[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]



 
         MODELING THE ECONOMIC EFFECT OF CHANGES IN TAX POLICY
=======================================================================


                                HEARING

                               BEFORE THE

                       SUBCOMMITTEE ON OVERSIGHT

                                 of the

                      COMMITTEE ON WAYS AND MEANS
                        HOUSE OF REPRESENTATIVES

                      ONE HUNDRED SEVENTH CONGRESS

                             SECOND SESSION

                               __________

                              MAY 7, 2002

                               __________

                           Serial No. 107-78

                               __________

         Printed for the use of the Committee on Ways and Means












                       U. S. GOVERNMENT PRINTING OFFICE
82-290                          WASHINGTON : 2002
___________________________________________________________________________
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                      COMMITTEE ON WAYS AND MEANS

                   BILL THOMAS, California, Chairman

PHILIP M. CRANE, Illinois            CHARLES B. RANGEL, New York
E. CLAY SHAW, Jr., Florida           FORTNEY PETE STARK, California
NANCY L. JOHNSON, Connecticut        ROBERT T. MATSUI, California
AMO HOUGHTON, New York               WILLIAM J. COYNE, Pennsylvania
WALLY HERGER, California             SANDER M. LEVIN, Michigan
JIM McCRERY, Louisiana               BENJAMIN L. CARDIN, Maryland
DAVE CAMP, Michigan                  JIM McDERMOTT, Washington
JIM RAMSTAD, Minnesota               GERALD D. KLECZKA, Wisconsin
JIM NUSSLE, Iowa                     JOHN LEWIS, Georgia
SAM JOHNSON, Texas                   RICHARD E. NEAL, Massachusetts
JENNIFER DUNN, Washington            MICHAEL R. McNULTY, New York
MAC COLLINS, Georgia                 WILLIAM J. JEFFERSON, Louisiana
ROB PORTMAN, Ohio                    JOHN S. TANNER, Tennessee
PHIL ENGLISH, Pennsylvania           XAVIER BECERRA, California
WES WATKINS, Oklahoma                KAREN L. THURMAN, Florida
J.D. HAYWORTH, Arizona               LLOYD DOGGETT, Texas
JERRY WELLER, Illinois               EARL POMEROY, North Dakota
KENNY C. HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin

                     Allison Giles, Chief of Staff
                  Janice Mays, Minority Chief Counsel

                                 ______

                       Subcommittee on Oversight

                    AMO HOUGHTON, New York, Chairman

ROB PORTMAN, Ohio                    WILLIAM J. COYNE, Pennsylvania
JERRY WELLER, Illinois               MICHAEL R. McNULTY, New York
KENNY C. HULSHOF, Missouri           JOHN LEWIS, Georgia
SCOTT McINNIS, Colorado              KAREN L. THURMAN, Florida
MARK FOLEY, Florida                  EARL POMEROY, North Dakota
SAM JOHNSON, Texas
JENNIFER DUNN, Washington


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hearing records of the Committee on Ways and Means are also published 
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                            C O N T E N T S

                               __________
                                                                   Page
Advisory of April 30, 2002, announcing the hearing...............     2

                               WITNESSES

Council of Economic Advisers, Hon. R. Glenn Hubbard, Chairman....     5

                                 ______

Joint Committee on Taxation, Lindy L. Paull......................     9

                       SUBMISSION FOR THE RECORD

CONSAD Research Corporation, Pittsburgh, PA, Wilbur A. Steger, 
  and Frederick H. Reuter, statement and attachment..............    38













         MODELING THE ECONOMIC EFFECT OF CHANGES IN TAX POLICY

                              ----------                              


                          TUESDAY, MAY 7, 2002

                  House of Representatives,
                       Committee on Ways and Means,
                                 Subcommittee on Oversight,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 2:02 p.m., in 
room 1100 Longworth House Office Building, Hon. Amo Houghton 
(Chairman of the Subcommittee) presiding.
    [The advisory announcing the hearing follows:]

ADVISORY

FROM THE 
COMMITTEE
 ON WAYS 
AND 
MEANS

                       SUBCOMMITTEE ON OVERSIGHT

                                                Contact: (202) 225-7601
FOR IMMEDIATE RELEASE
April 30, 2002
No. OV-11

 Houghton Announces Hearing on Modeling the Economic Effect of Changes 
                             in Tax Policy

    Congressman Amo Houghton (R-NY), Chairman, Subcommittee on 
Oversight of the Committee on Ways and Means, today announced that the 
Subcommittee will hold a hearing on modeling the economic effect of 
changes in tax policy. The hearing will take place on Tuesday, May 7, 
2002, in the main Committee hearing room, 1100 Longworth House Office 
Building, beginning at 2:00 p.m.

    In view of the limited time available to hear witnesses, oral 
testimony at this hearing will be from invited witnesses only. 
Witnesses will include Lindy Paull, Chief of Staff of the Joint 
Committee on Taxation (JCT) and the Honorable R. Glenn Hubbard, 
Chairman of the Council of Economic Advisers. However, any individual 
or organization not scheduled for an oral appearance may submit a 
written statement for consideration by the Committee and for inclusion 
in the printed record of the hearing.

BACKGROUND:

    The JCT and the U.S. Department of the Treasury, Office of Tax 
Analysis (OTA), provide revenue estimates to inform policymakers' 
decisions on contemplated changes in tax policy. Prior to reporting a 
tax legislative measure to the U.S. House of Representatives, the 
Committee on Ways and Means must obtain a revenue estimate of each 
proposal.

    The JCT and OTA economists rely on sophisticated economic models 
and assumptions about future economic conditions to arrive at 
conclusions about the revenue effect of tax legislative proposals up to 
10 years into the future. The workings of these models and the nature 
of economists' assumptions are therefore important to understanding the 
tax legislative process. These offices generally rely on the work of 
the Congressional Budget Office or the Office of Management and Budget, 
as well.

    Some economists have argued that it would improve the accuracy of 
the estimating process if the JCT and OTA took into account certain 
macroeconomic effects that are likely to result from changes in tax 
rates on businesses and individuals. Others have argued that it would 
be too difficult to model these effects with an acceptable degree of 
accuracy.

    In announcing the hearing, Chairman Houghton stated: ``Looking into 
the future is next to impossible. However there are trends and economic 
roadmaps we can use to more scientifically tell us probabilities. To 
have an understanding of legislation one must use these methods. There 
is no alternative other than to fly blind.''

FOCUS OF THE HEARING:

    The Subcommittee will review the economic models and assumptions 
that are used for the current estimating process, and explore ways to 
improve overall forecasting and analysis regarding legislation before 
the Committee on Ways and Means and Congress.

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

    Please Note: Due to the change in House mail policy, any person or 
organization wishing to submit a written statement for the printed 
record of the hearing should send it electronically to 
[email protected], along with a fax copy to 
(202) 225-2610 by the close of business, Tuesday, May 21, 2002. Those 
filing written statements who wish to have their statements distributed 
to the press and interested public at the hearing should deliver their 
200 copies to the Subcommittee on Oversight in room 1136 Longworth 
House Office Building, in an open and searchable package 48 hours 
before the hearing. The U.S. Capitol Police will refuse sealed-packaged 
deliveries to all House Office Buildings.

FORMATTING REQUIREMENTS:

    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.

    1. Due to the change in House mail policy, all statements and any 
accompanying exhibits for printing must be submitted electronically to 
[email protected], along with a fax copy to 
(202) 225-2610, in Word Perfect or MS Word format and MUST NOT exceed a 
total of 10 pages including attachments. Witnesses are advised that the 
Committee will rely on electronic submissions for printing the official 
hearing record.

    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.

    3. Any statements must include a list of all clients, persons, or 
organizations on whose behalf the witness appears. A supplemental sheet 
must accompany each statement listing the name, company, address, 
telephone and fax numbers of each witness.

    Note: All Committee advisories and news releases are available on 
the World Wide Web at http://waysandmeans.house.gov.
      

    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call (202) 225-1721 or (202) 226-3411 TTD/TTY in advance of the event 
(four business days notice is requested). Questions with regard to 
special accommodation needs in general (including availability of 
Committee materials in alternative formats) may be directed to the 
Committee as noted above.

                                 

    Chairman HOUGHTON. Good afternoon, ladies and gentlemen.
    We are delighted to have you here, Ms. Paull, Mr. Hubbard.
    I would like to make a few comments, and then my associate, 
Mr. Coyne, will make his comments.
    As we all know, despite the fact that I used to be in the 
glass business, looking into a crystal ball is not the easiest 
thing in the world. However, there are trends and there are 
economic road maps we can use to more scientifically tell us 
the probabilities. So to have an understanding of legislation, 
you got to use all sorts of different methods. There is no 
alternative other than to just fly blind, and, of course, we 
don't want to do that.
    Certainly, it is not realistic to expect that tax revenue 
estimates will faithfully predict the precise outcome of every 
tax proposal. That is just not going to happen. It is 
understood that your estimates represent the best judgment of 
experienced tax professionals and economists on your staffs, 
and they are not crystal ball predictions of the future. 
Nevertheless, the methods that are used to arrive at these 
estimates fundamentally affect tax policy for all of us. It 
makes sense to use the best tools available to make the best 
possible predictions.
    So because of the importance of your predictions in forming 
tax policy, it is also important that the methods behind them 
are publicly disclosed to the fullest extent possible. I 
understand you have disclosed a great deal of information about 
the estimating process, and I want to specifically acknowledge 
your willingness to work with congressional staff to understand 
individual estimates where the need arises.
    So today we will hear from Ms. Paull--we are delighted to 
have you here--the Chief of Staff of the Joint Committee on 
Taxation. I don't think there is anyone in the city who 
understands these issues better than you, Ms. Paull. You may 
disagree with me, but I feel that very strongly.
    In addition, we are honored by the presence of Glenn 
Hubbard, the Chairman of the President's Council of Economic 
Advisers (CEA). Mr. Hubbard was the Chief Economist in charge 
of estimating tax proposals for the U.S. Department of the 
Treasury during the first Bush administration and is 
wonderfully qualified to address this issue.
    So, we are delighted that you are here, and I would like 
now to yield to Mr. Coyne.
    [The opening statement of Chairman Houghton follows:]
    Opening Statement of the Hon. Amo Houghton, a Representative in 
  Congress from the State of New York, and Chairman, Subcommittee on 
                               Oversight
    Looking into the future is next to impossible. However there are 
trends and economic roadmaps we can use to more scientifically tell us 
probabilities. To have an understanding of legislation one must use 
these methods. There is no alternative other than to fly blind.
    Certainly, it is not realistic to expect that the tax revenue 
estimates will faithfully predict the precise outcome of every tax 
proposal. It is understood that your estimates represent the best 
judgment of experienced tax professionals and economists; they are not 
crystal ball predictions of the future. Nevertheless, the methods that 
are used to arrive at these estimates fundamentally affect tax policy. 
It makes sense to use the best tools available to us to make the best 
possible predictions.
    Because of the importance of your predictions in forming tax 
policy, it is also important that the methods behind them be publicly 
disclosed to the fullest extent possible. I understand that you have 
disclosed a great deal of information about the estimating process, and 
I want to specifically acknowledge your willingness to work with 
Congressional staff to understand individual estimates where the need 
arises.
    Today we will hear from a familiar face, Lindy Paull, the Chief of 
Staff of the Joint Committee on Taxation. Although she is not an 
economist, by training, I doubt there is anyone in this city who 
understands this issue better than you, Ms. Paull. In addition, we are 
honored by the presence of Glenn Hubbard, the Chairman of the 
President's Council of Economic Advisors. Mr. Hubbard was the chief 
economist in charge of estimating tax proposals for the Treasury 
Department during the first Bush Administration, and he is eminently 
well qualified to address this issue.
    I am pleased to yield to our ranking Democrat, Mr. Coyne.

                                 

    Mr. COYNE. Well, thank you, Mr. Chairman, and thank you for 
holding these hearings today.
    Revenue estimates are prepared by the Joint Committee for 
tax bills approved by the Committee on Ways and Means. These 
revenue estimates measure the anticipated changes in Federal 
receipts that result from proposed legislative changes in the 
Internal Revenue Service (IRS) Code. This information is very 
important to the development of tax policy, as we all know.
    It has been suggested that in making revenue estimates the 
Joint Committee should take into account the projected 
macroeconomic effects that would result from a particular tax 
proposal. As we explore this issue today, I think we will find 
that the dynamic scoring may sound good in theory but that it 
would be extremely problematic in practice.
    I look forward to the testimony of the Chief of Staff of 
the Joint Committee on Taxation on this issue and also the 
views of the administration. I know that we all benefit from 
the in-depth understanding of the methodology used by the Joint 
Committee in creating the revenue estimates that the Committee 
uses in marking up tax bills.
    Thank you, Mr. Chairman.
    [The opening statement of Mr. Coyne follows:]
   Opening Statement of the Hon. William Coyne, a Representative in 
                Congress from the State of Pennsylvania
    Thank you, Mr. Chairman, for holding these hearings. Revenue 
estimates are prepared by the Joint Committee on Taxation for tax bills 
approved by the Committee on Ways and Means. These revenue estimates 
measure the anticipated changes in Federal receipts that result from 
proposed legislative changes to the Internal Revenue Code. This 
information is very important to our development of tax policy.
    It has been suggested that, in making revenue estimates, the JCT 
should take into account the projected macroeconomic effects that would 
result from a particular tax proposal.
    As we explore this issue today, I think we will find that 
``dynamic'' scoring may sound good in theory but that it would be 
extremely problematic in practice. I look forward to the testimony of 
the Chief of Staff of the Joint Committee on Taxation, Lindy Paull, on 
this issue and also the views of the Administration.
    I know that we all benefit from an in-depth understanding of the 
methodology used by the JCT in creating the revenue estimates that the 
Committee uses in marking-up tax bills. Thank you, Mr. Chairman.

                                 

    Chairman HOUGHTON. Thank you very much, Mr. Coyne. Well, 
now we will call our panel, Ms. Paull and Mr. Hubbard. Will Mr. 
Hubbard begin?

