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This paper was written by Frederick Ribe while he was employed at the Congressional Budget Office. It was undertaken as technical background work in connection with ongoing studies of the Tax Reform Act of 1986.

The author wishes to thank William Beeman, Edward Gramlich, Robert Hartman, Yolanda Henderson, Rudolph Penner, George Perry, Leonard Sahling, Matthew Salomon, and Eric Toder for helpful comments. Rae L. Roy prepared the manuscript for publication.

Edward Gramlich
Acting Director
June 1987
 
 

What effect will the Tax Reform Act of 1986 have on the United States' economy? Will it slow the economic expansion or help it along? Will it raise interest rates? What will be the long-run economic benefits of the act, and how important are they likely to be? This study provides detailed analysis of these questions.
 

SHORT-TERM IMPACTS OF THE TAX REFORM ACT

The paper's estimates of the effects of tax reform over the period 1986-1988 are computed using three small short-run econometric models developed by the author. These models measure the effects of changes in tax provisions on demand in each important sector of the economy. Because these are simultaneous models, the results show not only the direct effects of tax reform on each sector, but also interactions among sectors, and multiplier effects.

The three models differ only in their treatment of business fixed investment: because there is still a great deal of controversy over the correct way to model that sector, this study used three separate approaches imputing varying degrees of sensitivity with respect to tax provisions for business investment. The results from the three models are shown in Summary Tables 1-3.

The most important short-run results are that:

• There is a risk that business fixed investment could be reduced sharply, though temporarily, by the business provisions of the Tax Reform Act. According to one investment model used in this study, the cutback in investment could reach a peak of about 1 1/2 percent of GNP during mid-1987, but the reduction would fade steadily after that.
  
  
• Uncertainty over the behavior of business investment suggests that tax reform could have a range of possible effects on the strength of the economic expansion. According to the estimates in this study, the effect during 1986 and 1987 is likely to be (or have been) at least slightly negative, with the estimates of the effect on the 1987 growth rate of real GNP ranging between -0.05 percentage point and -1.0 percentage point. The negative effects should have worn off by late 1988, however, so that by the end of that year the estimates of the effects on the growth rate of real GNP range from 0.0 percentage point to + 0.3 percentage point.
  
  
• Housing investment is likely to be reduced over the entire forecast period, with the reduction amounting to as much as 0.5 percent of GNP during 1988. The reduction is likely to be concentrated among multiple-family structures, which are especially hard hit by the Tax Reform Act's scaling back of tax benefits to tax shelterers and other business investors in structures. Investment in single-family housing is likely to be affected positively, if at all.
  
  
• Sales of consumer durable goods such as automobiles are likely to be affected positively, in the same way as single-family housing. While the reduction in marginal tax rates and the withdrawal of deductions for sales taxes and some consumer interest obligations will all make purchasing these goods more expensive, this negative effect will be more than offset by the positive impact of the increases in after-tax income that are promised to households as a group by the tax reform.
  
  
• Interest rates are likely to be reduced very slightly--perhaps a tenth of a percentage point--by the effects of the tax reform act in the near term. The range of estimated changes in market rates attributable to the act is from zero to -0.2 percentage point in 1987, and is effectively zero in 1988.

LONG-TERM EFFECTS OF THE TAX REFORM ACT

Apart from its impact during the first few years after enactment, the Tax Reform Act can be expected to have effects that are felt only after several years at least. Although there are several aspects to the long- run economic improvements promised by the act, among the most important is its effect in making the tax code more "neutral" with respect to different types of capital--that is, subjecting different types to effective tax rates that are more nearly equal than under the previous law. This implies that the capital stock should be more productive than before.

This study develops estimates of the output gain from greater tax neutrality using a neoclassical growth model that recognizes five different types of productive capital and the associated effective tax rates. The estimates suggest an output gain from improved neutrality of about 0.1 percent of the economy's present potential output. While this figure appears small, it is consistent with those in other studies. Even at that, the estimate may be overstated because it takes no account of an important nonnutritious that is preserved by the Tax Reform Act: the relatively low effective tax rate on the large stock of owner-occupied housing.

The estimates in the paper were made with an open-economy growth model that takes account of the possibility that some financial capital will stop flowing into--or actually begin flowing out of-the United States in response to changes in taxation and consequent changes in U. S. interest rates. Though the model suggests a net capital outflow in response to the tax reform, this has only a very slight effect on gross domestic product (GDP)--about 0.01 percent of present GNP. The effect on gross national product (GNP) is even smaller.

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