How the GOP Tax Bill Will Affect the Economy

By Parker Sheppard, Senior Policy Analyst, Center for Data Analysis at The Heritage Foundation, and David Burton, Senior Fellow, Roe Institute for Economic Policy Studies at The Heritage Foundation.

The House passed its version of the Tax Cuts and Jobs Act on Thursday, a bill that would reform the tax code by lowering marginal rates for most households, corporations, and small businesses.

The Senate is also working on its own version of the bill. Though the complete details are yet to be finalized, both the House and Senate versions contain enough in common that we can estimate the effect these bills would have on the economy once a new equilibrium is reached. Most of these effects would likely occur within the 10-year budget window.

The following estimates reflect the House bill as reported out of the Ways and Means Committee and the chairman’s mark being debated in the Senate Finance Committee. (The version that the House passed is nearly identical to the bill reported out of committee).

Main Reforms in the Bill

Both versions of the Tax Cuts and Jobs Act reduce the corporate tax rate from 35 percent to 20 percent, reduce tax rates on non-corporate (pass-through) businesses, and increase the present discounted value of capital cost recovery allowances.

The capital cost recovery allowance improvements are primarily a function of a reduced class life for structures in the Senate bill, and higher section 179 expensing thresholds, as well as temporary expensing for machinery and equipment in both the House and Senate bills.

The Senate bill generally lowers the rates on pass-through entities to a greater degree than the House bill.

Long-Run Estimates

The economy and our tax code are complex systems. A complete analysis of any tax reform proposal should reflect that complexity. However, a simple estimate that focuses on the key marginal rate changes is sufficient to give an idea of the magnitude of the economic effects without resorting to complicated models.

The estimates presented here are within a reasonable range of values, based on empirical studies as described below in the methodology section.

We estimate that the House bill would increase the capital stock related to equipment by 4.9 percent, and the capital stock related to structures by 9.1 percent. These estimates are very similar to the comparable projections for the Senate bill (4.6 percent and 10.9 percent for equipment and structures, respectively).

The House bill is projected to boost long-run gross domestic product (GDP) by 2.6 percent, and the Senate version is expected to increase long-run GDP by 2.8 percent. To put that number in perspective, the increase in GDP translates into an increase of $4,000 to $4,400 per household. These results are comparable to other recently published estimates, such as those released by the Tax Foundation and the Council of Economic Advisers.

Both bills only temporarily change the rules for expensing of new investment. We calculated the effects of the bills when the expensing rules are in place and the effects after the expensing changes have expired. Our reported estimates are the simple average of the two, which reflects business’ expectations that the changes in expensing rules may or may not be made permanent at a later date.

If the expensing rules were made permanent, we estimate that GDP would be 3.0 percent higher than baseline under both bills. If the expensing rules were to expire, we estimate the House bill would increase GDP by 2.3 percent and the Senate bill would increase GDP by 2.6 percent.

Methodology

Our estimate is based on a standard neoclassical production function, which shows how the amount of capital and labor used in production determine economic output. When more capital or labor is used in production, output increases.

Our estimates reflect the steady-state values of capital and labor. In the steady state, the capital stock and hours worked per person have reached their equilibrium values because the marginal costs from additional investment and work just equal the marginal benefits, after taxes. However, economic growth continues due to increases in population and technological innovation.

The presence of taxes on businesses and households creates differences between the returns generated by investment and the returns paid to savers, as well as differences between the wages paid by employers and the wages received by workers.

These differences create lost opportunities. Firms don’t invest and households don’t work on projects where the marginal benefit is lower than the amount of the tax. Economists often call this loss dead-weight loss or excess burden.

Our analysis shows the effects of the Tax Cuts and Jobs Act through two channels. The first channel focuses on the demand for financing capital. A firm considering an investment in capital has to weigh the marginal cost of the capital investment against its marginal benefit, which is its projected return. The cost of capital to a firm is a function of the return it pays to equity and debt holders, the rate of depreciation of capital, and the taxes due on that capital. The equation for calculating the cost, originally set forth by Robert Hall and Dale Jorgenson, is referred to as the user cost of capital. Higher corporate tax rates increase the user cost of capital. Additionally, increases in the present discounted value of capital cost recovery allowances decrease the user cost of capital.

The second channel focuses on the supply of labor. When households decide how much to work, they have to weigh the marginal benefit of their after-tax wages against the marginal cost of activities other than work. An increase in after-tax wages increases the benefit to households from forgoing other activities, resulting in additional hours worked.