   STATEMENT OF HON. R. GLENN HUBBARD, CHAIRMAN, COUNCIL OF 
                       ECONOMIC ADVISERS

    Mr. HUBBARD. Sure. Thank you very much, Mr. Chairman.
    I will be relatively brief and make a few observations 
about dynamic scoring in my experience as a Treasury Department 
official and then also the Administration's view on dynamic 
scoring.
    As you know, the staff of the Joint Committee and of the 
Treasury Department has for many years looked at behavioral 
effects of tax policy. That is not in and of itself easy. 
Having been the chief stargazer on that at the Treasury 
Department, I can attest to that.
    What I would like to do today is spend the time on the 
issue that you teed up in your remarks, and Mr. Coyne did as 
well, which is the issue of macroeconomic or aggregate effects, 
what I think popularly goes by the term dynamic scoring. Here, 
I think what economists usually have in mind is, can we somehow 
adjust revenue estimates that incorporate changes in the level 
of output in the economy and how that filters through the tax 
system, through the tax basis for earned income, for corporate 
profits, dividends, and so on?
    I would really just like to make five simple observations 
with you, and let me start with the simplest but perhaps most 
important.
    At a conceptual level, it is very hard to argue against 
having dynamic scoring. The idea is, in and of itself, correct, 
that if we are trying to do the best possible job of providing 
information to you as decisionmakers, we need to give you all 
of the information that we can. That would mean evaluating the 
economic growth effects of tax proposals and trying to suggest 
to you how we think those tax proposals would affect receipts 
through economic growth.
    Give you an example. If we were to tear up the current Tax 
Code and move to a broad-based consumption tax, I think most 
economists would suggest that would improve economic 
performance. A consensus estimate might be a level increase 
once and for all in Gross Domestic Product (GDP) of about 4 
percent. That would mean that every year we would have more 
wages, we would have more dividend and interest income and so 
on, and generate additional revenue. It is difficult to 
estimate these things, as Mr. Coyne himself teed up, but that 
doesn't invalidate the basic point.
    A second point, dynamic scoring, I think of as simply 
representing additional information about the tax policy 
process. In all of your minds as you think about tax policy, 
you are interested in no small part because you believe it will 
affect economic activity. You believe it will affect incentives 
to work, to save, to invest, to start a business, and so on. To 
be specific, I think it is straightforward to conduct a revenue 
estimate using existing methods, i.e., what the Joint Committee 
does now or the Treasury Department would do for us in the 
Administration, but to supplement those estimates with what I 
call, for lack of a better term, an impact statement that would 
give to you our views as economists of what the aggregate 
consequences are for the economy and for revenue.
    So, point one, it is conceptually correct. Point two, we 
need an impact statement. Now, what is point three? Dynamic 
scoring simply doesn't make sense for every proposal. I don't 
know how many proposals the Joint Committee estimates for 
revenue in a year, maybe 1,000, over 4,000. I am sure the 
Treasury Department would have similarly large numbers. Many 
policy changes, while they may be very important, arguably have 
a trivial impact on the economy. So if you were to think about 
dynamic scoring as something useful, you would want to restrict 
it to quite major exercises like, for example, the tax cut the 
President proposed and you enacted. I think of this as nothing 
more than a benefit cost test: Do the dynamic scoring to 
provide you information when you think the benefits of that 
information exceed the cost.
    The fourth simple observation I would like to offer you 
really just builds on the previous two that I gave you. Because 
not every proposal you are going to consider actually requires 
or would benefit from dynamic scoring and because macro-
consequences are really a supplement to, not a substitute for, 
the revenue estimates you get from the Joint Committee. I don't 
believe there is a need to imbed dynamic scoring in the budget 
process itself.
    Now let me be specific there. If we had PAY-GO rules, which 
we don't at the moment, but if we did I would suggest you don't 
want dynamic scoring for PAY-GO per se. However, what you 
wanted is information for you in deciding which proposals to 
accept.
    The final observation I would offer you is obvious, 
although many things economists say fall into that category 
perhaps. Dynamic scoring is actually quite hard. When you think 
about the methodologies that economists use, there are many 
different approaches to modeling tax policy, and while each of 
these models may have some strong attributes, they may have to 
give different answers. I would think that it is quite 
important for you to give a flavor for that and consider a 
range of estimates.
    To give you an example, suppose we were to imagine a 
proposal that would eliminate the double taxation of dividend 
incomes and suppose that we were to decide that this proposal 
were to be enacted this year but not become effective for two 
more years. We would want a model that somehow took into effect 
the announcement effect of that policy on asset prices, on 
savings and investment, and GDP. Quite frankly, many models 
used for commercial purposes don't do that. I think it is very 
important to acknowledge that different modeling strategies 
would give you different answers, but I still see great value 
for you in having a range of estimates that inform your 
decisions.
    So just revisiting these five simple observations, I think 
dynamic scoring is something you should take very seriously as 
a concept. I think you have to realize that it can't and should 
not be done all the time. I think you need to take into account 
the fact that there are different models that might give 
slightly different answers. What you really need is an impact 
statement that helps you make the decisions that you do. I 
would refer you to work, that you are already I am sure well 
aware of, the Joint Committee's exercise in the mid-nineties 
that led to a 1997 Joint Committee pamphlet, and the current 
work being done by the Joint Committee and by this Committee on 
modeling.
    Thank you very much, Mr. Chairman.
    [The prepared statement of Mr. Hubbard follows:]
 Statement of the Hon. R. Glenn Hubbard, Chairman, Council of Economic 
                                Advisers
    Chairman Houghton and members of the Subcommittee, it is a pleasure 
to appear before you today to discuss the important issue of budget 
scoring for tax proposals. Under current practice, the Joint Committee 
on Taxation (JCT)--the provider of revenue estimates to the U.S. 
Congress for tax legislation either enacted or under consideration--and 
the Department of the Treasury--which has a comparable role for the 
Administration--takes into consideration a wide variety of behavioral 
microeconomic responses to the incentives resulting from tax policies. 
The JCT examines the effect on realizations of a change in capital 
gains tax rates, or the shift in consumption of gasoline in response to 
gasoline excise taxes.
    The purpose of my remarks today is to discuss the notion of 
expanding the scope of the revenue estimating process to include in 
some way the effect of tax policy on the macroeconomy itself--sometimes 
called ``dynamic scoring''--including any such macroeconomic effects on 
receipts. Under a dynamic scoring approach, revenue estimates would 
explicitly incorporate not just individual or firm-level responses to 
tax-based incentives, but also changes in the overall scale of economic 
activity as a result of the tax policy. That is, revenue estimates for 
tax changes might incorporate current and future changes in the level 
of Gross Domestic Product and tax bases such as aggregate earned 
income, aggregate corporate profits, dividends, and so forth.
    Five observations frame the debate over dynamic scoring. First, the 
idea of dynamic scoring is conceptually correct. The basic notion in 
revenue estimation is to calculate the yearly revenue--from all 
relevant sources--over the appropriate budget window under current law. 
To do so requires evaluating the economic activity that would prevail 
using current tax rules, redoing the calculation using the tax code as 
modified by the proposal (which clearly requires knowing the economic 
activity--including all relevant tax bases--under the alternative tax 
rules), and comparing--on a year-by-year or other basis--the revenue in 
the latter to the revenue in the former. In doing so, changes in 
revenues from all sources would enter the revenue estimate without 
constraints such as a fixed macroeconomic baseline. So, for example, if 
one were to switch to a broad-based consumption tax, some economists 
estimate that the capital stock would rise by 14 percent over the first 
eight years, with GDP rising by 4 percent. The increase in wage, 
dividend, interest, and other sources of income embodied in these 
macroeconomic changes would be one source of additional revenue. Of 
course, in practice estimating these steps is fraught with difficulty. 
Still, these operational challenges, to which I will return below, 
should not disguise the basic objectives.
    The second observation is that dynamic scoring represents 
additional information about the tax policy process. As you know, a 
cost of the tax system is the distortion that taxes cause to incentives 
to undertake a wide range of economic activities--work, saving, 
investment, and so forth. The distortion causes GDP to be lower than it 
would be in the absence of the tax system, or at least lower than it 
would be in the presence of a more efficient tax system. Accordingly, a 
dynamic scoring process would reflect the reduction in deadweight loss 
(the economic activity foregone due to tax distortions) and increase in 
GDP as one part of the revenue consequences of the tax policy. For this 
reason, adding this information aids policymakers in making the right 
choices for the economy, and policy decisions should reflect economic 
effects as well as revenue effects.
    More mechanically, it is straightforward to conduct a revenue 
estimate using existing methods and supplement these estimates with an 
``impact statement'' that shows the macroeconomic consequences and the 
possible related revenue effects.
    The third observation is that dynamic scoring does not make sense 
for every tax proposal. For certain tax policy changes--substantial 
reductions in marginal tax rates, broad-based investment incentives, 
etc.--there are likely to be shifts in aggregate labor supply, saving, 
entrepreneurial ventures, composition of compensation, investment, and 
so forth substantial enough to alter both the path of the economy, and 
the level and time path of receipts. As an economist, I think of this 
in a benefit-cost framework. Dynamic scoring is harder, and thus more 
``costly'' in some general sense. For this reason it should be 
restricted to those circumstances in which it has real costs for the 
macroeconomy. We should examine the impact on the macroeconomy in those 
circumstances in which conventional scoring rules can reasonably be 
expected to give a misleading picture of both the overall revenue 
effects over the relevant budget window, and the growth or transition 
of revenues on a year-by-year basis.
    The fourth observation builds on the previous two: Because not 
every proposal merits full-blown dynamic scoring, and because the 
macroeconomic consequences can be viewed as a supplement to (as opposed 
to a substitute for) current procedures, there is no need to embed 
dynamic scoring in the existing budget process. Instead, for those 
proposals that meet the two criteria discussed earlier, the 
conventional scoring can be supplemented with an impact statement. This 
will be useful in two ways: Policies that merit an impact statement 
will stand out from other tax changes, and the impact statement will be 
useful in guiding priorities and decision-making. Accordingly, 
inclusion of an impact statement will likely have a real effect on the 
policy process.
    The final observation is that dynamic scoring of tax proposals is 
difficult. The empirical tax and economic modeling capability necessary 
is quite demanding. To get a flavor of the challenge, consider dynamic 
scoring of a proposal to eliminate the double-taxation of dividend 
income. Specifically, suppose that the policy were to be enacted this 
year, but not become effective for two years. And, suppose further that 
full implementation of the proposal was phased in over a period of 
several years.
    A model suitable for dynamic scoring would necessarily need to 
permit the announcement of the policy to affect corporate financial 
policy and investment, household saving and portfolio decisions, and 
the resulting macroeconomic consequences for interest rates, equity 
prices, saving, investment, and GDP. Further, the model necessary would 
distinguish between the ultimate effect when the policy had been fully 
phased in, and the transition path as the policy is incrementally 
implemented. Economic projections informing the revenue consequences on 
a year-by-year basis should reflect households' and businesses' 
judgments regarding the timing of their activities in response to not 
only the tax incentives, but also the economic environment--which, of 
course, is in part influenced by their decisions. Obviously, this is a 
difficult task. (Of course, the ease of a calculation does not make it 
correct; the difficulty of dynamic scoring is a not, per se, an 
indictment of its desirability.)
    Given the inherent difficulties, one can anticipate that different 
modeling strategies will yield alternative estimates. Some view this as 
an insurmountable impediment to the entire notion. In contrast, I see 
no reason why multiple impact statements might not be produced using a 
variety of modeling techniques for any single tax proposal.
    Revisiting the conventions used for evaluating tax proposals is a 
valuable exercise. I thank the committee for holding this hearing. More 
generally, I think it is important to recognize the history of efforts 
in this area by this committee, the Committee on Ways and Means, the 
Joint Committee on Taxation through its 1997 Symposium on Tax Modeling, 
and many others. The Administration looks forward to working with 
Congress on this issue.
    Thank you, Mr. Chairman, and I look forward to discussing with you 
this important topic.

                                 

    Chairman HOUGHTON. Thank you, Mr. Hubbard. Ms. Paull?

STATEMENT OF LINDY L. PAULL, CHIEF OF STAFF, JOINT COMMITTEE ON 
                            TAXATION

    Ms. PAULL. Thank you, Chairman Houghton, Mr. Coyne, Members 
of the Committee. Thank you for inviting us to visit with you 
today on the subject of dynamic scoring.
    I have fairly lengthy written testimony that I would like 
to summarize for you and have the entire testimony submitted 
for the record.
    This is one of those unusually obscure subjects, kind of an 
inside-the-Beltway type topic which involves the methodology we 
use to generate revenue estimates of proposed changes in the 
tax law. The Joint Committee staff is responsible for making 
those estimates under the Budget Act, and in recent years we 
have been estimating over 4,000 proposals a year.
    The staff is continuously striving to improve the revenue-
estimating process, and in doing that we tend to be guided by 
three principles: one, to produce a process that is going to 
provide consistently accurate estimates, a process that is 
viewed as fair and impartial, and the challenge of our staff is 
to keep abreast of the latest economic work and improve our 
methodology based on the consensus view of that economic work.
    An area of our work that has produced much confusion is the 
extent to which our estimates incorporate behavioral effects. 
We have always incorporated behavioral effects into our 
microeconomic estimates. That is to say, our estimates, our 
revenue estimates take into account numerous behavioral 
effects, and they are not static from that standpoint. For 
example, if we were to estimate a proposal to increase excise 
taxes, we would incorporate into that estimate the behavioral 
effect that sales of the product would diminish. So from that 
standpoint, our estimates are not static.
    It is worth repeating because we often get labeled as 
having static estimates, but the further step of incorporating 
macroeconomic effects into our estimates is not something that 
we have been doing, and that is the kind of effects that Mr. 
Hubbard was describing. That is, for example, the possible 
impact of a major tax proposal on the overall economy or on 
investment and savings and whether or not somebody would work 
more.
    Since 1997, the Joint Committee staff has been working on 
developing a macroeconomic growth model for this purpose. We 
have gained access to several other models, macroeconomic 
models, which we have described more fully in my written 
testimony.
    It is just worthy to note, however, that there are 
significant uncertainties that remain with respect to our 
ability to provide the type of information that Mr. Hubbard was 
describing that we would like to provide to you as a supplement 
to our revenue estimates, but we still have a number of 
uncertainties that need to be addressed further in order to be 
able to provide that information.
    Our goal is to be able to comply with the House rule and to 
be capable of providing a supplemental analysis of what the 
macroeconomic effects would be for a major--not a, you know, 
run-of-the-mill kind of tax law change, one that would have 
significant change in revenues. At the request of Chairman 
Thomas, we have invited a wide spectrum of economists with 
significant macroeconomic estimating and modeling experience to 
review our work, evaluate our model, and to make 
recommendations for its use and to make recommendations also on 
the kind of supplemental information that might be generated by 
this model. This effort will take the bulk of this year to 
accomplish.
    We are presently planning two meetings, one in June and one 
in September, and we will ultimately publish the results of the 
work of this panel of advisers.
    In summary, I would like to reiterate a couple of points.
    The revenue-estimating process should provide Members with 
consistently accurate estimates of their proposals. Difficult 
issues are presented in developing the ability to incorporate 
macroeconomic effects into revenue estimates, and these 
difficulties should not be minimized. While the staff remains 
committed to improving the revenue-estimating process by 
assessing the potential macroeconomic effects of major tax 
legislation, these issues must be addressed in a manner that is 
accepted by expert economists. To do otherwise would undermine 
the integrity of the revenue-estimating process and could 
reduce rather than enhance the accuracy of our staff's revenue 
estimates.
    With that, that ends the summary of my testimony.
    [The prepared statement of Ms. Paull follows:]
    Statement of Lindy L. Paull, Chief of Staff, Joint Committee on 
                                Taxation

                            I. INTRODUCTION

    My name is Lindy Paull. As Chief of Staff of the Joint Committee on 
Taxation, it is my pleasure to present the testimony of the Joint 
Committee on Taxation (``Joint Committee'') staff at this hearing of 
the Subcommittee on Oversight concerning modeling the economic effects 
of changes in tax policy.\1\
---------------------------------------------------------------------------
    \1\ This document may be cited as follows: Joint Committee on 
Taxation, Written Testimony of the Staff of the Joint Committee on 
Taxation at a Hearing of the Subcommittee on Oversight of the House 
Committee on Ways and Means Concerning Modeling the Economic Effects of 
Changes in Tax Policy (JCX-36-02), May 6, 2002.
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    Under the Congressional Budget and Impoundment Control Act of 1974, 
the revenue estimates of the Joint Committee are required to be used 
for purposes of all revenue legislation that is considered or enacted 
by the Congress. To satisfy this requirement, the Joint Committee staff 
prepares estimates for Members of Congress on the effects of revenue 
proposals on budget receipts. These estimates help Members determine 
whether specific legislation fits within targets set during the budget 
resolution process.
    The Joint Committee staff is constantly reviewing and updating the 
models used to prepare revenue estimates. In addition, since 1995, the 
Joint Committee staff has been engaged in ongoing and extensive efforts 
to improve the Joint Committee's revenue estimating capabilities by 
evaluating the feasibility of incorporating, to the extent appropriate, 
the macroeconomic effects of tax legislation.\2\ Three Joint Committee 
staff economists have devoted significant amounts of their time to this 
effort. The Joint Committee staff has utilized the services of economic 
consultants with macroeconomic expertise. Significant progress has been 
made, but significant work remains to be done.
---------------------------------------------------------------------------
    \2\ Attachment A to this testimony provides a listing of Joint 
Committee publications that address issues relating to the revenue 
estimating process, including publications prior to 1995.
---------------------------------------------------------------------------
    This testimony provides a brief overview of the Joint Committee 
revenue estimating process and discusses the status of the Joint 
Committee staff's investigation of the possible role of macroeconomic 
feedback analysis in revenue estimating. This discussion includes a 
summary of the Joint Committee staff's past research efforts, a 
description of the macroeconomic models that the Joint Committee staff 
is currently using, a discussion of the strengths and weaknesses in the 
current state of the art of macroeconomic analysis, and a description 
of the Joint Committee staff's plans for future work on macroeconomic 
analysis.

             II. OVERVIEW OF THE REVENUE ESTIMATING PROCESS

In general

    Revenue estimates measure the anticipated changes in Federal 
receipts that result from proposed legislative changes to the Federal 
tax laws (or other Federal laws). A revenue estimate is simply the 
measure of revenue projected to be collected if a particular 
legislative change is enacted compared to the revenue that is projected 
to be collected under present law. The starting point for a revenue 
estimate is the estimate of the receipts generated by the affected tax 
provisions under present law. Estimates of present-law receipts are 
based on the macroeconomic aggregates and growth rates projected by the 
Congressional Budget Office (``CBO'') as part of its budget forecasts. 
Estimates of projected revenues under a proposal are calculated based 
on assumptions about (1) the changes in tax liability intended to occur 
under the proposal, and (2) likely taxpayer responses to these tax 
liability changes.
    Proposals for which the Joint Committee staff prepares revenue 
estimates range from those affecting broad groups of taxpayers (e.g., 
proposals to reduce all individual income tax rates or to provide a tax 
credit for minor children) to those affecting a narrow class of 
taxpayers (e.g., proposals to change the excise tax on bows and arrows 
or to exclude parsonage allowances from gross income). For most 
estimates of broad proposals, the Joint Committee staff uses large 
computerized models of the Federal income tax system and the economy. 
The primary data source for most models is samples of the tax returns 
filed by individuals, partnerships, corporations, and fiduciaries 
compiled by the Internal Revenue Service (``IRS'') Statistics of Income 
Division. The models combine the most recently available taxpayer 
information with forecasts of the aggregate level of national income 
provided by the CBO. For estimates of narrow proposals, the Joint 
Committee staff creates more targeted models based on data from a 
variety of surveys and other sources.
    Efforts to improve the revenue estimating process are guided by 
certain principles. First, the revenue estimating process should 
consistently produce accurate estimates on which Members of Congress 
can rely in making legislative decisions. Second, the revenue 
estimating process must be viewed as fair and impartial. Third, revenue 
estimating methodologies should be improved whenever possible to 
enhance the accuracy of the work product.
History of revenue estimating process

    Although the basic formula by which a revenue estimate is 
calculated has not changed over time, the process of preparing revenue 
estimates undergoes frequent changes and improvements. These changes 
and improvements have enabled the Joint Committee staff to produce more 
accurate and timely estimates of proposals for Members of Congress.
    In the mid-1970s, the Joint Committee staff employed 5 economists 
who were responsible for preparing revenue estimates of all tax 
legislation; only 2 of these economists had computer training. The 
Joint Committee bought computer time from the Treasury Department and 
the Department of Commerce. Most of the revenue estimates prepared by 
the Joint Committee staff were done on adding machines.
    In 1986, when the Congress was considering the Tax Reform Act, the 
Joint Committee staff relied on a Treasury Department mainframe 
computer to do large individual tax model runs. A model run to 
calculate a revenue estimate for a proposal for one year took more than 
one hour and out year effects were then calculated manually. During 
1986, the Joint Committee staff responded to 474 revenue estimate 
requests.
    In 2001-2002, the Joint Committee staff employs 20 professionals 
involved in preparing revenue estimates: 15 Ph.D. level economists, 3 
computer specialists, and 2 statistical analysts. The Joint Committee 
staff has its own mainframe computer to do individual tax model runs 
yielding results for each year in the 10-year budget period. Each run 
can now be completed in less than 3 minutes and multiple runs take 
advantage of economies to shorten the average time per run. Each Joint 
Committee staff economist has a desktop computer that is more powerful 
than the large mainframe computers used in 1986. In 2001, the Joint 
Committee staff responded to 4,491 revenue estimate requests.
    In addition to these tangible measures of improvements in the 
revenue estimating process, the Joint Committee staff incorporates 
methodological and technological advances in the study of economics and 
public finance to further improve the reliability of its revenue 
estimates. For example, the Joint Committee staff has improved its 
individual tax model by using a new extrapolation technique based on 
linear programming that allows for a more precise targeting of future 
levels of specific variables. This improvement gives the Joint 
Committee staff better ability to match present-law baseline 
projections provided by the CBO, which is especially useful in 
analyzing the out-year effects of a proposal.
Behavioral effects

    The extent to which behavioral effects are taken into account in 
calculating the revenue effects of proposed tax legislation seems to 
cause the greatest confusion concerning the revenue estimating process. 
Commentators from time to time incorrectly argue that revenue estimates 
under existing methodologies are static and fail to incorporate 
behavioral effects. It is important to understand the differences 
between the significant behavioral effects that are taken into account 
under the current revenue estimating methodologies employed by the 
Joint Committee staff and potential macroeconomic effects.
    One of the most significant elements of Joint Committee staff 
revenue estimates is the assumed effect of a proposal on taxpayer 
behavior. In general, a revenue estimate prepared for any proposal that 
changes the treatment of an item of expense or income, or the rate of 
tax on certain types of income or consumption, will incorporate 
behavioral effects. For example, some of the common behavioral effects 
include the following: excise tax increases are assumed to result in 
lower sales of the taxed items; a reduction in the taxation of sales of 
capital assets is assumed to increase capital gains realizations; 
temporary tax cuts are assumed to accelerate some affected taxable 
transactions; temporary tax increases are assumed to delay some 
affected taxable transactions; and changes in individual income tax 
rates are assumed to affect portfolio management decisions. The 
estimates may also assume that employment and investment may shift 
among sectors or industries, depending on the nature of the tax 
proposal. In this sense, Joint Committee revenue estimates are not 
static, but incorporate many microeconomic behavioral effects. However, 
under existing revenue estimating methodologies, revenue estimates do 
not incorporate possible effects of tax law changes on economic 
aggregates such as gross domestic product and gross national product 
(i.e., macroeconomic effects).

