PWBM’s Default Settings for Key Parameters

This brief summarizes the default values of three key behavioral parameters that exert important effects on PWBM’s analytical results. Key parameters include the openness of the U.S. economy to international capital flows, the responsiveness of labor to changes in after-tax wages and the responsiveness of savings to changes in interest rates and potential changes to government outlays (spending) that could offset the deficit effects of changes to tax policy. Parameter choice ranges are based on findings in the economic literature. A brief description of the parameters and their role in framing the effects of policy changes is provided in a PWBM Brief: Setting Behavioral Responses in PWBM’s Dynamic Simulations. Table 1 shows PWBM’s default settings for key parameters.

Table 1: Default Settings for Key Parameters

Key Parameter Default Setting
Foreign Investment Flows into U.S. 40%
Labor Supply Elasticity 0.5
Savings Elasticity 0.5

Unfortunately, there is no definitive consensus among economists on how individuals respond to changes in their economic environment. Hence, on some simulators, PWBM provides users with alternative choices for setting those assumptions before implementing its dynamic analyses and budget projections.

“Foreign Investment Flows into the U.S.” measures the share of new issues of U.S. financial assets that foreign savers purchase. If foreign flows offset 100 percent of a change in national saving, domestic investment is unaffected by larger deficits or surpluses produced by a tax plan. If there is no offset, changes in national saving lead to equal changes in domestic investment. Table 1 shows that PWBM’s default setting for foreign investment flows into the U.S. is 40 percent. This setting means that 40 percent of each dollar of budget deficits is financed by foreign capital inflows, with the other 60 cents funded out of domestic saving. U.S. Treasury Department data show that since the year 2000, foreign savers purchased about 40 percent of annual increases in Treasury security issues. Estimates of foreign investment in private assets are lower.

Changes to tax policy can affect after-tax wages. The “Labor Supply Elasticity” measures how labor supply responds to changes in after-tax wages, holding total wealth constant. A higher labor supply elasticity setting implies a stronger labor supply response to changes in taxes on labor income. Individuals can change the amount they work by either changing the number of hours they work or by choosing to enter or exit a job. A lower setting dampens the labor supply response. Studies that compare individuals suggest that the labor supply elasticity for men lies between 0.0 and 0.1, as a short run response. In words, a value of 0.1 means that male labor supply increases by 0.1 percent as their after-tax income increases by 1 percent. For women, the elasticity ranges from 0.2 through 0.5. The elasticity for women has been declining, reflecting stronger labor-force attachments during recent decades. However, other empirical studies compare labor supplies across countries with different wages, which better reflect labor supply responses over the long run. Such studies estimate the labor supply elasticity to be slightly more than 1.0, although larger values have also been found. Table 1 shows that PWBM’s baseline setting for labor supply elasticity is 0.5.

Changes to tax policy can affect net-of-tax interest, dividends and capital gains. The “Savings Elasticity” measures how national saving responds to a change in the return to saving. A higher saving elasticity setting implies a stronger savings response to changes in after-tax returns. A lower setting dampens the savings response. Most saving elasticity estimates suggest a low value – well below 1.0. Studies based on changes in taxes and income tax rebates report estimates less than 0.5. Studies based on appropriately calibrated computable life-cycle models of consumer behavior, which account for alternative saving responses, estimate the saving elasticity to be 0.65. Table 1 shows that PWBM’s baseline setting for savings elasticity is 0.5.