The lower the corporate tax rate, the greater the number of investment projects that are economically worthwhile, and higher the steady-state level of capital. Similarly, the lower the income tax rate, the greater the number of job opportunities that are economically worthwhile, and the higher the steady-state level of hours worked.

Economic growth would increase temporarily following the passage of the Tax Cuts and Jobs Act as the economy would move to a new steady state with a higher per-capita GDP. The benefits of these reforms would accrue every year as the economy would operate in a steady state with higher GDP into the indefinite future.

Details About How the Estimate Was Conducted

We take the nominal rate of the return to capital to be 9 percent, which is the approximate average annual nominal return on the S&P 500 from 1871 to 2017. Recent yields on Baa corporate bonds have averaged around 5 percent. We take the inflation rate to be 2 percent, which is the value that the Federal Open Market Committee judges to constitute stable prices. Assuming that companies rely on debt for 25 percent of their financing, these values imply a required real rate of return of 6 percent. We assume that interest rates remain the same following the change in taxes.

The marginal tax rates for pass-through entities change with income and type of pass-through entity. We simplify the range of rates and take the current law to have a marginal rate of 28 percent, the House bill to lower the marginal rate to 25 percent, and the Senate bill to lower the marginal rate to 21 percent.

For depreciation rates, we use 0.13 for equipment and 0.03 for structures, which correspond to the average depreciation relative to the current-cost stock of each asset type as reported by the Bureau of Economic Analysis in the period 2006-2016.

The user-cost elasticity of capital describes the percentage change in the capital stock given a one percent increase in the user cost of capital. It also corresponds to the elasticity of substitution between capital and labor in production. The larger this value, the easier it is for firms to change the mix of capital and labor used in production. The standard neoclassical Cobb-Douglas production function implies a value for this elasticity of -1. A recent report from the Council of Economic Advisers notes a consensus in the literature around this value.

The cut in the corporate tax rate only applies to corporations, which hold about 75 percent of private, non-residential fixed assets, according to data from the Bureau of Economic Analysis. The changes in expensing will apply to all firms. Our estimates of the change in capital stock reflect the distribution of capital holdings by legal form of organization.

The output elasticity of capital describes the percentage change in output that follows a one percent increase in capital. We use values of 0.15 for equipment and 0.13 for structures, which are both taken from a paper by Akos Valentinyi and Berthold Herrendorf.

Though both bills maintain the graduated income tax brackets, for simplicity we reduce the several marginal income tax brackets to a single marginal rate. We take a weighted average of the marginal rates according to the proportion of filers in each bracket as reported by the U.S. Census. The weighted changes are dominated by the $15,000-$75,000 bracket, which contains approximately half of households. We take both bills to increase after-tax wages by 4 percent.

We use a labor supply elasticity of 0.3. In a survey, Michael Keane suggests that this is a typical estimate for the labor supply elasticity of individuals. It is also the value used by the Tax Foundation in their Taxes and Growth model.

We use a value of 0.6 for the output elasticity of labor. That value approximately corresponds to the share of labor’s compensation in output.

Additional Considerations

The estimates we report are for our preferred values. Changing the parameters of the model or incorporating additional features will produce slightly different estimates, though they should be within the range of what we report here.

There is some disagreement in the literature about the appropriate value for the user-cost elasticity of capital. However, a relatively recent survey by Robert Chirinko reports a number of estimates in that range, but places more weight on estimates in the range of -0.4 to -0.6. Using these alternative values suggests that the change in GDP due to changes in the cost of capital would be half as large as reported in the table above. We also note that the lower the elasticity of substitution between capital and labor, the higher the increase in labor productivity and wages from additional investment.

Additionally, there is a range of estimates for labor supply elasticity. This range is in part due to differences between labor supply at the individual household level and at the aggregate, economy-wide level. Individuals tend to work around 40-hour work weeks, and may change hours only a little in response to lower taxes. However, lower income taxes are more substantial factors for people deciding whether or not to enter the workforce. Thus, while the micro estimates may place the elasticity of labor supply around 0.3, Edward Prescott and Johanna Wallenius suggest that the aggregate labor supply elasticity is around 3. That elasticity would imply that the effects of the Tax Cuts and Jobs Act on labor supply are 10 times larger than what we have reported in our estimates. However, we choose to use the conservative elasticity value in our estimates.