             III. MACROECONOMIC EFFECTS OF TAX LAW CHANGES

    It is generally agreed that certain major tax proposals, such as a 
proposal to eliminate the Federal income tax and replace it with a 
consumption tax, would not only affect Federal tax receipts, but would 
also affect certain macroeconomic aggregates, such as gross domestic 
product. Certain changes in tax policy may be expected, and in some 
cases may be designed, to affect the strength or growth of the national 
economy. For such proposals, a standard revenue estimate may not convey 
the complete picture of the long-term budgetary impacts of the 
proposal. The Joint Committee staff has been working to analyze the 
feasibility of incorporating both the long-term growth and short-term 
cyclical effects of such proposals so that additional analysis of 
potential macroeconomic effects can be provided along with the revenue 
estimates of these proposals.

A. History of Joint Committee Staff Work on Macroeconomic Modeling

    In January 1995, the Joint Committee staff testified before a joint 
hearing of the House and Senate Budget Committees on the revenue 
estimating process. In that testimony,\3\ the Joint Committee staff 
discussed some of the issues that arise in considering whether to 
modify the revenue estimating methodology to take into account 
macroeconomic effects. The consensus of the expert economists who 
testified at the hearing was that economists had not yet developed 
models of the economy that could predict the timing and magnitude of 
macroeconomic effects with sufficient accuracy to justify including 
them in revenue estimates.
---------------------------------------------------------------------------
    \3\ Joint Committee on Taxation, Written Testimony of the Staff of 
the Joint Committee on Taxation Regarding the Revenue Estimating 
Process (JCX-1-95), January 9, 1995.
---------------------------------------------------------------------------
    In 1996, the Joint Committee staff convened a group of 
macroeconomic modelers who had used forecasting or simulation models of 
the U.S. economy to predict the macroeconomic effects of major tax 
reform. The group was asked to work together on a modeling experiment 
that would help the Joint Committee staff to identify the sources of 
variation in their predictions, as well as the strengths of each type 
of model. This experiment required all of the modelers to start with 
the same present-law baseline forecast of the economy, and to estimate 
the same tax reform proposals. The results spanned a wide range of 
outcomes. They were made public in a symposium held in January 1997.\4\
---------------------------------------------------------------------------
    \4\ The models, the proposals, and the results are summarized in 
Joint Committee on Taxation, Joint Committee on Taxation Tax Modeling 
Project and 1997 Tax Symposium Papers (JCS-21-97), November 20, 1997.
---------------------------------------------------------------------------
    All of the models used in the 1996 study projected that tax 
restructuring in the form of a consumption tax ultimately would produce 
higher economic growth. However, the models produced considerable 
variation in the magnitude and time path of the growth effects. The 
variations in the responses arose from both major structural 
differences in the models and from differences in assumptions about key 
behavioral parameters.
    Some significant factors that explained the differences in modeling 
results were attributable to assumptions about the strength of 
behavioral responses to tax incentives, the operations of international 
financial markets, and the actions of the Federal Reserve Board. Each 
of these factors significantly influenced the outcomes predicted by the 
different models. Several less obvious, but equally important factors, 
also contributed to the differences in model predictions. Because the 
present-law tax Code is quite complex, the modeling of the present-law 
tax system was quite different among the models. As a result, the 
estimation of the magnitude of tax-induced changes in after-tax 
investment returns and after-tax wage rates, which are the major 
factors that influence taxpayer behavior, varied significantly among 
the models. In addition, certain structural features of the different 
models that were chosen to facilitate the mathematical solutions of the 
models significantly affected the predicted outcomes of certain types 
of tax policy. Finally, each variation in the tax reform proposal being 
analyzed required weeks of new modeling effort to accommodate a 
reasonably accurate representation of that change.
    Since the 1997 symposium, the Joint Committee staff (1) has worked 
to develop a model that could be used in conjunction with detailed tax 
return data to provide accurate estimates of the effects of specific 
tax proposals on different groups of taxpayers (the model is discussed 
in more detail below); (2) has conducted a review of existing empirical 
studies that have estimated the size of behavioral responses to tax 
policy changes; and (3) is in the process of testing the basic 
structure and performance of the Joint Committee staff model.
    The significant challenge in developing a macroeconomic model is to 
keep the solution mechanisms of the basic macroeconomic model flexible 
enough to allow for the analysis of several versions of a tax proposal 
without major recalibration of the model. In addition, the model must 
be capable of utilizing input from the Joint Committee microsimulation 
tax models to provide the necessary detail to simulate tax policy 
proposals within the macroeconomic models. As explained below, the 
Joint Committee staff has devoted much effort to creating analytic 
links between Joint Committee microsimulation tax models and the Joint 
Committee macroeconomic model.
    The Joint Committee staff review of existing empirical studies has 
focused in particular on studies that provide behavioral information 
about specific types of taxpayers, so that appropriate behavioral 
assumptions can be applied to each group. The two main growth-related 
responses that have been estimated by multiple studies, and that are 
explicitly built into the Joint Committee macroeconomic model, are the 
decisions by individuals to work more or less, and the decisions by 
businesses to invest more or less in response to changes in tax policy. 
In addition, the decision to consume or save, which affects both short-
run demand fluctuations and long-term capital growth, is an important 
behavioral parameter that has been the subject of much study. The Joint 
Committee staff has attempted to identify near-consensus assumptions 
and to use those in its modeling efforts.
    Finally, the Joint Committee staff has been testing the basic 
structure and performance of the Joint Committee macroeconomic model by 
simulating different large tax policy changes, varying key underlying 
solution equations and behavioral assumptions, and analyzing the 
results for internal inconsistencies and sensitivity to different 
assumptions. Several important issues remain to be addressed including 
the appropriate modeling of the policy of the Federal Reserve Board and 
international capital flows. These two issues can cause large swings in 
short-run economic activity and, therefore, the uncertainties 
surrounding their appropriate treatment lead to a high level of 
uncertainty in short-run forecasts.

LB. Description of Macroeconomic Models Available to the Joint 
        Committee Staff

    The Joint Committee staff is developing an in-house model for use 
in analyzing the macroeconomic effects of tax proposals. This model, 
the macroeconomic equilibrium growth (``MEG'') model, is a 
computational equilibrium model with neoclassical foundations that can 
be used to analyze both long-run growth effects and short-run 
disequilibrium adjustments resulting from proposed tax changes. The 
Joint Committee staff also subscribes to two commercially marketed 
econometric models and has access to an intertemporal general 
equilibrium model with overlapping generations and forward looking 
agents.\5\
---------------------------------------------------------------------------
    \5\ These models are the Washington University Macroeconomic Model 
(``WUMM''), provided by Macroeconomic Advisers, Inc, and the DRI 
econometric model, formerly provided by Standard and Poors, Inc., but 
now provided by Global Insight Inc.
---------------------------------------------------------------------------
    It is important to note that each of the models described below is 
well designed to examine a set of the issues that are critical to 
understanding the effects of tax policy changes, but none of the models 
is designed to address all of the issues that arise in the 
macroeconomic analysis of tax policy changes. For this reason, the 
Joint Committee staff employs a variety of models to gain an 
understanding of the contributions and limits of current state of the 
art macroeconomic modeling in tax policy analysis.
Macroeconomic Equilibrium Growth (``MEG'') Model

    The MEG model has been developed with the help of an outside 
contractor. The MEG model has the following features: (1) a 
neoclassical growth foundation in which long-run economic growth is 
determined by labor supply, investment and savings, and total factor 
productivity growth; (2) a tax sector calibrated to the Joint Committee 
staff's microsimulation models of the Federal tax system; and (3) a 
flexible structure that facilitates running simulations in several 
different equilibrium modes and to allow short-run disequilibrium 
adjustments in response to changes in fiscal policy.
    Labor supply is determined by taxpayer responses to changes in the 
average and marginal after-tax wage rates, and by general demographic 
trends. Capital resources are determined by the stock of undepreciated 
capital from previous periods plus investment in the current period. 
Total investment is determined by the responses of domestic savings and 
international capital flows to tax changes. The amount of domestic 
investment in the current period is responsive to proposed tax changes 
through the effect of the changes on the after-tax rate of return on 
investment. The amount of international investment is responsive to 
changes in demand for imports. The Joint Committee staff uses its 
microsimulation individual and corporate income tax models to determine 
the effects of a tax proposal on changes in effective and marginal tax 
rates on the following sources of income: wages, dividends, interest, 
rent, and capital gains. This information is used as input into the 
behavioral equations in the MEG model. Behavioral parameters in these 
equations are drawn from empirical economic literature.
    The MEG model is designed to simulate the transition path to the 
long run equilibrium in the economy using several different solution 
methods. Equilibrium solution methods require that all markets clear 
during each period in the transition from the initial steady state to 
the new long run steady state. Equilibrium solutions for simulations of 
changes in tax policy require mechanisms to negate any changes in 
aggregate demand that the tax change could be expected to stimulate. 
One such mechanism is to model an ``omniscient'' Federal Reserve 
monetary policy, which changes interest rates each period to offset 
changes in demand. Another such mechanism is to balance any net change 
in tax revenues with an offsetting lump sum change in government 
expenditure (set at levels designed to neutralize the ``balanced 
budget'' multiplier effect). These two equilibrium approaches yield 
different implications for the interim growth effects of a given tax 
proposal. A third approach requires the model to use ``potential'' 
output rather than actual output in deriving investment responses to 
tax changes, which mitigates the short-run disequilibrium movements of 
variables in the model, and thus can be used to isolate supply side 
growth effects.
    The MEG model can also simulate the transition path to the new long 
run equilibrium using a short run disequilibrium system that converges 
to a long run equilibrium that is consistent with neoclassical growth 
theory. A lag structure is in place for most of the behavioral 
decisions so that movements toward desired levels of investment, labor 
supply, and output take place over periods of several quarters. Several 
different Federal Reserve monetary reaction functions can be 
incorporated into these disequilibrium simulations. In addition to 
providing information on the range of short run responses the economy 
may have to specific tax proposals, this analytic framework is useful 
for comparing MEG results to results from commercial econometric 
models.
    As part of the Joint Committee's ongoing work to refine the MEG 
model, the Joint Committee staff has used the model to simulate the 
effects of various tax proposals to analyze the model's performance. 
These simulations have revealed areas in which the model has needed 
substantial alteration. As a result, the MEG model is still in 
development in a number of areas. The Joint Committee staff is in the 
process of expanding the number of labor supply and investment income 
equations in the MEG model in order to improve the linkages between 
this model and the detailed microsimulation models used by the Joint 
Committee staff. Measures of taxpayer response to tax changes within 
the MEG model continue to be the subject of substantial scrutiny and 
ongoing research. There is also substantial uncertainty as to the 
appropriate modeling of monetary policy of the Federal Reserve Board 
and the likely responsiveness of international capital markets to U.S. 
tax changes.
Intertemporal model

    The Joint Committee staff has access to an intertemporal general 
equilibrium model with forward looking agents (that is, consumers and 
firm managers who make decisions based on their expectations about the 
future). Individual behavior is modeled using an overlapping 
generations framework that consists of fifty-five cohorts, denoted by 
ages that range from zero to 54, as the model's individual life span is 
known (with certainty) to be 55 years. Each generation is represented 
by a single individual, who has an economic life span of fifty-five 
years, works for the first forty-five of those years, and is retired 
for the last ten. Consistent with the life-cycle theory, the model 
assumes that individuals borrow money in the early years of life, pay 
back their debts and save for retirement in their prime working years, 
and draw down their savings during retirement. Under this theory, an 
individual's lifetime consumption path is flatter than his lifetime 
earnings pattern. In addition, the model includes the following 
features: tax deferred savings, a simple bequest motive, a model of the 
Social Security system, payroll taxes, and progressive tax rates on 
wages. The income tax is modeled as a progressive tax on labor income 
coupled with flat rate taxes on capital income. Capital income is taxed 
at flat rates on dividends, on interest, and on capital gains. The tax 
rate on capital gains is an effective annual accrual rate, taking into 
account the benefits of deferral of tax until gains are realized and 
tax exemption of gains transferred at death.
    On the production side, the model assumes that firm managers act to 
maximize the value of the firm in a perfectly competitive environment 
in the absence of uncertainty. The approach utilized is based on 
Tobin's ``q'' theory of investment, as extended to include adjustment 
costs.\6\ It is similar to the firm modeling approaches used by several 
others.\7\ The economy has a single production sector in which firm 
values are calculated explicitly. Firms finance new investment through 
retained earnings, issuing debt and issuing new shares of equity. Firms 
pay dividends equal to constant fraction of after-tax profits net of 
economic depreciation, and new debt issues are a constant fraction of 
net investment. For tax purposes firms are allowed to depreciate 
capital more rapidly than the economic rate of depreciation. The model 
distinguishes between the present value of depreciation deductions on 
existing and future capital. In addition, the model includes a 
quadratic adjustment cost function that increases the cost of investing 
in and installing new capital goods.
---------------------------------------------------------------------------
    \6\ Hayashi, F., ``Tobin's Marginal q and Average q: A Neoclassical 
Interpretation,'' Econometrica 50 (1982), pp. 213-224.
    \7\ See, for example, Auerbach, A. and Kotlikoff, L. (1987). 
Dynamic Fiscal Policy, Cambridge, MA: Harvard University Press; and 
Goulder, L. and Summers, L., ``Tax Policy, Asset Prices, and Growth,'' 
39 Journal of Public Economics (1989), pp. 265-296.
---------------------------------------------------------------------------
    The model assumes that the resources in the economy are fully 
employed in each year and therefore does not account for short-run 
disequilibria (i.e., cyclical movements in the economy) in the markets 
for labor, capital, or other goods that would occur during transition 
periods.
Other models

    The Joint Committee staff subscribes to two commercially available 
macroeconomic models (WUMM and DRI) to provide a range of possible 
transition scenarios in analyzing the effects of proposed tax changes. 
The models simulate the effects of proposals assuming different Federal 
Reserve Board and international responses. Because of the uncertainty 
inherent in making such assumptions, these types of simulations are 
best used to provide information about the possible range of outcomes 
and the degree of sensitivity of the estimated ranges to the 
assumptions used. A general description of the WUMM model is provided 
in the following paragraphs. The DRI model is similar to the WUMM 
model.
    WUMM is a large-scale structural macroeconometric model. In the 
long run, the equilibrium is determined by equations that are derived 
from neoclassical microeconomic foundations. The long-run level of 
output depends on prevailing tax rates since long-run output is 
determined by the stock of capital and labor supply and households and 
firms decisions depend explicitly on after-tax prices and rates of 
return. In the short run, the resources in the economy are less than 
fully employed as prices and wages adjust slowly to their equilibrium 
values. Model parameters and behavioral responses are estimated using 
post-war quarterly data.
    WUMM's consumption function is based on the life-cycle theory of 
consumption. Consumer spending depends on the average age of the 
consuming population, labor income, asset income, transfer payments and 
net worth. Business fixed investment in equipment and structures is 
derived using the neoclassical theory developed by Jorgenson. The 
demand for capital is derived from a production function with a unitary 
elasticity of substitution between labor and capital. Housing demand 
depends on demographics, disposable income, and the user cost of 
housing. The real exchange rate and the relative price of domestic and 
foreign goods determine net exports. Government spending is exogenous 
except for interest payments on the national debt.
    In general, the price level is modeled as a markup over smoothed 
labor costs. In the short run, the markup equation and the relationship 
between unemployment and inflation determine prices. In the short run, 
the real interest rate is determined by the supply and demand for money 
or by a function that describes the Federal Reserve Board's monetary 
policy. In the long run, the real interest rate is equal to the value 
that equates savings and investment.

