Tax Cuts and Jobs Act

How Would Reforms Affect the U.S. Economy?

April 12, 2024

Key Takeaways

  1. The Partial and Full Extension scenarios would lead to a temporary boost in real GDP growth due to increases in aggregate demand. The Clausing-Sarin scenario, on the other hand, would lead to a temporary decrease in aggregate demand, slowing real GDP growth.

  2. After approximately five years, however, these direct demand effects would fade, with the two Extension scenarios leaving the economy on a (slightly) slower real growth path and Clausing-Sarin leaving it on a faster real growth path in the long run, largely as a result of increases in business investment.

  3. Reductions in federal borrowing under Clausing-Sarin would lead to persistently lower interest rates relative to baseline, while increases in borrowing would lead to higher interest rates under both Full and Partial Extension.

In this section, we present estimates of how the reform options would each affect macroeconomic aggregates such as GDP, inflation, and interest rates, as well as the feedback effects that any changes in economic growth would have on revenues. To produce these estimates, use the FRB/US macroeconomic model, an open-source general-equilibrium model of the U.S. economy used by staff at the Federal Reserve since 1996. We further note that the Budget Lab’s macroeconomic modeling efforts are a work in progress, and we plan to refine our approach in the future.

It is important to emphasize that the magnitudes of all estimated macroeconomic effects, as well as their timing, are highly dependent on our assumptions about the response of monetary policy to fiscal shocks (both temporary and permanent). This is especially true in the case of interest rates, since in the FRB/US model the response of interest rates to changes in the federal deficit is driven almost entirely by the response of the Federal Reserve to changes in fiscal variables (revenue and outlays) driving the change in the deficit. (In other words, there is no independent “crowd out” in the FRB/US model due directly to changes in federal borrowing.) In the results presented below, we assume that the Federal Reserve follows an inertial Taylor rule in setting interest rates,1 and that the equilibrium real federal funds rate (r*) adjusts dynamically. (For a detailed explanation of our use of FRB/US for dynamic revenue estimation, see here.)

Effects on Macroeconomic Aggregates

As shown in the figure below, the Partial and Full Extension scenarios would lead to a temporary boost in real GDP growth due to increases in aggregate demand. The Clausing-Sarin scenario, on the other hand, would lead to a temporary decrease in aggregate demand, slowing real GDP growth. After approximately five years, however, these direct demand effects would fade, with the two Extension scenarios leaving the economy on a (slightly) slower real growth path and Clausing-Sarin leaving it on a faster real growth path in the long run, largely as a result of increases in business investment.

The changes in GDP growth mean that in the short-run, the level of GDP is higher under some form of TCJA extension, but in the long-run it is higher under Clausing-Sarin.

The figure below, meanwhile, shows that the three scenarios would have consistent effects on aggregate inflation: the two Extension scenarios would leave the economy on a slightly faster path of price growth relative to baseline, while the Clausing-Sarin proposal leads to slower inflation in both the short and long run.

A key difference between the scenarios is their effects on interest rates. As shown in the figure below, reductions in federal borrowing under Clausing-Sarin would lead to persistently lower interest rates relative to baseline, while increases in borrowing would lead to higher interest rates under both Full and Partial Extension.

Footnotes

  1. Empirically, monetary policy rules with inertia tend to fit historical policy rates more closely than rules without inertia. See e.g., Figure 1 of Carlstrom and Fuerst (2008). This characteristic of inertial rules has strengthened since the Great Recession and the increasing importance of the binding zero lower bound. Carlstrom, Charles T. and Timothy S. Fuerst. “Inertial Taylor Rules: The Benefit of Signaling Future Policy.” Federal Reserve Bank of St. Louis Review, May/June 2008, 90(3, Part 2):193-203. https://files.stlouisfed.org/files/htdocs/publications/review/08/05/part2/Carlstrom.pdf