All of our estimates assume that wages and interest rates remain constant. The changes in the tax code constitute shifts in the demand for capital financing and the supply of labor. Wages and interest rates will only stay constant if the supply of savings and the demand for labor are perfectly elastic. The former is more plausible once the international mobility of capital is considered. The lower the elasticity of these curves, the larger the increase in returns and decrease in pre-tax wages, and the smaller the increases in capital and labor.

This calculation is not meant to substitute for the full analysis of a more detailed model. However, the simplicity of the calculation clarifies the mechanisms at work.

The Tax Cuts and Jobs Act would lower the cost of capital and increase after-tax wages, which would increase the capital stock and number of hours worked, both of which would cause an increase in GDP.

*To read this article in The Daily Signal, click here.


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Trump Can End Congress’ Illegal Obamacare Exemption with the Stroke of a Pen

By John Malcolm, Vice President for the Institute for Constitutional Government and Michael Cannon, Director of health policy studies at the Cato Institute Congress' ongoing failure to repeal Obamacare means ordinary citizens will continue to suffer that law's rising penalties, wage cuts, reduced choice, rising premiums, eroding coverage, administrative burdens, and collapsing markets. But don't worry, members of…

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Trump Is Right. ‘Our Tax Code Is a Giant, Self-Inflicted Economic Wound.’

By Adam Michel, Policy Analyst, Thomas A. Roe Institute for Economic Policy Studies In his second speech in two weeks on the need for tax reform, President Donald Trump again made a strong case, explaining that “our tax code is a giant, self-inflicted economic wound.” This time speaking in North…

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Trump’s Budget Deal With Democrats Will Only Worsen Our Fiscal Situation

By Justin Bogie, senior policy analyst in fiscal affairs at The Heritage Foundation. Late Wednesday night, the Senate released the text of legislation that would provide disaster relief funding and other federal aid for Hurricane Harvey and other 2017 disasters, suspend the debt limit, and extend the National Flood Insurance Program and government…

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Governors Urge Greater Flexibility for States in Creating and Implementing Health Care Policy

By Rachel del Guidice, reporter for The Daily Signal. Five governors—representing both parties and from states across the country—told a Senate committee Thursday that inaction on health care is not an option and lawmakers should look to the states for solutions. Colorado Gov. John Hickenlooper, a Democrat, praised the successes of…

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Trump’s Reversal of Obama Pay Gap Rule Is Good News for Women, Minorities

By Romina Boccia, Deputy Director of the Thomas A. Roe Institute for Economic Policy Studies and Grover M. Hermann fellow at The Heritage Foundation. The Trump administration put a stop this week to an Obama-era rule that would have hurt the wage and employment prospects of all workers, and would have…

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Conservatives Should Take Full Advantage of the Debt Ceiling

By Sutton Truluck, Research Assistant at Heritage Action for America. On Sunday, the Trump administration formally requested Congress pair an 18-month suspension of our nation’s debt ceiling with much-needed emergency spending for Hurricane Harvey relief. Today, President Trump reportedly endorsed the idea of pairing Harvey spending with a short-term suspension…

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Why I and Other Lawmakers Should Live Under Obamacare

By Rep. Ron DeSantis, Republican, representing Florida's 6th District. For seven years, Republican candidates running for every office from president to dogcatcher campaigned on the need to repeal and replace Obamacare. The spectacular collapse of the repeal effort in the Senate revealed that these promises were, at least for some…

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How to Bring Real Stability to the Health Care Market

By Edmund Haislmaier, expert in health care policy and markets at The Heritage Foundation. Following Congress’ failure to enact “repeal and replace” legislation this summer, the new Obamacare buzz phrase for the fall is “market stabilization.” An ad hoc group of House members calling themselves the “Bipartisan Problem Solvers Caucus”…

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As GOP Senators, Governors Pitch Plan to Save Obamacare, White House ‘Can’t Imagine’ Backing Bailout

By Fred Lucas, White House correspondent for The Daily Signal. The White House says it “can’t imagine” supporting an Obamacare bailout, even as some Republican senators and governors are urging boosting federal subsidies to insurance companies to stabilize the endangered Obamacare exchanges. The Senate Health, Education, Labor and Pensions (HELP) Committee…

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VIDEO: Michael Needham discusses Harvey aid and the debt ceiling