LC. Issues and Problems With the Use of Macroeconomic Analysis in 
        Revenue Estimates

    While substantial progress has been made to develop a model that 
willassess the potential macroeconomic effects of tax law changes, 
difficult problems remain to be solved. In theory, the incorporation of 
macroeconomic feedback effects in revenue estimates would provide year-
by-year estimates of changes in revenues resulting from the influence 
of tax policy on national economic aggregates like business profits, 
wages and interest rates. However, to achieve this goal would require 
the modeling of the effects of tax policy changes to decide on a single 
set of assumptions with respect to (1) the effects of short-run, or 
business cycle, fluctuations in the economy, (2) changes in Federal 
Reserve Board policies, (3) the reactions of international capital 
markets, and (4) budgetary scoring conventions on the expenditure side. 
As detailed below, these issues present significant challenges that 
remain to be resolved.
1. Sources of uncertainty
Effects of business cycle fluctuations

    Business cycle fluctuations lend uncertainty to any attempt to 
measure the macroeconomic effects of a tax change. A net cut in taxes 
should stimulate consumption and investment in the short-run, resulting 
in an increase in aggregate demand. The ultimate effect of this 
increase in demand on the economy will depend on facts such as whether 
resources in the economy would otherwise be in full use at the time of 
the tax reduction, on the response of the Federal Reserve Board to the 
policy, and on the responses of international capital flows. Short-run 
fluctuations are also critical to accurate assessment of the effects of 
tax proposals on long-term growth, because of the interactions of these 
cyclical effects and the rate of business investment, which can affect 
the growth capacity of the economy for a period of years.
    When the economy is doing very well, at a ``peak'' stage of the 
business cycle, virtually everyone who wants to be employed is already 
employed, and productive buildings and equipment are operating near 
capacity. Under these circumstances, domestic businesses would be 
unable to increase production significantly in response to a sudden 
increase in demand such as would be created by a large net tax cut. 
When demand for goods and services increases more rapidly than the 
supply of goods and services, a potentially inflationary situation 
exists. Any apparent growth in output of the economy (as measured by 
the dollars spent on goods and services or dollars received as income) 
is likely to be primarily from a growth in prices, rather than in real 
production. In contrast, if the economy is slowing down, nearing the 
``trough'' of a business cycle, unemployed people and under-used 
productive capacity will be available to respond to increases in demand 
with increases in supply. In this situation, less inflationary pressure 
exists, and growth in output is likely to reflect an actual increase in 
economic activity. Although in both cases the increase in demand would 
be likely to result in a temporary increase in tax receipts for the 
Federal government, this distinction between inflationary and real 
growth is important from a budgetary ``scoring'' standpoint. In the 
first case, the costs faced by the government to provide the same level 
of services will also increase due to inflation, resulting in possibly 
no net improvement of the Federal government's fiscal situation. In the 
second case, a temporary increase in real economic activity could 
generate additional revenues without generating additional costs, thus 
improving the net fiscal position of the Federal government.
    Assessing whether or not the economy will be operating near a peak 
in the business cycle at the time a proposed tax cut is actually 
enacted and the tax savings in the hands of the taxpayers is a 
notoriously uncertain task. Because economic forecasting models 
generally rely most heavily on the more recent characteristics of the 
economy, they are not well suited to predicting the exact timing of a 
change in the direction of the economy.
Actions of the Federal Reserve Board and international capital flows

    Another major source of uncertainty is the reaction of the Federal 
Reserve Board to fiscal policy changes. If the Federal Reserve Board 
believes there is a significant risk of inflation associated with an 
expansionary fiscal policy, then it may raise interest rates to reduce 
the risk of inflation. An increase in interest rates reduces consumer 
purchases of durable goods and business investment, and thus would slow 
the growth of the economy. In addition, since the exchange rate and the 
U.S. interest rate are positively related, an increase in the interest 
rate would reduce net exports. This occurs because an increase in the 
exchange rate makes U.S. goods relatively more expensive to foreigners 
and imports relatively cheaper to consumers in the United States. These 
reductions counter-act the growth effects of an expansionary fiscal 
policy and thus could render dynamic revenue estimates less reliable if 
the Federal Reserve Board's actions are not predicted accurately. 
Existing macroeconomic models use an array of monetary policy rules to 
describe the actions of the Federal Reserve Board; however, there is no 
way to be certain of how the Federal Reserve Board will act in the 
future. Furthermore, there is an unknown lag associated with monetary 
or fiscal policy that contributes to the uncertainty of determining how 
the Federal Reserve Board actions would affect the path of the economy.
    It is also unclear how international capital markets will react to 
either a change in tax policy or a change in Federal Reserve Board 
policy. Some macroeconomic models assume that an increase in the 
returns on business investment will induce increased international as 
well as domestic investment, and some do not. The amount of 
international investment induced by a tax change can affect the amount 
of total investment, the size of the capital stock and net economic 
growth it induces. The independent actions of the Federal Reserve Board 
and foreign banks introduce a high degree of uncertainty in 
macroeconomic forecasting. It is unclear at this time that there is any 
way to reduce these sources of uncertainty through modeling 
improvements and, therefore, to make accurate year-by-year 
macroeconomic predictions.
Effects of changes in the Federal budget deficit on the interest rate

    Conventional economic theory suggests that a relationship exists 
between interest rates and the size of the Federal deficit, through its 
potential effect on the supply of loanable funds. Specifically, 
conventional economic theory predicts that an increase (decrease) in 
the Federal budget deficit would decrease (increase) the supply of 
loanable funds, causing an increase (decrease) in interest rates, and 
thus, decrease (increase) consumer purchases of durable goods and 
business investment. This relationship between the size of the Federal 
deficit and the interest rate implies that larger budget deficits would 
be associated with a smaller stock of capital and a lower rate of 
growth in the economy. Changes in the pattern of business capital 
accumulation can affect the economy's growth capacity for a sustained 
period of time. This effect would tend to offset positive economic 
growth induced by the positive behavioral incentives in some tax cuts.
    However, even though this view is considered the conventional 
theory in the economic literature, a less widely held, but nonetheless 
important, view of the economy questions the validity of the 
conventional theory. The empirical literature on this subject fails to 
provide conclusive evidence supporting either view.\8\ The relationship 
between changing Federal government deficits and the interest rate is 
commonly included in structural macroeconometric models that focus on 
short run forecasting. It is usually not included in general 
equilibrium simulation models, which typically assume ``balanced 
budget'' tax changes to simplify model solutions. This inconsistency 
between classes of models makes efforts to isolate ``supply side'' 
effects from general macroeconomic effects an important component of 
dynamic analysis.
---------------------------------------------------------------------------
    \8\ For more on this issue see Elmendorf, D. and Mankiw, N. 
Gregory, ``Government Debt,'' National Bureau of Economic Research 
Working Paper 6470 (1998).
---------------------------------------------------------------------------
Sensitivity of results to behavioral assumptions and model structure

    The effects of tax policy changes on the long-term growth of the 
economy depend on how the tax policy affects after-tax returns to labor 
and capital, and on how the suppliers of this labor and capital respond 
to these changes. The way a model treats costs of labor and capital 
varies significantly across different types of models. Some models 
incorporate these effects through simple elasticities incorporated in 
labor supply, savings, and investment equations. In other models, these 
responses are embedded within more complex sets of equations that 
attempt to capture multiple feedback interactions between labor, 
capital, consumers, and financial markets. In either case, the results 
generated can vary significantly depending on the parameters selected 
and the functional forms and solution criteria for the equations used. 
While empirical studies provide some information about reasonable 
ranges and assumptions for some of these assumptions, there are many 
different views as to which approach is the ``most correct.''
2. Small magnitude of macroeconomic effects of most proposals
    Most revenue proposals are likely to have little or no 
macroeconomic consequences since many of these proposals are of limited 
scope or represent changes that are subject to modest or offsetting 
influences from a macroeconomic perspective. For example, a proposal to 
encourage investment in a targeted area may simply shift investment 
away from alternative areas in the economy. Such a shift may achieve 
the desired effect within the targeted area, but may not have a net 
effect on the economy as a whole.
    Revenue proposals also may be subject to opposing incentive 
effects. For example, a reduction in marginal tax rates will increase 
the after-tax return on additional labor and saving and thereby 
encourage additional work and savings effort. However, a reduction in 
marginal tax rates is typically accompanied by an increase in after-tax 
income as well. This ``income effect'' tends to work in the opposite 
direction from the positive incentive effects, lessening the need to 
work or save to achieve a desired level of consumption. The net effect 
depends upon the relative importance of these two potentially 
offsetting factors and the relative sensitivity to the two factors 
among affected taxpayers.
    Other proposals, such as cuts in capital gains taxes and 
accelerated depreciation, that increase the after-tax profitability of 
business investment, may be expected to affect the long-run growth of 
the economy through a build up in the amount of productive plant and 
equipment. However, it is likely that this capital build up will 
develop gradually, with most of the budgetary consequences occurring 
outside the near-term budget horizon. Even a ten-year forecasting 
period may not be long enough for the full effects of increased 
productivity resulting from increased capital to be fully manifested.
3. Baseline assumptions
    The reference point for Joint Committee revenue estimates is the 
CBO ten-year projection of Federal receipts, referred to as the revenue 
baseline.\9\ The revenue baseline serves as the benchmark for measuring 
the effects of proposed law changes. The baseline assumes that present 
law remains unchanged during the ten-year budget period. Thus, the 
revenue baseline is an estimate of the Federal revenues that will be 
collected over the next ten years in the absence of statutory changes.
---------------------------------------------------------------------------
    \9\ The revenue baseline is a component of the budget baseline 
prepared by the CBO, which includes expenditures as well as receipts.
---------------------------------------------------------------------------
    The revenue baseline is based upon CBO forecasts of macroeconomic 
variables such as the annual rate of growth of nominal gross domestic 
product, inflation rates, interest rates, and employment levels.\10\ 
For modeling purposes, a number of elements of the CBO forecast are 
disaggregated to match specific tax-related variables. For example, the 
aggregate forecast of wages and salaries paid is statistically matched 
to various types of taxpayers by income class.
---------------------------------------------------------------------------
    \10\ For a detailed discussion of the methodologies employed by the 
CBO to forecast Federal revenues, see Congressional Budget Office, 
Description of CBO's Models and Methods for Projecting Federal 
Revenues, May 2001.
---------------------------------------------------------------------------
    Some argue against using the present-law revenue and expenditure 
baselines as the benchmark for measuring the effects of proposed law 
changes on the grounds that changes in revenues may have an induced 
effect on government spending behavior. They suggest that the effects 
of a proposed tax cut should be measured relative to the effects of an 
offsetting expenditure change, rather than relative to present law. 
However, the public availability of the present-law baseline is an 
important feature of the current revenue estimating process that may be 
more difficult to achieve if some other reference point were adopted; 
it serves as an objective and observable reference point for measuring 
all budget proposals, including spending proposals.
4. Budget symmetry
    The argument in favor of providing macroeconomic analysis for 
certain revenue proposals is essentially an argument in favor of 
expanding the scope and accuracy of the information used in the budget 
process. This argument, however, is not limited either to the revenue 
effects of a tax proposal, or to proposals affecting revenues. The most 
direct example of the desirability of including some outlay analysis is 
the relationship between net changes in tax revenues and Federal debt 
service expenses. A proposed tax increase that would result in a net 
reduction in the deficit would also result in a net reduction in public 
debt. The decrease in public debt would result in a reduction in 
Federal outlays to service the debt.
    Many argue that direct changes in some Federal spending programs 
should be subjected to macroeconomic feedback analysis. A proposal that 
would expand the nation's infrastructure, or improve education, can 
have similar macroeconomic effects to revenue proposals. Providing 
macroeconomic analysis on the revenue side of the budget, but not 
developing similar analysis on the outlay side of the budget, raises 
the possibility of biasing the consideration of competing revenue and 
outlay proposals.
    The capacity of macroeconomic analysis to expand the scope and 
accuracy of revenue analysis has been debated over a period of years 
and remains a subject of controversy. This controversy also applies to 
the feedback effects of outlay proposals. Although the general 
implications of certain improvements to public infrastructure on 
national production are clear in theory, efforts to quantify these 
implications are problematic.
5. Coordination with CBO baseline and budget reconciliation analysis
    To the extent that macroeconomic feedback effects would eventually 
be incorporated into revenue estimates for budget scoring purposes, 
issues of consistency and coordination may arise. For example, the 
effects of a tax cut on changes in Federal debt service expenses may be 
incorporated in the reconciliation process itself, through the budget 
projections provided by the CBO. These net budget effects can extend 
beyond the mechanical change in debt service to underlying effects on 
national savings, interest rates, and private capital formation. This 
was the case, for example, in the 1997 Deficit Reduction Act, for which 
CBO estimated an explicit net budget effect attributed to moving the 
budget onto balanced budget path. The fact that the scoring of tax 
legislation may differ from proposal to proposal depending on the 
manner in which policy initiatives are considered raises possibility of 
including inconsistent, or double-counted general fiscal effects. In 
addition, it would be problematic for the scoring of revenue proposals 
to incorporate these short-run macroeconomic feedback effects if 
scoring of expenditure proposals does not include them as well. An 
important component of the development of Joint Committee's 
macroeconomic analysis of revenue proposals is coordination with CBO's 
budget scoring. Coordination between the Joint Committee staff and the 
CBO staff would be necessary.

                             IV. CONCLUSION

Summary of significant issues

    The Joint Committee staff has made substantial progress since 1995 
in the development of a macroeconomic model that would analyze the 
potential effects on the economy of a major change in tax policy. The 
Joint Committee staff has also obtained several other types of 
macroeconomic models to insure that a wide variety of tools would be 
available to analyze changes in tax policy.
    An important point to keep in mind is that the vast majority of the 
revenue estimates produced by the Joint Committee staff each year 
relate to relatively narrow or modest changes in Federal tax laws. Such 
changes would not be expected to have any measurable effect on the 
economy. In addition, some major tax legislation may have proposals 
with opposing incentive effects so that the net effect of the 
legislation on the economy may be quite small. Thus, for the vast 
majority of Joint Committee revenue estimates, no measurable 
macroeconomic effects would be identified.
    Revenue estimates are provided, under the existing budget rules, 
for a relatively short time period (at most 10 years). Forecasting the 
timing and magnitude of the effects of a change in tax policy on the 
economy is the aspect of macroeconomic modeling that is associated with 
the greatest amount of uncertainty. There are a variety of issues 
giving rise to this uncertainty and each issue raises serious problems 
with respect to the reliability of estimates of the timing and 
magnitude of any potential macroeconomic effect. The validity and 
utility of any estimates of macroeconomic effects remain subject to 
question until these issues are addressed.
    The major issues that remain to be resolved can be summarized as 
follows:

        1. LPredicting the effects of business cycle fluctuations.--One 
        of the most difficult aspects of economic modeling is the 
        prediction of when the economy is likely to change direction, 
        either to slow down during a period of growth, or to begin 
        recovering during a period of recession. The effect of a tax 
        change on real, near-term economic growth depends on the state 
        of the economy at the time of the change. If the economy is 
        near capacity, inflationary pressures may reduce the net 
        positive effect of tax changes on the economy.

        2. LPredicting the potential response of the Federal Reserve 
        Board to fiscal policy changes.--The Federal Reserve Board's 
        policies on interest rates affect the rate of growth of the 
        economy and, thus, affect the potential macroeconomic effects 
        of a major tax policy change. Absent some definitive 
        information, such as a statement from the Federal Reserve Board 
        with respect to its expected policies, it is impossible to 
        predict with any precision how the Federal Reserve Board will 
        react to a change in tax policy. It could be assumed that there 
        would be no change in Federal Reserve Board policies, but such 
        an assumption would undoubtedly be incorrect. Within the budget 
        forecasting period, such effects can overwhelm any impacts on 
        long-term growth that might result from a particular policy 
        change.

        3. LPredicting how the macroeconomic effects of tax policy 
        changes would influence different types of individual and 
        corporate income and international capital flows.--The 
        predicted size of the effects of any given proposal on 
        individual and corporate income and international capital flows 
        can vary significantly depending on the structure of the model 
        and various assumptions about the strength of behavioral 
        responses built into the model. Ultimately, the importance of 
        these types of responses would have to be determined from 
        existing empirical economic evidence. The Joint Committee staff 
        is continuing to enhance these components of the MEG model, and 
        to experiment with other modeling approaches.

        4. LSensitivity of results to behavioral assumptions and model 
        structure.--The effects of tax policy changes on the long-term 
        growth of the economy depend on how the tax policy affects 
        after-tax returns to labor and capital, and on how the 
        suppliers of this labor and capital respond to these changes. 
        The way a model treats costs of labor and capital varies 
        significantly across different types of models and can result 
        in significant disparities in the results.

