provisions in the forthcoming tax bill could prove particularly important if, under some but not all, assumptions, the bill would be consistent with the second budget resolution revenue floor for fiscal year 1979.
I suspect that because of the interest in the issue the Senator has raised, and I know it has been discussed by the chairman of the Committee on Finance and others, we may well have that question raised at the time the Finance Committee bill comes before the Senate, and we shall try to be ready for it.
Mr. HATHAWAY. I thank the distinguished chairman for his answers to my questions and his assurance that such speculative revenue impacts will be challenged when the bill is brought to the floor.
Mr. MUSKIE. I thank my good friend.