Heritage Action CEO Michael Needham discussed the debate on America's debt ceiling and relief funding for Harvey on Fox News Sunday September 3, 2017.…

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VIDEO: Dan Holler on Harvey spending package

Heritage Action Vice President Dan Holler discusses the Hurricane Harvey spending package on Fox Business's Varney & Co. September 5, 2017.…

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Budget Reconciliation: A Viable Path for CHOICE Act Reforms

By Norbert Michel, Director, Center for Data Analysis at The Heritage Foundation. One of the big unfinished items on this year’s Congressional agenda is financial regulatory reform. The House passed the Financial CHOICE Act, a major financial reform bill in June. But the Senate has yet to offer a companion bill, and it is pretty…

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3 Ways the US Tax Code Is Killing Our Economy’s Potential

By Sondra Clark, Managing Director of Communications and Grassroots at Heritage Action for America. President Donald Trump, Speaker Paul Ryan, and Senate Majority Leader Mitch McConnell told the American people that if they gave Republicans the chance to govern, pro-growth tax reform would be their major legislative priority in 2017.…

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VIDEO: Michael Needham discusses tax reform

Heritage Action for America’s CEO Michael Needham discusses tax reform on Bloomberg TV.…

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Trump Says Tax Reform Could Create ‘Millions and Millions of New Jobs’

By Fred Lucas, White House correspondent for The Daily Signal. President Donald Trump hit his campaign themes of bringing back American jobs and raising wages in launching his quest for tax reform, while blasting special interest loopholes. “Let’s put, or at least try to put, the partisan posturing behind us…

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OPINION: The key to passing tax reform: Keep it simple, stupid

By Stephen Moore, Distinguished Visiting Fellow for Project for Economic Growth at The Heritage Foundation. One of the most enduring lessons from the ObamaCare fiasco is that to win a political battle, it is best to keep the message simple. If there are too many moving parts to a plan, if…

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Conservatives Must Oppose Obamacare Bailouts

By Sutton Truluck, Research Assistant at Heritage Action for America. Last month, Senate Republicans failed to deliver on their seven-year promise to repeal and replace Obamacare. Understandably so, many conservatives were left demoralized. Millions of Americans remain stuck with a failing health care law—due in part to Republicans inability to…

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Taxes, Regulations Hurt Economy

By David W. Kreutzer, Ph.D, Senior Research Fellow, Labor Markets and Trade at The Heritage Foundation. If bigger government, higher taxes, larger subsidies, more regulations and double-digit minimum wages led to better middle-class incomes, the U.S. would be experiencing the fastest wage growth in its history. However, they don’t, and…

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VIDEO: Dr. Feulner discusses tax reform and Trump, Congress.

The Heritage Foundation’s President Dr. Ed Feulner discusses tax reform and the relationship between President Trump and Congress on Fox Business Network.…

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How the Senate’s baseline budget could make or break tax reform

By Romina Boccia, fiscal and economic expert at The Heritage Foundation, and Adam Michel, policy analyst at The Heritage Foundation. Tax reform is one of the most important legislative priorities for Congress and the administration this fall. Good tax reform will unleash economic growth, creating greater opportunity and prosperity for all…

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This Key Reform Must Be Central to Any New Tax Plan

By Salim Furth, Research Fellow in Macroeconomics at The Heritage Foundation, and Adam Michael, Policy Analyst in the Thomas A. Roe Institute at The Heritage Foundation. As Congress and the president move toward consensus on tax reform, one key reform should remain the centerpiece of any plan that moves forward: making…

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VIDEO: IRS Rehires 213 Employees

213—that’s how many employees the IRS rehired after they were dismissed for falsifying documents and avoiding paying their own taxes. How does this happen? To view this video on The Daily Signal Facebook page, click here.…

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Why Bernie Sanders’ Single-Payer Health Care Bill Would Be a Disaster

By Robert E. Moffit, senior fellow in The Heritage Foundation's Center for Health Policy Studies. Senate Republicans’ failure to enact a health reform bill has created a big policy vacuum, and liberals in Congress and elsewhere are eager to fill it. Their solution: Move to a “single-payer system.” That anodyne…

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Over 45 Conservatives to Congress: Support the Employee Rights Act

Dear Members of Congress: On behalf of our organizations and the millions of Americans we represent across all fifty states, we encourage you to co-sponsor H.R. 2723, the Employee Rights Act, sponsored by Rep. Phil Roe. This important bill represents the first major update to federal labor law in seventy…