        5. LConsistency of treatment between revenue and spending 
        proposals.--If macroeconomic effects are accounted for with 
        respect to revenue proposals, it can be argued that a similar 
        approach is necessary with respect to spending proposals. If 
        the issues of consistency of treatment for Federal budget 
        scorekeeping purposes are not addressed, then two equivalent 
        policies would have different projected effects on the economy 
        depending upon whether the policies were achieved through the 
        tax system or through Federal spending. It would be necessary 
        to coordinate with the CBO staff to address these possible 
        issues of consistency.
Future plans

    The goal of the Joint Committee staff efforts is to improve the 
quality and accuracy of the revenue estimating process. Because of the 
sources of uncertainty and differences in modeling outlook with respect 
to the issues that have been identified, Ways and Means Chairman Bill 
Thomas and the Joint Committee staff have invited a ``blue ribbon'' 
panel of macroeconomic modeling experts to review the Joint Committee's 
work and make suggestions both for modeling improvements and for the 
type of information that should be included in these analyses.
    In the near term, the objective of the Joint Committee 
macroeconomic modeling project is to provide background information 
about the range of likely economic feedback effects of major tax 
proposals, including an explanation of the areas of greater and lesser 
uncertainty. The Joint Committee staff has identified several areas for 
improving modeling capacity, particularly in improving the links 
between the Joint Committee microeconomic tax simulation models and 
macroeconomic models. Work is underway on several specific enhancements 
to labor supply and consumption modeling within the MEG model to 
improve this linkage.
    In addition, the Joint Committee staff is in the process of 
soliciting input from other macroeconomic modeling groups on the MEG 
model and suggestions for future directions for modeling improvement. 
This process would include discussions with the CBO on baseline 
assumptions and appropriate expenditure interactions. Another component 
of this process will involve producing a series of working papers 
describing key technical features of the MEG model and using the model 
to estimate the longer-run macroeconomic growth effects of several 
types of tax proposals. The papers will be circulated to other tax and 
macroeconomists for purposes of stimulating discussion on the validity 
of the Joint Committee analysis, which will be used to inform further 
refinements to the model.
    In the near future, the Joint Committee staff expect to be able to 
produce comparative analyses of the long-term growth and associated 
revenue feedback effects of major tax proposals, and to attach 
``macroeconomic feedback notes'' containing this analysis to revenue 
estimates of those proposals for which such a note is clearly 
indicated. This analysis would include a description of the major 
assumptions used to produce the analysis, as well as a discussion of 
the degree of certainty associated with the results.
Conclusion

    It is important to reiterate a point that was made at the beginning 
of this testimony. The revenue estimating process should provide 
Members with consistently accurate estimates of their proposals. The 
difficult issues presented in developing the ability to incorporate 
macroeconomic effects in revenue estimates should not be minimized. 
While the Joint Committee staff remains committed to improving the 
revenue estimating process by assessing the potential macroeconomic 
effects of major tax legislation, these issues must be addressed in a 
manner that is accepted by expert economists. To do otherwise would 
undermine the integrity of the revenue estimating process and could 
reduce, rather than enhance, the accuracy of the Joint Committee staff 
revenue estimates.
                                 ______
                                 

   Attachment A--Selected List of Revenue Estimating Methodological 
      Publications of the Joint Committee on Taxation (1990-2001)

Joint Committee on Taxation, Explanation of Methodology Used to 
        Estimate Proposals Affecting The Taxation of Income From 
        Capital Gains (JCS-12-90), March 27, 1990.

Joint Committee on Taxation, Tax Policy and the Macroeconomy: 
        Stabilization, Growth, and Income Distribution Scheduled for 
        Hearings Before the House Committee on Ways and Means on 
        December 17-18, 1991 (JCS-18-91), December 12, 1991.

Joint Committee on Taxation, Discussion of Revenue Estimation 
        Methodology and Process (JCS-14-92), August 13, 1992.

Joint Committee on Taxation, Discussion of Revenue Estimation 
        Methodology and Process (JCX-31-92), August 4, 1992.

Joint Committee on Taxation, Methodology and Issues in Measuring 
        Changes in the Distribution of Tax Burdens (JCS-7-93), June 14, 
        1993.

Joint Committee on Taxation, Written Testimony of the Staff of The 
        Joint Committee on Taxation Regarding the Revenue Estimating 
        Process for the Joint Hearing of the House and Senate Budget 
        Committees of the 104th Congress on January 10, 1995 (JCX-1-
        95), January 9, 1995.

Joint Committee on Taxation, Methodology and Issues in the Revenue 
        Estimating Process Scheduled for a Hearing Before the Senate 
        Committee on Finance on January 24, 1995 (JCX-2-95), January 
        23, 1995.

Joint Committee on Taxation, Membership of the Joint Committee on 
        Taxation Revenue Estimating Advisory Board (JCX-29-95), June 
        29, 1995.

Joint Committee on Taxation, Description and Analysis of Tax Proposals 
        Relating to Savings and Investment (Capital Gains, IRAs, and 
        Estate and Gift Tax) Scheduled for a Public Hearing Before the 
        House Committee on Ways and Means on March 19, 1997 (JCX-5-97), 
        March 18, 1997.

Joint Committee on Taxation, Joint Committee on Taxation Tax Modeling 
        Project and 1997 Tax Symposium Papers (JCS-21-97), November 20, 
        1997.

Joint Committee on Taxation, Background Information Relating to the 
        Joint Committee on Taxation (JCX-4-99), February 3, 1999.

Joint Committee on Taxation, Testimony of The Staff of The Joint 
        Committee on Taxation Before the Committee on Ways and Means 
        (JCX-82-99), November 10, 1999.

Joint Committee on Taxation, Appendix I to JCX-82-99: NIPA and Federal 
        Income Tax Receipts Data (JCX-83-99), November 10, 1999.

Joint Committee on Taxation, Background Information Relating to the 
        Joint Committee on Taxation (JCX-1-00), January 12, 2000.

Joint Committee on Taxation, Background Information Relating to the 
        Joint Committee on Taxation (JCX-24-01), April 10, 2001.

                                 

