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How Would Each Reform Affect the U.S. Economy?

Key Takeaways

  1. Other than the full FSA reform scenario, each option would increase deficits. In the short run, the associated increase in aggregate demand leads to a temporary boost in real output.

  2. We expect that the Federal Reserve would respond to higher deficits with by increasing interest rates. This increase dampens investment and results in a slightly slower growth path in the long run. The opposite dynamic is true for the full FSA, which reduces deficits.

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, we 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. (For a detailed explanation of our use of FRB/US for dynamic revenue estimation, see here.) 

In principle, expansions of the Child Tax Credit affect both aggregate supply and aggregate demand:

  • On the supply side, reforms to the CTC affect work incentives through changes in marginal tax rates.
  • On the demand side, reforms to the CTC affect households’ after-tax income, leading to changes in their demand for goods and services.

Importantly, in our use of the FRB/US model, we limit ourselves to the demand-side effects of the policy changes we study and do not currently account for the effects on labor supply and earnings discussed in the previous section. Additionally, because the FRB/US model reflects only limited heterogeneity among households, the model may understate effects on the demand side if lower-income households have a higher marginal propensity to consume out of income than the average U.S. household. We should 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 also important to emphasize that the magnitudes of all macroeconomic effects, as well as their timing, are highly dependent on our assumptions about the monetary policy response to fiscal shocks (both temporary and permanent). We assume that the Federal Reserve follows an inertial Taylor rule in setting interest rates, and that the equilibrium real Federal funds rate (r*) adjusts dynamically.1

Effects on Macreoconomic Aggregates

As shown in the following figure, all reforms except for the full FSA would lead to small, short-run increases in real GDP growth due to increases in aggregate demand. The FSA, on the other hand, would lead to a temporary but small decrease in aggregate demand, slowing real GDP growth in the short run. After approximately five years, however, these direct demand effects would fade and the policies would look largely similar with respect to GDP growth, although the FSA would boost GDP growth very slightly in the longer run.

The changes in GDP growth mean that in the short run the level of GDP is slightly higher under the non-FSA reforms, while in the long run it is slightly higher under the FSA. While this difference in real GDP does not reflect the increases in employment or earnings in the microeconomic feedback section discussed above, it does emphasize the importance of considering pay-fors when thinking about long-run investments in support for families.

The figure below, meanwhile, shows that the different scenarios would have very small effects on aggregate inflation in both the short and long run. 

All reforms would have small but persistent effects on interest rates. As shown in the following figure, reductions in federal borrowing under the FSA would lead to lower interest rates relative to baseline, while increases in borrowing would lead to higher interest rates under the remaining scenarios.