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Business Owner Legislative Strategy Call 08/17/17

Yesterday conservatives working in the business owner community all came together for our monthly Legislative Strategy Call. During the call, we heard from Heritage Action’s Wesley Coopersmith, Policy Manager, and Matt Lauer, Grassroots Director.  Wesley walked through updates on the state of tax reform, legislation to establish a budget, and health care reform.…

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Tax Reform for Investment and Jobs

By Adam Michael, Policy Analyst for the Thomas A. Roe Institute at The Heritage Foundation. Fixing a quirk in the U.S. tax code would let businesses add new jobs and increase economic growth immediately. The remedy, known to economists as “expensing,” lets businesses deduct from their taxable income the full value…

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Corporations, Democrats Join Forces to Block Trump Nominee to Run Export-Import Bank

By Fred Lucas, White House correspondent for The Daily Signal. The business community of South Carolina is pressuring Republican Sens. Lindsey Graham and Tim Scott to oppose President Donald Trump’s nomination of a critic of the Export-Import Bank to run the institution. Thus far, the most vocal critics of the…

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Farmer Faces Multimillion Dollar Fine For Plowing Fields Without Government’s Permission

By Amy Swearer, visiting legal fellow at the Meese Center for Legal and Judicial Studies at The Heritage Foundation. This week, a federal judge will determine whether to levy a multimillion-dollar fine against John Duarte, as requested by the Department of Justice. Duarte’s wrongdoing? Plowing fields without first asking the permission of the…

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America Is Heading Straight Into Its Most Avoidable Crisis Ever

By Justin Bogie, senior policy analyst in fiscal affairs at The Heritage Foundation, and Chase Flowers, member of The Heritage Foundation's Young Leaders Program. In the looming shadow of another debt limit debate, Congress should stand firm and demand spending controls before increasing the debt limit again. Most people are familiar…

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Add Homebuilders to the List of Industries Hurt by Tariffs

By Tori Whiting,  Research Associate in the Center for Free Markets and Regulatory Reform at The Heritage Foundation & Robert Bellafiore, Member of the Young Leaders Program at The Heritage Foundation. New data show that protectionism is taking a toll on the confidence of homebuilders. Last month, homebuilder confidence hit its lowest reading since…

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These Obama Regulations Make a Strong Case for Tax Reform

By Adam Michel, Heritage Foundation Policy Analyst & Jacob Lubenow, member of the Young Leaders Program at The Heritage Foundation. Congress is pivoting to tax reform, which if done correctly, should replace a list of draconian Obama-era regulations that went to extraordinary lengths to keep American companies from leaving the U.S.…

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A Conservative View of Trump vs. Amazon

By Dan Holler, Vice President of Heritage Action For America Amazon’s successful business model is “destroying department stores and retailing all over the country,” President Donald Trump told radio host Hugh Hewitt last year. How should free market conservatives interpret the president’s continued critique of Amazon? That question becomes particularly important as…

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VIDEO: What a Tax Cut Would Mean For You

  The Heritage Foundation’s President Ed Feulner discusses what a tax cut would mean for you on Fox Business Network.…

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How the Latest GOP Health Care Bill Stacks Up

By Edmund Haislmaier, Heritage Foundation Health Care Policy Expert After last month’s disappointing failure to roll back Obamacare’s damage, senators are now reflecting on how best to proceed. One approach reportedly under consideration is a bill put together by Sens. Lindsey Graham, R-S.C.; Bill Cassidy, R-La.; and Dean Heller, R-Nev.…

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Food Stamp Reform is Necessary for the Budget and Compassionate for the Poor

By Danielle DiQuattro Back in 1996, Congress passed a law adding work requirements to the federal government’s largest cash-welfare program. Although this was a step in the right direction, reforming one program is merely incidental when trillions of dollars have been spent on means-tested welfare programs that have proven to be ineffective…

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Here Are 7 Implications of Ending Obamacare’s Cost-Sharing Reduction Payments

By Edmund Haislmaier, Heritage Foundation Health Care Policy Expert In the wake of Congress’ failure to pass Obamacare repeal and replace legislation, the Trump administration is reportedly debating whether to stop paying Obamacare’s “cost-sharing reduction” subsidies to health insurers. Those payments are the subject of a lawsuit brought two years…

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