    Chairman HOUGHTON. Thank you very much, Ms. Paull. Mr. 
Coyne?
    Mr. COYNE. Thank you, Mr. Chairman.
    Ms. Paull, the Congressional Budget Office (CBO) considers 
the dynamic effect of tax legislation enacted into law when it 
recalculates its baseline each year, but your testimony 
indicates that the Joint Committee includes some behavioral 
responses--is that your testimony here--when you provide the 
Committee with your estimates as well?
    Ms. PAULL. Yes, we do. For example, if you were--I gave the 
example of increasing the excise tax would reduce consumption 
and therefore reduce the amount of purchases, sales of those 
products. Another example would be we would incorporate the 
changes in investment strategies that individuals might 
undertake with respect to, let us say, a change in the capital 
gains tax rate or in expansion of interest of tax-free bonds, 
things like that.
    Mr. COYNE. Why did the Joint Committee on Taxation's 
analysis use a 10-year period rather than a year-by-year 
approach in estimating?
    Ms. PAULL. Well, we have not--our estimates today do not 
include the macroeconomic feedback effects or these dynamic 
effects. What we are attempting to become capable of but we 
have not provided this yet--that is what this panel of advisers 
is going to help us on--is to look over the overall 10-year 
period and provide some supplemental information to our 
traditional estimates. That information will be discussed with 
these advisers, and we will try to formulate a set of 
information which we think would rise to the level of accuracy 
that we think would be useful for Members to consider along 
with any proposed changes in the law.
    Today, we do our estimates on a year-by-year basis, but the 
reason why you would want to do the supplemental information 
over a longer timeframe, it is because these macroeconomic 
effects would take a long time--there is a lot of disagreement 
within the economists as to the timing and the magnitude of 
these effects, but it would take a long timeframe to realize 
some of the effects.
    Mr. COYNE. Why did your analysis of the entire bill, the 
tax bill, the most recent tax bill, why did you evaluate the 
entire bill rather than on a provision-by-provision basis of 
the bill?
    Ms. PAULL. Well, we did provide our traditional revenue 
estimates on the entire bill on a provision-by-provision basis 
over 10 years because, while the House has a 5-year Budget Act, 
the Senate has a 10-year budget requirement. In addition to 
that, at the request of--under the House rule of--I believe it 
was the Budget Committee Chairman, but I am not positive of 
that--we included a footnote in last year's revenue table that 
indicated, not quantifying in any way, but that the marginal 
rate cuts that were in the bill would have some positive long-
term economic effects on the economy investment savings.
    Mr. COYNE. Could you describe for us a macroeconomic 
feedback note? Just in your words how do you describe what that 
is?
    Ms. PAULL. Well, as I said, that is something that--the 
kind of analytical information that we would want to provide to 
the Congress would be broken down into sectors of the economy 
as to--depending on the type of tax proposal that we are 
analyzing, it would be broken down into, for example, would the 
proposal encourage people to work more or less? Would it 
encourage them to save more or less, businesses invest more or 
less? What the overall impact--well, perhaps what the impact on 
interest rates might be, a number of factors, depending on the 
proposal, and give you some detailed analytical information 
about that.
    Again, as I said, we would like to utilize this panel of 
advisers that we were just in the process of setting up a 
meeting with to help us formulate that kind of analysis.
    Mr. COYNE. Would that be more than the concept of the 2001 
footnote? Would it go beyond that?
    Ms. PAULL. Yes, it would.
    Mr. COYNE. You would. Thank you.
    Chairman HOUGHTON. Ms. Dunn.
    Ms. DUNN. Thank you, Mr. Chairman.
    I think this is such an interesting topic. I think we have 
got to be nuts to be so fascinated by the scoring system, and 
yet I think if we hear anything discussed behind the scenes it 
is how frustrating it is to try to get an accurate score on a 
bill.
    I have been working with death tax repeal for years now, 
and I still don't believe that we do enough to take into 
consideration the positive aspects of what would happen if we 
truly had predictability in scoring on the death tax. In fact, 
recently I have heard a number of groups in our debate on tax 
permanence on the Floor a couple--few weeks ago, talk in terms 
of how much the Treasury Department would lose between 2011 and 
2020 if death tax were made permanent. They say $4 trillion.
    What is your view of long-term predictability of our 
economy, and how it would be affected by some of these tax 
relief proposals? Is there any validity to them, or are we 
still at the point where we think truly a 5-year estimate is 
much more realistic than anything beyond that time?
    I would ask you both to answer that.
    Mr. HUBBARD. I think you have raised a very important 
question, and the reason that I suggested using an impact 
statement is to get at exactly that. If you take the 
President's tax bill that became the tax law, our estimates are 
that, over the long term, say over the next 20 years, that 
probably adds to GDP growth about 15 basis points a year. Now 
that may not sound like much, but over a 10-year period it is 
very, very large indeed, and it is very important I think for 
all of you to have that information.
    The same, frankly, would be true for the death tax which, 
as you know very well, is a capital tax. It discourages savings 
and investment. The kind of information you get in these long-
term impact statements would be very useful, I would think.
    Ms. PAULL. Well, I think one of the hurdles--we have done 
extensive review of the economic research in this area, and one 
of the kind of challenges for us to be able to provide more 
information to you is there is probably agreement about a 
number of kinds of tax proposals, what the effect would be over 
the long term. The magnitude of those effects, there are wide 
ranges, and kind of the timing of those effects are--you know, 
for example, Mr. Hubbard just mentioned 20 years. We are 
operating within a 10-year budgetary regime as all we are 
capable of right now, but some of these effects really go on 
outside 10, 20, 30 years, and that is what a lot of the 
economists are able to work on--you know, predict at this 
point.
    So that is what our challenge is, to find a comfort zone 
where there is enough economic work that you can find some 
consensus for a reasonable range here and the magnitude and the 
timing, and that is what we are trying to work towards.
    Ms. DUNN. I think the other end of that is important, too. 
In the example I cited, the permanent repeal of the death tax, 
there are impacts that occur early on that are positive because 
of predictability, phasing out, making permanent the repeal of 
that tax.
    For example, there would not be a need to plan beyond 
January 1, 2010, if we knew that it were going to be permanent, 
to purchase expensive life insurance policies or to spend great 
deals of time with certified public accountants, CPAs, lawyers, 
and so forth. So where we seem often to take into consideration 
the negative impact of these proposals, we don't always add in 
what can happen at the front end.
    I simply wanted to say, Ms. Paull, I am very happy to hear 
you talk about that Committee of macroeconomists who I hope are 
going to be looking at this whole area, and we will be 
interested in their report after the end of the year.
    I would say specifically, Mr. Hubbard, that the impact 
statement used to supplant the scoring of a bill would be very 
interesting to me. I am wondering, how you would see this work? 
Would you do it automatically or would you take a look at 
whether an impact statement, a behavioral look at a piece of 
legislation would be worth it, or would you simply be directed 
by the wish of some Member of Congress or a Committee that 
wanted something scored that way?
    Mr. HUBBARD. Well, of course, that decision would be yours. 
My advice would be that you do it only for large proposals and 
where you think it would make a difference.
    Let me give you a concrete example. Suppose you were trying 
to decide between a proposal to give everyone rebates every 
year in perpetuity or to cut marginal tax rates. The cash flow 
implications of those two proposals on revenue may look very 
similar, but an impact statement would reveal to you that the 
growth effects of cutting marginal tax rates are substantially 
greater, so that might be information you would want to have in 
making your decision. So, I would do it for big proposals and 
where you think it can highlight a contrast for you.
    Ms. DUNN. Mr. Chairman, I am sorry to push into my 
overtime, but I guess the point I would make, it is very tough 
to get scores out within months. I have a letter in, I think, 
Ms. Paull, to your organization, Joint Tax, of last February 
requesting a score that we still haven't gotten. So I am sure 
that it is seasonal and it has to do with whether the models 
are prepared or not, but I worry that we are asking for 
something that is simply going to increase the length of time 
for us to get the score. What do you think about that, Ms. 
Paull?
    Ms. PAULL. Well, many of the kind of proposals that we 
score from the standpoint of our normal estimating process have 
a very narrow scope to them, and they are really not the kind 
of proposals--they are very narrowly focused, they are small--
that would have any significant macroeconomic feedback effects. 
You really need to focus the macroeconomic feedback scoring or 
analysis on major proposals, and so I don't think it should 
hold up.
    I regret that you have a proposal in that hasn't been 
estimated for that length of time, but it should not hold up 
our normal estimates in any way.
    Ms. DUNN. Thank you, Mr. Chairman.
    Chairman HOUGHTON. Thanks, Ms. Dunn. Mrs. Thurman?
    Mrs. THURMAN. Thank you, Mr. Chairman and thank the two 
witnesses for being here today.
    Ms. Paull, I was looking at your testimony, and it is my 
understanding that I guess it is House rule 13 that actually 
allows us to include a dynamic estimate of the changes in the 
Federal revenue after the enactment of a piece of legislation. 
Has that been used before?
    Ms. PAULL. On occasion, we have had requests. I would say 
my experience is, I think, it has only been once since I have 
been in this position. It is----
    Mrs. THURMAN. Do you know when that was?
    Ms. PAULL. For last year.
    Mrs. THURMAN. Okay. For the tax----
    Ms. PAULL. The way the rule is written, it is a request of 
the Majority Leader who then is to request the Chairman of the 
Joint Committee, I think, because the House Member--it is 
Chairman Thomas--to ask for that estimate. It is supplemental 
information, and, as I said, we have not provided any sort of 
detailed, quantified kind of estimate pursuant to that rule. We 
have been doing all this work to become capable pursuant to 
that rule, and we have provided the kind of thing that was 
reflected in the footnotes to the major tax bill last year on 
occasion to Members who have asked for an estimate of a 
significant type of a tax proposal.
    Mrs. THURMAN. I appreciate that, because I noticed in your 
conclusion in your testimony that there really are a lot of 
factors that it sounds to me that have not really been settled 
as to why these macroeconomic issues may be a problem in some 
cases. Because you mentioned what still needs to be resolved in 
any of this is predicting the effects of business cycle, 
fluctuations, predicting the potential response of the Federal 
Reserve Board, predicting how the macroeconomic effects of tax 
policy changes would influence different types of individual 
and corporate income, sensitivity of results to behavioral 
assumptions, and then the consistency of treatment between 
revenue and spending proposals.
    So, there are a lot of outstanding issues in using this 
particular way of looking at a tax proposal, and so I 
appreciate the fact that you have brought that to our attention 
that there are still some problems in it. It sounds like to me 
that there are a lot of people still having a rather lengthy 
discussion about these issues.
    Ms. PAULL. Yes, this is an area that is fraught with some 
problems and uncertainties, and that is why I think even Mr. 
Hubbard is not suggesting that these estimates--this kind of 
estimate be incorporated in our year-by-year estimates but be 
provided in a supplemental manner. When you provide it in a 
supplemental manner--that is what we are going to explore with 
this panel of advisers--it is possible that the range of views 
could be quite broad and so----
    Mrs. THURMAN. Right. I think Mr. Hubbard----
    Ms. PAULL. That would be supplemental information for you, 
but it would be difficult to, you know, have a pinpoint saying 
this is what we think the answer is.
    Mrs. THURMAN. I think what Mr. Hubbard said was it is of 
great value, but you need the range of estimates so that we, as 
policymakers, would have the opportunity to have that 
discussion.
    Mr. HUBBARD. I think that is right.
    I would like to caution you, though, that because something 
is difficult doesn't mean you shouldn't do it. Surely the 
microeconomic estimates are subject to the same uncertainty and 
disagreement. So while there is a range, I wouldn't want to 
leave you with the impression that dynamic scoring is, in and 
of itself, harder to do than the traditional.
    Mrs. THURMAN. I am not suggesting that. What I am 
suggesting, though, that what I do believe you are saying, and 
you can tell me yes or no, is that it is better for us to have 
a range of these estimates, to have what is currently being 
done and others and not just for the politics of making it 
sound better. Is there really good policy and understanding of 
what action we are taking and the consequences of that action? 
I mean, it would seem to me that for us, being kind of the 
people supposed to look at the taxpayers, that it is important 
for us to have a wide range of these analyses in front of us, 
versus just one. Is that----
    Mr. HUBBARD. I would certainly agree with that, absolutely.
    Mrs. THURMAN. Okay. The second thing I would ask very 
quickly, and Ms. Paull knows this because I brought it up in 
the last markup, an issue on some bond issues. I am just 
curious as to why we don't use this on some spending bills, 
because certainly there would be economists that would argue 
that you stimulate the economy through providing jobs and that 
jobs may be through building roads, infrastructure, water and 
sewerage, those kinds of things. In your consideration are you 
looking at this as far as spending bills as well?
    Ms. PAULL. Well, that would be a question for the CBO that 
does the scoring for the spending. So, you know, I think that 
is a legitimate question. If you are going to do one part of 
the budget, why not do the other part of the budget? Again, I 
think that you would have to be looking at something that is of 
major significance, as opposed to just every single kind of 
smaller spending proposal. Otherwise, there would be such a de 
minimis impact on the economy, but that would be something I 
would ask the CBO.
    Mrs. THURMAN. Mr. Hubbard, do you have a comment on that?
    Mr. HUBBARD. I would certainly agree with what Lindy just 
said, but add something as well.
    I think in the tax area there is much more agreement on 
effects of major tax policies. There has to be a range, to be 
sure. Economists can never really agree on any one thing. If 
you were to say, what is the effect of moving to a consumption 
tax, that is a question that is easier to answer than what is 
the effect of, say, a large increase in early childhood 
education. So I would caution you, it is a much more difficult 
exercise, although I certainly agree with you in principle.
    Chairman HOUGHTON. Mr. Portman.
    Mr. PORTMAN. Thank you, Mr. Chairman.
    Mr. Hubbard, I appreciate your being here, and, Lindy, 
thank you for all the help you give us. I have another meeting 
I am late for. I just wanted to express quickly a couple 
thoughts and then yield to Mr. Crane.
    First is, we should also be talking about revenue raisers, 
because I think the macroeconomic effects, sometimes we don't 
consider, and historically, when you look back, some of our 
revenue raisers have not raised revenue that they were intended 
to.
    The second point is, I love the idea of the impact 
statements. I appreciate what the CEA provided for us in 
relationship to the tax relief but also the most recent 
stimulus package, but for those of us who are legislators, we 
need more than that.
    A good example would be tax simplification. Many of us 
believe the alternative minimum tax, AMT, should be repealed, 
for instance, but it is difficult for us to move with 
simplification because of the enormous costs. So having an 
impact statement is wonderful. It gives us something to talk 
about on the Floor. Actually to get it through the process and 
to deal with the budgetary impact, I think we do need to figure 
out a way to get the macroeconomic impact incorporated into the 
estimate.
    With that, I yield to Mr. Crane.
    Mr. CRANE. Thank you very much. I appreciate the 
opportunity to be here, even though I am not a Member of the 
Subcommittee. I have been very fascinated with this entire 
subject, and I have had communications, as Lindy knows, with 
her office with a view to trying to effect some potential 
reforms.
    I remember vividly when we had witnesses testifying back in 
1978 on the impact of cutting the capital gains rate at that 
time and all of the experts came in and told us what a revenue 
loser it would be, and it turned out to be a big revenue 
raiser. Then I remember in 1981 when we cut the capital gains 
rate yet again, and this time even Reagan represented those 
anguished when the question was put: what might the revenue 
impact be? Well, it might be a loser, but still we think it is 
a good thing. It was an even bigger revenue raiser than the cut 
in 1978 was.
    This is the sort of thing that, from our standpoint here in 
trying to contemplate what might be moves in the right 
direction and most beneficial to our economy, we all on the 
Committee on Ways and Means are very much involved in. That is 
why we really need the input from you experts, and I don't want 
to try to dictate guidelines. You are the ones that have better 
insights certainly than I do on this subject.
    I was wondering if there is anything, Lindy, that you are 
working on in the way of new macroeconomic models with a view 
to giving us estimates in the future.
    Ms. PAULL. Mr. Crane, I only summarized my testimony--the 
written testimony. We do describe in our written testimony the 
model we have been working on for macroeconomic estimation. 
This model is one that we hired an outside consultant to work 
carefully with us, and we have devoted two to three of our 
Ph.D. economists to work on this model since 1997 when we held 
the symposium. So we are in the process now of--we have 
recently invited a number of outside experts on macroeconomic 
modeling to come in and review our work, the work that we have 
been doing in-house, and to help us make any improvements that 
need to be made to this and also help us design the kind of 
output, the kind of information that we could provide to the 
Committee as a supplement to our normal revenue estimates.
    We also have access through subscriptions to three other 
models that we would use to supplement the information, but 
this model is designed to work with our big other macro--micro-
Internal Revenue Servicemodels so that it would provide a 
really--I guess it is really well-suited toward the kinds of 
needs we would have in the future for being able to do some of 
this kind of work.
    Mr. CRANE. Well, I hope that you might let Members 
currently review some of the methodology using the score bills, 
but to tell you and our distinguished guest here today, Mr. 
Hubbard, that--what resources you folks need in your efforts 
please communicate with us, because what you do is critically 
important to the job we have to do.
    I want to thank the Chairman for letting me come here not 
as a Member on the Subcommittee and participate in this. Thank 
you, and I yield back the balance of my time.
    Ms. PAULL. Thank you, Mr. Crane. I know we have had 
continuous discussions about this over the years.
    Chairman HOUGHTON. Thanks very much, Phil. Mr. Johnson?
    Mr. JOHNSON. Thank you, Mr. Chairman. Hi, Lindy.
    You know, the IRS decided to issue regulations regarding 
employee stock purchase plans and that would overturn 30 years 
of tax policy by requiring payroll taxes be paid on the plans. 
If the IRS simply decides to reverse itself and return to 
previous policy, there is no revenue impact. If the court 
subsequently overturned the rates, there is no revenue impact. 
Yet, if the Congress is forced to legislate to overturn the new 
IRS position, the score is costing $23 billion.
    When the House passed the Retirement Security Act, there 
was no real objection to the House spending $23 billion because 
no one seems to believe the fairy-tale revenue estimating that 
accompanies it from you guys. Remember, these are regulations 
that have never gone into effect, yet we are being told it will 
cost $23 billion to overturn them. I wonder if you could 
explain that, either one of you or both.
    Ms. PAULL. Well, Mr. Johnson, as I think I indicated at the 
markup, these are unusual situations, but whenever we are faced 
with them, I don't think anybody likes the result.
    Mr. JOHNSON. That isn't the question. Why are you doing it 
that way, if nobody else thinks it costs anything?
    Ms. PAULL. Well, the reason we are doing it that way is 
that the starting point for our estimates, our revenue 
estimates, is whatever present law is. While the IRS may not 
have enforced the law or maybe they could interpret it a 
different way, they now have assessed the law to be that an 
employer should be collecting the payroll taxes because there 
is no specific exemption from the payroll tax for this item. 
Even in the absence of their regulations, because we did face 
this issue in the Senate about a year ago, we would have scored 
this the same way.
    In the absence of a pronouncement by the IRS saying there 
is no tax, we will never collect any tax on the stock options. 
Basically, the way the law works is, unless there is a specific 
exemption from the payroll tax, employers are supposed to pay 
the payroll tax. That is the state of present law today.
    Mr. JOHNSON. I understand, but you don't consider whether 
the revenue is coming in or not in your estimates.
    Ms. PAULL. Well, the revenues are not coming in right now 
because the IRS said they won't collect any revenue until 
beginning next year. There was a somewhat de minimis but a 
mixed bag of revenue that was being collected before the IRS 
made that announcement. So there has been some tax--I would 
have to say that it was erratic--but some tax that has been 
collected on stock options in the past.
    Mr. JOHNSON. Do you have anything to add, Mr. Hubbard?
    Mr. HUBBARD. No, I will leave it to Lindy to----
    Mr. JOHNSON. Well, she is smarter, I think, on that issue.
    Let me ask you another one. There are times when the tax 
consequences of current law preclude companies from engaging in 
certain business transactions. These same transactions, 
however, can be performed without any tax consequence by 
nonprofit organizations in government entities. By not 
providing a level playingfield, I think in the long run the 
government loses revenue because only nonprofits are doing the 
work, rather than tax-paying businesses, and I will give you an 
example.
    A good example is a bill regarding Contributions in Aid of 
Construction, or CIAC, when privatizing to the U.S. Department 
of Defense (DoD) water treatment facilities which is House bill 
2130. Right now, the DoD can donate existing water treatment 
facilities to municipal governments and other nonprofits that 
renovate or replace the equipment and then run the new facility 
for the DoD. That is privatizing. However, if DoD tries to 
privatize a water treatment plant using a for-profit business, 
in other words, if they go out and offer this property to 
everybody, the IRS says the contribution of the rundown 
facility is a taxable transaction.
    For-profit businesses believe they can outperform 
traditional water treatment facilities in the long term, even 
with the burden of paying income taxes which they don't object 
to. The problem is, they can't start the process with a huge 
tax burden being taxable of the gift. If this initial layer of 
taxes is not lifted, I don't think businesses can compete. 
Would you like to comment on that, and tell me what the tax 
consequences are for us for private enterprise?
    Ms. PAULL. Yes. Mr. Johnson, this is a consequence of, 
actually, the law. I don't think it is an IRS ruling.
    When you make a contribution, it was really designed toward 
developers. When you make a contribution of the infrastructure 
to a private facility, the private facility is to include in 
income the amount of the infrastructure. In this case a water 
treatment facility, they would depreciate it, and then get 
depreciation deductions over the life of the property as they 
were earning the income. That is a----
    Mr. JOHNSON. Well, most of these are----
    Ms. PAULL. Consequence of the tax law.
    Mr. JOHNSON. Most of these are 20 or 40 years old, so they 
have been depreciated out probably already.
    Ms. PAULL. Well, but they were owned, you are saying, by 
the DoD, so there----
    Mr. JOHNSON. Yes.
    Ms. PAULL. They wasted away, is what you are saying.
    Mr. JOHNSON. Yes.
    Ms. PAULL. So then if they are not valued very high, then 
there wouldn't be much different income derived from----
    Mr. JOHNSON. Are you saying it is okay to tax for-profit 
but not----
    Ms. PAULL. No. I am saying that is a feature of the tax 
law.
    Mr. JOHNSON. Can we change that law, and what is----
    Ms. PAULL. So you need to change the law----
    Mr. JOHNSON. What is it going to cost us to do it?
    Ms. PAULL. I don't----
    Mr. JOHNSON. Would there be an impact----
    Ms. PAULL. Remember that estimate off the top of my head, 
but I believe we had a----
    Mr. JOHNSON. Is there an impact?
    Ms. PAULL. Yes, there is.
    Mr. JOHNSON. So, you are going to charge us to change the 
law, even though nobody is making any money off of it right 
now. It is another case like we just discussed. There is no 
money coming in from that right now----
    Ms. PAULL. The----
    Mr. JOHNSON. Because we give it to somebody, you won't----
    Ms. PAULL. The facilities have some value, I assume. The 
facilities have some value, or there would be no tax 
consequence.
    Mr. JOHNSON. Well, Mr. Chairman, I hope we will look at 
that. You understand what I am saying. Two instances here where 
we are costing us to make the law change when there is no cost 
at all, and it is scored wrong. Maybe we need to write some 
rules on how to score, I don't know.
    Thank you very much. I appreciate your time.
    Chairman HOUGHTON. Thanks, Mr. Johnson. Mr. Pomeroy?
    Mr. POMEROY. Thank you very much, Mr. Chairman.
    As you know, there is no one in Congress that I hold in 
higher regard than you, and so I am glad you are having this 
hearing.
    That said, the hearing--the subject matter of the hearing 
and the conclusion announced by our Joint Tax Committee expert 
does cause me some concern. One year ago, we passed a tax plan, 
and now we are hearing that there is going to be a vote on 
debt-limitation increase within 13 months of enactment of that 
tax plan. At the time, no one was talking about any need for 
debt increases. The forecasts--you were in this room, Ms. 
Paull, you heard them as well as I did--were quite different 
than what has happened.
    To me, this discussion is like getting lost using a road 
map, and so you want to get a different road map. You are still 
lost, and I think we are heading the wrong way, and I don't 
care how you figure it. We are still heading the wrong way 
fiscally, and I think that the truth is in the numbers.
    You indicate in your testimony there have been some 
improvements made since 1995 in our ability to do this, but I 
do want to cite two individuals that testified at a January 10, 
1995, hearing. I hold them both in high regard and want us to 
reflect briefly on their testimony at that time.
    Ken Kies, former Joint Tax Committee Chief of Staff, 
testified problems on dynamic scoring including macroeconomics 
effects of revenue proposals but not spending proposals would 
cause a serious inconsistency. Most revenue proposals would 
have little or no macroeconomic consequence. Complexity and 
lack of consensus on macroeconomic effects would undermine 
credibility of estimating process and, finally, macroeconomic 
analysis would reduce pressure to address the Federal deficit 
problem.
    Now, even though we may have gone some ways in terms of 
modeling proficiencies since 1995, are those issues still with 
us today, Ms. Paull?
    Ms. PAULL. Sure. Those issues are still present. They are 
still described in our testimony.
    Mr. POMEROY. They are. I note six that you outline. I will 
talk about them in a minute.
    Alan Greenspan is quoted from the same hearing as saying, 
and I quote: ``Unfortunately, the analytical tools required to 
achieve dynamic scoring are deficient. In fact, the goal 
ultimately may be unreachable. Accordingly, we should be 
especially cautious about adopting technical scoring procedures 
that may be susceptible to overly optimistic assessments of the 
budgetary consequences of fiscal actions. In summary, the 
current relatively straightforward scoring system has served us 
well in many respects.''
    It almost undeniably produces a more conservative number 
than dynamic scoring, and, therefore, if we are to try to plan 
for downside scenarios, that result may not be altogether a bad 
one from a policy standpoint.
    Ms. Paull, do you think so?
    Ms. PAULL. Well, I think what was suggested in my testimony 
was to provide supplemental information that supplements our 
estimates. Our estimates are still based on the baseline that 
is provided to us by the CBO, and there is uncertainty in that 
baseline, especially nobody can predict the downturns in 
business cycles.
    Mr. POMEROY. In fact, I note--I guess I said six. I think 
it is five. You indicate predicting the effects of business 
cycle fluctuation, predicting the potential response of the 
Federal Reserve Board to fiscal policy changes, predicting how 
the macroeconomic effects of tax policy changes would influence 
different types of individual and corporate income and 
international capital flows, sensitivity of results to 
behavioral assumption and model structure, and, five, 
consistency of treatment between revenue and spending 
proposals.
    You indicate all of those are very real problems, still, in 
terms of building a dynamic scoring model, all of which I agree 
with, and then you come up with a conclusion I don't agree 
with. So let us build a dynamic scoring model.
    You have seen this Committee grab whatever, a number, you 
will be so well aware, because the number is the creation of 
you and your staff. It is basically a theoretical abstraction 
based upon modeling that may or may not have accurate 
assumptions built into it, but once the dollar is out there, it 
is as though we have a dollar in hand, an absolutely concrete 
figure. We commit based upon that figure. That is certainly 
what happened in the tax vote last year.
    Do you really think having one number and, yet, an 
additional number--one number based on already difficult 
modeling to project and another number based upon even more 
speculative, subjectively based dynamic scoring--is going to 
help our process?
    Ms. PAULL. Well, to the extent--I think you came in after I 
testified. These are issues that we are going to be exploring 
with a broad spectrum of macroeconomic experts, modeling 
experts, and we will see if you can come up with a consensus to 
try to deal with each of these difficult issues.
    These difficult issues are not going away. That is the work 
we are going to be doing this year, and we would invite you to 
participate, if you wish, in that. You know, this is an issue 
that I think, to the extent we can find useful information that 
is--that meets a standard of accuracy, that we would like to 
provide it to the Congress as a supplement to the estimates 
that we already provide. That is what we will be working on 
this year with this panel of advisers, to see what kind of 
information could be developed that would produce a range of 
accuracy based on the economic literature and based on the work 
of, really, experts in the field.
    Mr. POMEROY. Thank you, Ms. Paull.
    Mr. Chairman, thank you. I believe it is a start down a 
very slippery slope indeed. I will be happy to be involved in--
not in coming up with a new modeling formula, I guess that is a 
little beyond my abilities, but I will want to keep an eye on 
what you are doing.
    Ms. PAULL. Sure.
    Chairman HOUGHTON. Thanks, Mr. Pomeroy. Mr. Ryan?
    Mr. RYAN. Thank you, Mr. Chairman. I, too, am not on the 
Subcommittee, so I want to thank you for allowing me to 
participate in this conversation. I just flew in from 
Wisconsin.
    So, Ms. Paull, I missed your opening testimony, and you and 
I have talked about this quite a bit in the past, and to me it 
all goes down to whether or not we have the truth. When we 
legislate here, hopefully we are legislating in pursuit of the 
truth. If we don't know what the consequences, the real-life 
consequences, are of the policy we pass through this Committee 
and into law, we end up exacerbating misinformed public policy.
    So the idea of dynamic scoring is really a well--well-
regarded, well-known, well-honed skill. It is no longer voodoo 
scoring, voodoo economics. It actually is more appropriately 
called reality-based scoring. It seems to me that the 
importance is in pursuit of the truth and in pursuit of making 
sure that when we measure not just tax relief or tax cuts, but 
maybe revenue-generating things that don't end up generating as 
much revenue because they adversely affect personal behavior, 
it seems that we want to find the truth.
    We want to make sure that we, as accurately as, possible 
measure all of the policies coming out of this Committee. 
Because there is so much academic literature available on this, 
there are so many in the field of economics who have worked on 
these issues, who work on this, who run very well--
sophisticated models that are continually updated, that at the 
very least, it would be important to have transparency in our 
scoring system so that we can engage in a dialog. We can 
continue to improve, we can continue to make progress on 
pursuing the truth with respect to our economic measuring 
sticks.
    So, by involving and incorporating those who are also 
participating in this process, those who in the private 
sector--whether it be the Wharton people or whoever gets 
involved in this process--at the very least transparency, I 
think, is important.
    Lindy, you and I have talked about this, and last summer I 
raised a number of questions about capital gains tax cuts, 
capital gains policy, the scoring of it, and about the change 
in stock prices that result from tax changes and how the change 
in stock prices affects the change in economic growth, and the 
change in GDP growth ends up changing revenues.
    The fact that we hadn't been incorporating that process--a 
very, very well-documented process--has led to very, very off 
scores, very, very misleading scores which impact public 
policy. You asked me to put to you in a memo--I am not trying 
to play ``gotcha'' here, Lindy, but you asked me to give you my 
concerns in a memo, to which you would respond.
    I sent the memo last August; we followed up a number of 
times. We haven't heard from Joint Tax yet on our concerns on 
some of those fundamental scoring issues. I understand you 
talked about your Blue Ribbon panel. Maybe that is where these 
issues are going to be discussed.
    I have two questions. One, I don't know if you want me to 
go through all of the concerns I raised in that memo on capital 
gains scoring. I would like to get your--I would just like to 
get a commitment that you will respond to that.
    Ms. PAULL. Yes. You have my commitment.
    Mr. RYAN. Okay. Soon, please.
    Ms. PAULL. Okay.
    Mr. RYAN. It has been a while.
    Also, what do you hope to get out of this Blue Ribbon 
panel? Is this Blue Ribbon panel--is it going to be like the 
1997 JCT Symposium where we got a lot of good testimony, where 
we heard about the new macroeconomic modeling techniques, where 
we saw how much more accurate they were; or is it going to be a 
panel that actually produces results?
    Is there a time line? Is there going to be more 
transparency coming from this? Will there be specific 
recommendations that will be implemented from this, or what?
    Ms. PAULL. Those are great questions. Let me tell you--let 
me describe to you what we have in mind and also invite you to 
participate, if you wish.
    We will be holding two sessions, at the moment, with these 
advisers, one in June and one in September. The first session 
will involve a detailed description of the model that we--the 
framework that we purchased, and then all of the modeling work 
we did basically in-house since then, so that there is a 
discussion about--kind of critiquing the work that we have 
done. At that same session we planned to have done a simulation 
and will present the simulation to the advisers as food for 
thought also.
    Mr. RYAN. From your current model?
    Ms. PAULL. Yes. Then we would be requesting some input on 
the kind of information that would be useful to be provided as 
a supplement in a lot of detail as opposed to, yes, this would 
have a positive or negative effect on various factors, but in a 
lot more detail.
    Then we would be doing a second simulation during the 
summer--many of these are academics where it is difficult to 
get them to meet in the summer, so early September is when we 
would be following up--and we would be, at the first meeting, 
asking for input on what additional simulations they would like 
to see us do. We would be presenting that information at the 
follow-up session so that--and, again, having a full discussion 
and critique about the results or the ranges of results and the 
different, alternative kinds of assumptions you might be 
making. Then we would be publishing the results of that. We 
would then be making improvements.
    I think that the staff that has been working on this 
project, all but one participated in 1996-1997, were benefited 
greatly from the discussion of the modeling, having experts in 
the room discussing modeling issues, and bringing to their 
attention the various types of research and concerns that we 
would be raising with them. So, it is a nuts-and-bolts kind of 
a session, not just reviewing other people's work.
    Mr. RYAN. It seems like it is a very constructive thing to 
do, but would you agree that it would be even more constructive 
to do it on an ongoing basis, meaning----
    Ms. PAULL. Sure.
    Mr. RYAN. Releasing the data, releasing your R-squares, 
releasing all of the supporting data you have when you release 
a score, and releasing all of the supporting data within the 
model on an ongoing basis so that the public--so that those who 
are engaged in econometrics can send you suggestions, can 
evaluate the modeling.
    Maybe then you will be able to mark and put your model up 
against other models to see from now on whether or not they are 
closer in reaching the truth than other models. If not, maybe 
you can learn some from the models that have been more 
accurate.
    If you go back historically, I think you will find some 
other models more accurately predicted revenue effects from 
different changes in tax policy. So, I think that it would be 
helpful to have more transparency at Joint Tax, and at the 
Treasury Department, of course, and maybe we can learn 
something from these other models that have historically been 
shown to be a little bit more on the mark on revenue changes 
than the models we use here at Office of Tax Analysis, OTA, and 
at Joint Tax.
    Ms. PAULL. Well, Mr. Ryan, we have provided detailed 
descriptions of our models periodically, and we haven't updated 
that recently, and we plan to. I am not sure if you want 
something different from--I mean, those are quite detailed----
    Mr. RYAN. Something that is accurate.
    Ms. PAULL. Models. The problem here is, of course, we are 
available to discuss with anybody the assumptions that underlie 
our estimates, but we have a small staff.
    Mr. RYAN. I know.
    Ms. PAULL. We produce over 4,000 estimates a year in recent 
years.
    Mr. RYAN. I know you do. You guys----
    Ms. PAULL. For us it is very labor-intensive work for 
people who don't care--all they want is their number--for us to 
do that kind of detailed analysis with respect to every 
estimate that we produce.
    Mr. RYAN. I realize that. That is why I have been patient 
since my August memo to get a response.
    Ms. PAULL. Yeah. This estimating--building this model is 
really oriented toward large proposals as opposed to a lot of 
the kind of day-to-day stuff that we do.
    Mr. RYAN. That's right, but these large proposals impact 
the day-to-day numbers, the day-to-day estimates, and they 
impact whether or not we are getting closer to reality or the 
truth. We will not. Then we will make better decisions.
    That is more of a statement than a question. I see my time 
has run up.
    Lindy, I appreciate what you guys do. You guys work very 
hard down there. Every time I leave the building late at night, 
you guys are still there. So you have great staff, and you have 
hardworking, intelligent people. It is just the concern that 
every time we conduct tax policy, I fear that there is a bias 
against incorporating the real effects, and we miss the truth 
sometimes.
    We all can improve, and I just hope that we can have open 
minds to improve our models and to have transparency, so we can 
have a good exchange to try and better perfect what we do here. 
That is all.
    So thank you. Appreciate it, Mr. Chairman.
    Chairman HOUGHTON. Thank you, Mr. Ryan.
    Well, I guess I am the last one on the panel. I would like 
to ask you a couple of questions.
    Mr. Hubbard, when you were a Professor of Economics at 
Columbia University--I think it was 1995 we began discussing 
this dynamic scoring system--what has changed since those days?
    Mr. HUBBARD. Well, I think the topic remains very, very 
important. There are always new developments in economics, but 
to go back to Mr. Ryan's question, I think that what has 
changed is an increasing indication of interest and willingness 
on the Committee for this sort of information.
    Chairman HOUGHTON. Ms. Paull, you were what in those days?
    Ms. PAULL. I was working for the Senate Committee on 
Finance.
    Chairman HOUGHTON. Did you get into this issue at all?
    Ms. PAULL. Yeah. I think that interest in this issue is 
shared among certain Members of the Senate Finance Committee, 
as well, sure.
    I met Mr. Hubbard--the first time I met him was over the 
capital gains tax back in the early nineties, when he was 
serving at the Treasury Department--or maybe it was the early--
late eighties, serving at the Treasury Department, and the 
Senate Finance Committee was considering whether or not the 
capital gains tax was too high. He went and did a thorough 
briefing on all of the economic literature in that area, which, 
you know, there is--there are selected topics in revenues where 
there is significant economic research, but it does not cover 
all of the areas that we have to cover when we are doing 
revenue estimating. There are some very significant areas, and 
we keep abreast of that research, and the research is ongoing.
    Chairman HOUGHTON. Are you possibly saying that the 
difficulty with dynamic scoring is that the science, or the 
number of people required to do the analysis, is not there?
    Mr. HUBBARD. I don't think, Mr. Chairman, that dynamic 
scoring, in and of itself, is harder or subject to greater 
uncertainty than the estimates that you see. I think, though, 
that what you wanted is just additional information. I think 
you have a right and, I would humbly suggest, a responsibility 
to know the economic-growth consequences of the policies that 
you consider. So, I think it is something you should well 
pursue.
    Chairman HOUGHTON. One of the things that always intrigued 
me when I was first on the Committee on Budget is that, as 
contrasted to business where no business, I think, can exist 
without the static scoring system because you couldn't get a 
return on investment, and payback you wouldn't know, but you 
would spend X amount of money, and yet, you wouldn't really 
record if that was fruitful money invested.
    That was always very difficult for me to understand, 
because our job as Members of this Committee, or as Members of 
the Budget Committee, is to see whether there is a proper 
return for the citizens of this country. One of the things that 
I am always interested in is trends in impact and effect, 
making sure that we are on the right track, and I am not sure 
that we coordinate properly.
    For example, I would be very happy, whether it is static or 
dynamic scoring, to be able to have regular reports in terms 
of, you know, you are doing an appropriation on the XYZ 
project. This is what happened last year, this is what happened 
5 years ago, this is what the result was. I don't think we mesh 
our information together.
    Do you have any comments to make on that?
    Ms. PAULL. Well, I think those are very important oversight 
functions, and typically what happens as opposed to having a 
comprehensive oversight plan, we end up picking and choosing 
which things we are going to look at by sending the GAO out to 
look at it or whatever.
    I mean, our function is principally oriented toward the 
legislative process and not looking back at what is already 
achieved. So, your Subcommittee is an oversight Subcommittee 
and often needs to use other resources to be able to do that, 
because we are so focused and busy all the time with the 
legislative process.
    I think you have a valid point and not enough attention is 
paid sometimes to whether or not tax proposals are achieving 
the purpose for which they were designed.
    Chairman HOUGHTON. I am comfortable operating on 1 year 
budgets, but if you have got to go 20 years, you take a look at 
a 1-year budget, and you can say there is 90-percent 
probability. For a 5-year budget, maybe it is 50 percent. For 
10 year budgets, maybe it is 20 percent; 20 year budgets is 20 
percent.
    I don't think we evaluate those things. You give us the 
figures, and we are not interacting with you, and I think that 
is a real mistake.
    Ms. PAULL. Well, it is hard to go backward and evaluate, 
especially in the tax arena, as to--because the tax law, there 
are so many things that can affect particular--sometimes it is 
a very narrowly crafted provision, and you can look and see 
what has happened. Often there is interaction with a lot of 
other things, and it is hard to pinpoint what the effect was of 
any one particular item.
    So, it is difficult for us to go back and look and see if 
we did a good job estimating a particular item, especially when 
you are talking about the individual--overall individual income 
tax, where a lot of changes have been occurring recently.
    Chairman HOUGHTON. I always remember the story of--I think 
it was John Gardner--in 1965, when Medicare went in, and they 
estimated 25 years out, 1990, that Medicare would cost 
something like $12 billion for the country. I don't know how 
many hundreds of billions of dollars--if we had had dynamic 
scoring, would we have done a better job?
    Ms. PAULL. No.
    Chairman HOUGHTON. Why not?
    Ms. PAULL. Well, I think that one is one of the legendary--
there are a number of legendary items--that is, we just--the 
estimations. This was not out of our office, so I can't really 
give you a full flavor of why. This is something that was 
estimated by the CBO, I believe, or maybe it predates them 
even.
    I would just note to you that on the revenue side, every 
year, we update our big models, the individual income tax 
model, the corporate income tax model, and with the latest 
information and with the latest macroeconomic estimates of the 
forecast of the CBO. I think every year our modeling does 
improve, and that is, I think, the most you can expect from 
this kind of a process that is not precise. The consistencies 
and the improvements all lead you in a direction that 
provides--that is providing you with more accuracy.
    I think that is what is happening on the spending side also 
at the CBO. They are much better at estimating the proposals 
now than they were then, but brand-new programs, just like in 
the tax law, brand-new tax credits--let us say, for something 
brand-new, there is a high level of uncertainty because you 
have no experience in estimating those kind of things. It is 
good to put a sunset on them and reevaluate over a period of 
time.
    Chairman HOUGHTON. Mr. Hubbard, are there other countries 
that do a better job of forecasting or estimating than we do?
    Mr. HUBBARD. Well, the truth is, it is hard everywhere. 
Economists here are just as two-handed as they are anywhere 
else in the world. It is very hard to forecast receipts 
generally, not so much because of dynamic scoring issues, 
macro-issues, as shifts in relationships.
    For example, what is the relationship between receipts and 
taxable income because of executive compensation or other 
issues, all of these are factors? So, I think it is very 
difficult around the world.
    Chairman HOUGHTON. If you were setting up a scoring system 
and your projection was for 10 years, wouldn't you tell those 
people who would appropriate the money--let's say, 3 years out 
into the 10 years--if there had been some major disruption, 
that there was a disruption and those figures were going to be 
dramatically impacted?
    I don't see the give-and-take.
    Mr. HUBBARD. Well, I think, to go back to Lindy's answer, 
that would be an appropriate oversight function. It is not 
clear that it is so much a revenue function, as going back and 
back-casting, if you will. It is difficult, because many other 
things have also changed in the economy, but I agree that both 
for spending and for receipts, you would like some sense that 
the forecasts you have been given at the beginning were true.
    Chairman HOUGHTON. Is on track or not. Right.
    Do you have any questions? No?
    Do you? Any other comments you would like to make?
    Well, I thank you very much for your testimony. There being 
no further business before the Subcommittee, the hearing is 
adjourned.
    [Whereupon, at 3:20 p.m., the hearing was adjourned.]
    [A submission for the record follows:]
 Statement of Wilbur A. Steger, Ph.D. and Frederick H. Rueter, Ph.D., 
         CONSAD Research Corporation, Pittsburgh, Pennsylvania

              DYNAMIC SCORING EXPERIENCE: TAX BILL OF 2001

1.0 Introduction
    The purpose of this report is to describe an analytical modeling 
effort performed by CONSAD Research Corporation, to design, implement, 
and analyze policy analysis models, the results of which were to be 
utilized by parties involved and interested in Hearings before the 
Senate Finance Committee's Subcommittee on Taxation and IRS Oversight 
on ``Preserving and Protecting Family Business Legacies''. This report 
draws heavily on Dr. Wilbur A. Steger's ``Testimony before the Senate 
Finance Committee Subcommittee on Taxation and IRS Oversight on 
`Preserving and Protecting Family Business Legacies' '' (March 13, 
2001), as well as an earlier Final Report, ``The Federal Estate Tax: An 
Analysis of Three Prominent Issues'' (February 7, 2001), prepared by 
CONSAD for the Food Marketing Institute. Dr. Steger's colleague and 
Vice President of CONSAD, Dr. Frederick H. Rueter, participated on an 
equal basis in all these efforts; Mr. Scott Kinross, a CONSAD analyst, 
participated throughout, also.
    Many analytic/modeling tools were used in addressing issues. In 
Section 2.0, below, we review the results of macroeconomic (more 
precisely, regional econometric) modeling estimating outcomes--changes 
in regional and national product and employment, and in Treasury 
revenue--resulting from reductions and, then, elimination of the 
Federal estate tax. Relative to such outcomes, other analytic 
investigations have examined changes in liquidity-related vulnerability 
of family-owned businesses due to changes in the estate tax; and the 
prevalence of family-owned businesses in taxable estates. Section 3.0 
analyzes other effects of reducing and/or estimating the estate tax, 
particularly that relating to the growth of unrealized capital gains in 
the hands of heirs, and the related revenue effects.
    The above analyses, and those described below, would be described, 
by some, as ``dynamic scoring'', i.e., reflecting prospective 
behavioral (micro) and aggregative (macro) effects (see statement on 
``Dynamic Scoring'', Kevin Hassett, American Enterprise Institute, May 
2, 2002 for current thinking about and attitudes toward the inclusion 
of such effects on the policy-making process). Section 4.0 discusses 
the implications of the experience described in this paper for future 
dynamic scoring efforts.
2.0 Summary of Macroeconomic and Related Effects of Reducing or 
        Eliminating the Estate Tax
    There is a lengthy and complex history to deliberations regarding 
the estate tax and capital gains. The March, 2001, Senate Subcommittee 
on Taxation and IRS Oversight was unique, however, since they focused 
on the economic effects on family business and workers of reducing or 
eliminating the estate tax, and of the direct and side effects of 
freeing locked-in capital markets.
    First, CONSAD addressed the issue of the magnitude of the problem 
and explored, explicitly, who is impacted. We were able to find a more 
accurate measure for defining the financial attributes of an estate 
that includes a family-owned business. The summary data that the 
Internal Revenue Service (IRS) has compiled from estate tax returns 
indicate that the assets of family-owned businesses are sizable 
portions of the estates reported on a substantial percentage of taxable 
estate tax returns. Rather than being less than 500 in a typical year, 
we estimated the total number of taxable estates that consist largely 
of family-owned businesses likely exceeds 10,000 annually.
    Based on macroeconomic modeling, we found that important economic 
benefits would result from the reduction or elimination of the estate 
tax and, in the context of repeal, changing the basis for taxing 
capital gains. These effects include the following:

         LAggregate economic effects are positive. Currently, 
        many small business owners, and estates with non-liquid assets, 
        must break up their business or holdings in order to raise 
        money to pay their estate tax debts. All sides of the debate 
        agree that this has a considerable disruptive effect on many 
        family businesses, including farmers. Proposals to reduce or 
        eliminate the estate tax would make it much easier for these 
        businesses to continue to operate without undue disruption. The 
        research CONSAD has conducted estimates the macroeconomic 
        consequence of the elimination or substantial reduction of the 
        estate tax: i.e., the extent to which these would beneficially 
        affect employment, national income, and economic output. While 
        we did not consider (in that report) the revenue and economic 
        effects of the carryover of basis, as called for in many 
        legislative proposals, we continue to believe that the 
        investment and liquidity-enhancing effects of the elimination 
        or reduction of the estate tax will increase the survivability 
        of family business and their positive effects on local and 
        regional economies. Our research also confirms the benefits of 
        speeding these effects, e.g., through immediate reduction or 
        elimination, particularly if and as economic conditions worsen. 
        Here, CONSAD used an economic forecasting model developed by 
        Regional Economic Models, Inc. to estimate the effects of the 
        resulting changes in those peoples' consumption and investment 
        spending on the aggregate economy: this is one of the few 
        macroeconomic models that take account of differences in 
        regional productivity, energy sources and uses, and industrial 
        structure. The estimates indicate that eliminating the tax 
        would result in an initial surge in gross domestic product 
        (GDP), the aggregate value added for all firms in all 
        industries throughout the economy. Then, by the fourth year 
        after the repeal, the benefits from reallocating resources 
        toward investment, tempered by monetary policy aimed at 
        averting inflationary pressure, would stabilize and yield 
        steady growth in value added.
         LRevenue losses will be lower than were initially 
        anticipated. Experts differ on the estimates of the precise 
        revenue consequences of both eliminating the estate tax and 
        changing the tax treatment of capital gains. Our ongoing 
        research appears to indicate that the revenue gain from the 
        correlate change to the carryover basis will yield annual 
        revenue gains beginning at $5 billion and gradually rising to 
        more than $15 billion yearly. The change in basis at death will 
        lead to more revenue gains than are currently contemplated (see 
        below, Section 3.0). Similarly, while we did not estimate the 
        revenue consequences for the Treasury of the macroeconomic 
        effects described immediately above, they would be positive and 
        substantial.
         LPreserving family businesses. Currently, families and 
        estate executors face a complicated set of overlapping tax 
        rules that include the estate tax, capital gains tax, and the 
        gift tax. Many Americans devote considerable time and resources 
        on estate planning to arrange their personal and business 
        affairs in an attempt to minimize their total taxes at death. 
        Unfortunately, without such planning, some estates face an 
        unnecessarily high tax burden that hurts families and small 
        businesses. In the ideal economic model, the simplification of 
        the tax code that would flow from the elimination of the estate 
        tax would result in a clearer picture of expected tax burdens 
        at death, and free up resources now spent on navigating the 
        maze of the tax code.
3.0 Elimination of the Estate Tax and Unlocking Unrealized Capital 
        Gains
    Since the middle of the last century, this subject has enjoyed an 
active history. Not surprisingly, during the early years of the Clinton 
Administration, the President's economic think-tank called for an end 
to the (income) tax exemption for unrealized capital gains held when a 
person dies. This proposal cited an ultimate revenue yield of $5 
billion per year as well as enhanced equity as justifications (Shapiro, 
1992). This marked the approximately fiftieth anniversary of the 
pathbreaking article on this subject--with a similar objective to 
President Clinton's--by the celebrated income tax specialist and 
reformer, Stanley S. Surrey (Surrey, 1941).
3.1 Background and History
    Professor Surrey was destined to bring this important notion, and 
an affirmative assessment of its constitutional validity, to the 
attention of Presidents Kennedy and Johnson while serving as their 
Assistant Secretary of the Treasury for Tax Policy during the 1960s. 
Under President Johnson, a Treasury Department study recommended taxing 
gains as income on a decedent's final tax return. Then House Ways and 
Means Chairman Wilbur Mills, working with Surrey and the principal 
author of this report (Steger, 1957, 1961) during this period, held 
committee hearings on this and closely related income and estate tax 
subjects (Steger, 1959; Heller, 1955). Also during this period, leading 
public finance economists of the day (F.M. Bator, R. Blough, J.K. 
Butters, R.F. Gemmill, J.K. Lintner, L.H. Seltzer, H.M. Somers, L.E. 
Thompson, and others) provided excellent insights into prospective 
economic and equity effects of taxing capital gains as though realized 
at death and/or disallowing the stepped-up basis.
    Most recently (2001), tax expenditure estimates by the Treasury 
Department's Office of Tax Analysis, based on a retrospective analysis, 
were indeed quite high. Conversely, the CBO estimate of revenue gain 
appears to have been lower, as explained below. Such analyses were 
performed using different, but reconcilable, assumptions. The estimate 
in Mandate for Change (Shapiro, 1992), for example, assumed the 
continuation of the current exemption for capital gains on assets 
willed to a spouse or donated to a charity, as well as gains in a small 
business or a farm, and provides additional exemptions (up to $125,000) 
for gains from the sale of a residence.

         LAside from its uncertain but clearly substantial 
        revenue consequences, a variety of economic and equity reasons 
        were advanced for reform of the tax treatment of assets at 
        death (Steger, 1957, 1959, 1961; Surrey, 1941; CBO, 1992; 
        Butters, 1953):
         LReducing the disparity between those who save through 
        an appreciating asset and those whose income is entirely 
        taxable (i.e., the Haig-Simons-Vickery economic concept of 
        taxable income)
         LReducing the incentive for investors to hold assets 
        until death to avoid capital gains taxes (the ``lock-in'' 
        effect), thus diminishing (or preventing) the blocking of 
        otherwise economically efficient investment decisions
         LAssessing a tax on income at death involves adverse 
        consequence for economic incentives and efficiency during 
        lifetime, both for the decedent and their heirs.

    The Bush Administration (2001) appears to have supported the tax 
treatment at death for unrealized gains described in the Kyl-Breaux 
Estate Act of Tax Elimination Act of 2001. (There were similar 
arrangements in other bills.) The proposal allowed every individual to 
continue to step-up the tax basis of assets in his or her estate to the 
fair market value at the date of death, subject to an overall 
limitation on untaxed capital gains of $2.8 million per individual (or 
$5.6 million per married couple). The per-person exemption was to be 
indexed for inflation. The limited step-up in basis would protect small 
estates from any new capital-gains tax liability and reporting 
requirements. Such liability and reporting requirements was to apply 
only to estates with unrealized gains in excess of $2.8 million (or 
$5.6 million in the case of a married couple). Other bills took 
different approaches, also using the decedent's tax basis in one way or 
another.
    Questions have been raised about these unrealized capital gains--
considered together with the degree to which the estate tax is 
curtailed or eliminated:

        1. LWhat is the current magnitude of these unrealized capital 
        gains and their distribution among asset classes?
        2. LWhat would be the revenue effects of various treatments 
        (e.g., degree and method of carryover, phasing, grandfathering, 
        etc.)? How would each variation affect the current estimates of 
        the decrease in tax revenues that would result from repealing 
        the estate tax?
        3. LWhat effect on the economy would result from alternative 
        treatment, in terms of employment and output in specific 
        industrial sectors by state and region. How might these 
        economic effects alter estimates of impacts on tax revenues?
        4. LWhat would be the effect on different demographic groups 
        (e.g., income, age, family type) from each treatment variation?

    CONSAD conducted a preliminary analysis using a regional 
econometric model and associated analytic software and interpretation 
of tax research results to estimate the revenue, economic, and 
demographic consequences of a set of ``what if'' realization patterns 
of these capital gains. This research is ongoing.
3.2 Estimating Consequences
    Consider, for illustrative purposes only, that $15 trillion for 
capital gains (in current dollars) are created and accrued over a 25 to 
30 year ``generation'' of taxpaying earners. This rough estimate draws 
upon research findings made by Steger (1957, 1959) and, thirty years 
later, by Gravelle and Lindsey (1988) that: (a) on average, only 3.1 
percent of the stock of accrued gains are realized in any given year, 
over a 25-year period; and (b) that realized capital gains in each year 
average only 24 percent of the total capital gains accruing to the 
household sector in that year, specifically:

         LApproximately fifteen trillion dollars (more or less, 
        as of late 2001) of unrealized capital gains will become more 
        free and fluid to serve the interests of American businesses 
        and their workers. We have come to know, through research and 
        judgment [Steger, 1957; Gravelle and Lindsey, 1988; Burman, et 
        al., 1997; Auten and Joulfaian, 2001 (forthcoming)] that there 
        is an immense pool of accrued but yet unrealized capital gains. 
        As estimated above, these currently amount to as much as $15 
        trillion, and are growing. Proposals to transition from the 
        stepped-up tax basis for capital gains to the carryover basis 
        will result in increased revenues, partially offsetting the 
        loss in estate tax revenues. The stepped-up basis will, by and 
        large, diminish in importance with the elimination of the 
        estate tax.

    Many economists believe that the majority of capital gains, under 
the current system (with a stepped-up basis), are never realized, but, 
instead, are passed on to heirs with a step-up in basis or given away 
in a tax-free transaction. It would seem that, were unrealized gains 
taxed at current capital gains tax rates, either at death or to heirs 
over their lifetimes, a yearly equivalent of many billions of dollars 
in additional taxable gains might result. How would these complement 
the current revenue of approximately $90 billion for realized capital 
gains?
    During the spring of 2001, CONSAD conducted a new study of the 
economic and revenue consequences of then-current alternative 
proposals, using analytic software and matching databases addressing 
the following issues related to the reduction or elimination of the 
estate tax and its capital gain correlates:

         LFederal government revenue changes (from both the 
        income and the estate tax),
         LChanging patterns of capital gains realization,
         LChanging acquisition and disposition patterns of 
        capital assets.

    The possible economic and fiscal impacts range from relatively 
minor to significant. The purpose of this research was to narrow the 
range of prospective outcomes, such that they would provide information 
helpful in distinguishing among alternative policy options.
    In addition, through the study of the positive aggregate economic 
effects of the elimination of the estate tax (Section 2.0, above, 
employing the most widely utilized regional econometric model), we 
discovered that reducing or repealing the estate tax would free up 
substantial resources for alternative purposes. The heirs of people who 
die would inherit additional funds that otherwise would have been 
collected as taxes. Also, the resources that people now expend (i.e., 
planning costs) to mitigate the consequences of the estate tax would be 
released for other uses. We also discovered that the aggregate gains in 
value added in the majority of U.S. industry substantially exceeded the 
decreases that would occur in the few industries that would experience 
decreases in demand for their services due directly or indirectly to 
the reduction or repeal of the estate tax. This research also 
established the additional benefit, particularly in tight economic 
times, of making the reduction or elimination take place as quickly as 
possible, including immediately. Our ongoing research has altered these 
estimates only slightly while, at the same time, realizing increased 
revenues to the Treasury.
3.3 Interim Results: Incorporation of Behavioral Consequences
    The combination of the estate tax and the stepped-up basis at death 
determine the total tax paid by estates and their heirs. So, 
alternatively, would a system with no tax (at death) on estates and a 
carryover (primarily) of basis. However, just as it took time for the 
current system to settle into a relatively predictable pattern, it will 
take years for any new system to settle into its routine.
    This section summarizes the results that have been produced by the 
model that CONSAD has developed for estimating the changes in 
government revenues that would occur under a number of proposals that 
change provisions of the estate tax, the gift tax, and the generation-
skipping transfer tax. [This draws heavily on research performed by 
Douglas Holtz-Eakin (see References, below).]
    The elimination or phasing-out of these transfer taxes would 
naturally lead to a decrease in government revenues. Our analysis 
indicates that there are several behavioral responses to a change in 
tax structure that would offset at least a portion of the revenues 
forgone.
    In particular, there would be a positive effect on the rate of 
capital gains realizations by older people who currently experience a 
``lock-in effect'' as they age and plan for their demise. If the 
existing step-up in the basis for measuring taxable capital gains is 
replaced with a carry-over in basis, these people will likely realize 
gains at rates similar to those observed for somewhat younger people. 
These extra realizations by prospective decedents would be taxed at the 
capital gains tax rate, and would yield additional government revenues.
    The second behavioral change relates to realizations of accrued 
capital gains bequeathed to the heirs of large estates. These 
realizations would also be taxed at the capital gains tax rate 
throughout the lives of the heirs, adding revenues to the government 
throughout the period after initiation of the carry-over in basis.
    CONSAD has developed a computer model that estimates the effects of 
these behavioral changes and revisions of tax structure on government 
revenues. [A description of the general procedures (translated to a 
computer model) for estimating incremental capital gains realization 
and associated tax revenues under specified realization and carryover 
assumptions is available on request.] The methods and evidence used to 
model each of these effects are discussed briefly below. (The 
associated databases and explanation of the calculations are available 
on request.) Then, the estimates developed for several specified tax 
reform scenarios are summarized briefly.
    Realizations by prospective decedents--The empirical research 
literature suggests that under the current estate tax system the 
wealthy begin to experience a ``lock-in effect'' after age seventy-
five. With the elimination or phasing-out of the tax at death, people 
will lose the incentive to retain the accrued capital gains in 
investments in anticipation of death. Instead, they will be free to 
exercise the opportunity to realize and re-invest accrued capital gains 
at rates similar to those that they were applying earlier in life. Such 
behavior will generate additional capital gains tax revenues for the 
government.
    Realizations by heirs--People who inherit wealth can be expected to 
use that wealth in ways that are similar to the use observed for others 
in similar financial circumstances. In addition, the economics 
literature suggests that inheritances provide windfalls that 
fundamentally change some people's economic behavior, such as their 
participation in the labor force and their willingness to become 
entrepreneurs. The elimination or phasing-out of the estate tax also 
naturally increases the amounts bequeathed to heirs. Initiation of a 
carry-over in basis for measuring taxable capital gains will cause 
these actions and events to yield additional revenues for the 
government.
    Phase-out of tax provisions--Phasing out of the estate, gift, and 
generation-skipping transfer taxes over several years can be 
accomplished in many ways. All of them will involve, at least, 
reductions in the tax rates applied to the values of assets contained 
in the estates, and increases in the amount of assets that can be 
bequeathed without incurring tax liability (the Unified Credit). 
Changes in those provisions of the transfer tax structure will produce 
changes in the average tax rates that effectively are imposed on 
estates of different sizes. In comparison to the current situation, 
estate tax revenues will decline; however, in comparison to immediate 
repeal of the taxes, additional government revenues will be collected.
    Results derived for specified scenarios--In the initial application 
of the computer model, CONSAD has analyzed three scenarios for 
potential changes in transfer tax policy. Two scenarios consider the 
immediate repeal of the estate tax. In Scenario One, repeal is combined 
with a phased-in limitation of the step-up in basis (i.e., a phased-in 
provision of carry-over in basis) over five years. In Scenario Two, 
repeal is accompanied by immediate establishment of a limited step-up 
in basis at the high level proposed in the Kyl Proposal (S. 275). In 
the third scenario, the transfer taxes are phased out over a four-year 
period, after which the taxes are repealed and a limited step-up in 
basis is established at the maximum level specified in Scenario One. 
The government revenues estimated for the three effects throughout the 
ten-year period from 2002 through 2011 for those scenarios are 
summarized in the following table:

 
----------------------------------------------------------------------------------------------------------------
                 Source of Tax Revenues                     Scenario One       Scenario Two      Scenario Three
----------------------------------------------------------------------------------------------------------------
Capital Gains Realizations by Prospective Decedents....      $18.7 billion      $11.5 billion      $17.7 billion
----------------------------------------------------------------------------------------------------------------
Capital Gains Realizations by Heirs....................      $86.2 billion      $70.8 billion      $26.9 billion
----------------------------------------------------------------------------------------------------------------
Estate Tax Revenues during Phase-out...................  .................  .................      $58.5 billion
----------------------------------------------------------------------------------------------------------------
Total Incremental Government Revenues..................     $104.9 billion      $82.3 billion     $103.1 billion
----------------------------------------------------------------------------------------------------------------

    The amounts reported in the table are offsets against the transfer 
tax revenues that would be foregone if the transfer taxes were 
immediately repealed. In response to suggestions by model users, we are 
still refining the estimators that we are using for some calculations. 
Thus, some of the values in the table may change slightly when the 
final calibration of the model is completed.
4.0 Concluding Remarks
    Those who have looked at the policy/budgetary process and the 
history and future of dynamic effects when scoring spending and tax 
bills (e.g., ``Dynamic Scoring'', op. cit.) have not said ``put these 
aside''. Rather, they have focused on better ways for Congress (JCT), 
the Federal Reserve, CBO, et al., to use their revenue estimating 
staffs and what ``information revelation'' practices would accompany 
such changes.
    The technical approaches discussed in this report (Sections 2.0 and 
3.0) found their ways into the above organizations (as well as the 
Treasury, CEA, and NEC)--during the estate tax debates and discussions 
of the 2001 Tax Bill primarily--and, indeed, appeared to have the 
intended effect: to raise questions about ``official'' estimates 
produced and used during the final discussion process. Where the 
behavioral effects--of prospective decedents and/or unrealized gains-
heavy heirs--had been reported in reputable research journals, where 
the modeling software utilizing these finding was transparent and 
available for validation and sensitivity-testing purposes, and where 
these models could be turned over (for use) by parties involved in the 
many (often closed-door) discussions--we believe that such dynamic 
effects had telling consequences, in opening up minds and discussion.
    We believe there is a role--semi-academic, semi-policy analytic--
for such ``entrepreneurial'', informed intrusions into the process. We 
predict these ``intrusions'' will become more welcome with time and 
with increasingly successful instances of behavioral effects/scoring. 
There are two arenas where we believe these instances will occur more 
often:

        1. LThe two way and interactive causality of the personal 
        income tax systems with respect to the size (e.g., wage bill) 
        of the business yielding that income. How income from a 
        business (corporation or subchapter C or S) is taxed leads to 
        more or less savings/income to invest in a business as well as 
        its liquidity position (research by Henry Rosen, James Poterba, 
        and Douglas Holtz-Eakin) and, therefore, the ensuing and 
        affected elasticity of the wage bill (i.e., ``jobs'').
        2. LThe personal tax system's incentive effects (vis-a-vis 
        capital gains and losses) on entrepreneurship opportunities and 
        self-employment investment (Poterba).

    Figures 1 and 2 represent an attempt to describe a general 
framework for subjects where behavioral research could be put to 
unified policy analytic studies; and how CONSAD's work, to date, does 
its technical behavioral scoring work.
5.0 References
    A complete list of references drawn upon for writing this paper is 
available upon request of the longer version of the paper.
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