The House Tax Cuts and Jobs Act: Dynamic Effect on the Budget and the Economy

Key Points

  • This brief reports Penn Wharton Budget Model’s (PWBM) dynamic analysis of the Tax Cuts and Jobs Act (TCJA), which complements our static analysis previously released.
  • PWBM’s dynamic analysis finds that, depending on parameter values, the bill lowers tax revenues between $1.4 trillion to $1.7 trillion over 10 years while increasing federal debt between $2.0 trillion and $2.1 trillion over the same time period. By 2040, debt is between $6.3 trillion and $6.8 trillion higher than otherwise.
  • TCJA raises GDP in 2027 between 0.33% and 0.83% relative to its projected value in 2027 with no policy change. However, this small boost fades over time, due to rising debt. By 2040, GDP may even fall below current policy’s GDP.

The House Tax Cuts and Jobs Act: Dynamic Effect on the Budget and the Economy

Introduction

Penn Wharton Budget Model’s (PWBM) static analysis found that the Tax Cuts and Jobs Act (TCJA)1 reduces federal revenues in the short- and long-run. Our static analysis also discusses the reforms included in TCJA. This brief uses the PWBM to report the projected impact that the bill will have on the economy and federal budget, including revenues and debt held by the public.

PWBM’s Dynamic Model

The dynamic version of PWBM is based on an overlapping-generations (OLG) model where households maximize their welfare in a forward-looking manner. The OLG model allows households to respond to policy changes by altering their economic choices – labor supply, consumption and saving. These feedback effects may reinforce or offset the direct effects of tax policy changes on the size of the economy, economic growth, distribution of income and federal revenues.

Integration between PWBM’s dynamic model and static model is achieved by first running the OLG model in “static” mode and then running the model in “dynamic” mode. The differences between the two are then layered on top of the static microsimulation results. This approach captures the richness of detail in the microsimulation model along with the behavioral changes observed in the OLG model.

As discussed in previous analysis, PWBM’s Tax Policy Simulator allows for two different assumptions on the initial rate of return on capital: (a) a “high” return, where the return to capital is assumed to be the marginal product of capital net of depreciation, and (b) a “low” return, where the return to capital is assumed to be close to the risk-free (Treasury bill) rate. A “high” rate of return produces macroeconomic results that are generally more favorable for tax cuts. However, the “low” return assumption is generally more consistent with existing tax law that allows for tax loss offsets, which means that the tax on the “equity premium” portion of the marginal product of capital is effectively risk shared with the government. For corporations, the “low” return is more applicable. For entrepreneurs, where reselling tax losses is more challenging, an argument can be made for focusing on the higher initial return, although other tax law provisions, such as IRS 83(b) election, provide additional benefits. We sidestep this issue by reporting our results as a range across both assumptions.

Budget Effects of the Tax Cuts and Jobs Act

Table 1 shows that, over the 10-year budget window, the Tax Cuts and Jobs Act is projected to reduce federal tax revenues between $1.4 trillion (high initial return to capital) to $1.7 trillion (low initial return to capital). Debt rises by more, by about $2.0 trillion, over this period due to debt services. By 2040, revenue falls between $3.7 trillion and $4.5 trillion, whereas debt increases by $6.3 trillion to $6.8 trillion.

Table 1: TCJA Effects on Revenue and Debt Relative to Current Policy

Revenue (billions of $) Debt (billions of $)
Static Dynamic Static Dynamic
Years High return to capital Low return to capital High return to capital Low return to capital
2018-2027 -$1,811 -$1,444 -$1,671 $2,114 $1,955 $2,079
2018-2040 -$4,582 -$3,659 -$4,457 $6,824 $6,284 $6,818

Note: The above estimates focus on the official definition of “revenue” and, therefore, do not incorporate tax refunds, which are recorded as outlays. As a result, the 10-year revenue loss of $1,811 billion shown above is $61 billion larger than shown in our previous static analysis that incorporates refunds as is consistent with JCT’s methodology. Debt rises faster than lost revenue due to debt service.

Economic Effects of the Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act has effects beyond federal revenues, including effects on debt, GDP, labor income and U.S. capital services. These effects are presented in Figures 1 through 5.

Figure 1: Federal Tax Revenue Under Tax Cuts and Jobs Act With High and Low Return to Capital

Figure 2: Federal Debt Held by the Public Under Tax Cuts and Jobs Act With High and Low Return to Capital

Figure 3: Gross Domestic Product Under Tax Cuts and Jobs Act With High and Low Return to Capital

Figure 4: Labor Income Under Tax Cuts and Jobs Act With High and Low Return to Capital

Figure 5: Capital Services Under Tax Cuts and Jobs Act With High and Low Return to Capital

Table 2 summarizes the results. By 2027, GDP is between 0.33% and 0.83% larger than current policy in that year. However, this initial boost fades over time as more debt accumulates. By 2040, GDP is between -0.25% and 0.41% larger than current policy in that year.

Table 2: TCJA Effects on Key Macroeconomic Variables Relative to Current Policy in Year Shown

GDP (% change) Labor Income (% change) Capital Services (% change)
Year High return to capital Low return to capital High return to capital Low return to capital High return to capital Low return to capital
2027 0.83% 0.33% 0.79% 0.30% 2.04% 0.45%
2040 0.41% -0.25% 0.39% -0.29% 1.22% -0.86%

Sensitivity Analysis

Consistent with our previous dynamic analysis and the empirical evidence, the projections above assume that the U.S. economy is 40% open and 60% closed. Specifically, 40% of new government debt is purchased by foreigners. To show the sensitivity of our results to this assumption, Table 3 considers two extreme cases: 100% open (consistent with a small open economy) and 0% open (consistent with a closed economy, maybe due to trade restrictions). In general, the combination of a higher initial return to capital and more openness (fewer trade barriers) leads to more economic growth than a lower return which also dampens the revenue effects of tax cuts.

Table 3: Sensitivity of Dynamic Results to “Openness” of the Economy

10 Year Revenue (billions of $) GDP relative to 2027 (% change)
Dynamic Dynamic
High return to capital Low return to capital High return to capital Low return to capital
100% Open -$896 -$1,396 1.92% 0.97%
0% Open -$1,809 -$1,854 0.10% -0.90%

Conclusion

Penn Wharton Budget Model’s dynamic analysis projects that the Tax Cuts and Jobs Act reduces federal tax revenue in both the short- and long-run relative to current policy. In the near term, there is a small boost to GDP, but that increase diminishes over time.


  1. TCJA version dated November 5, 2017. Small amendments have been subsequently made.  ↩

Year,Current Law,Dynamic Low Rate of Return,Dynamic High Rate of Return
2016,3318.764,3318.764,3318.764
2017,3438.958,3438.95,3438.95
2018,3595.593,3347.106,3364.285
2019,3733.549,3519.518,3536.536
2020,3962.472,3759.808,3778.639
2021,4077.394,3886.658,3906.977
2022,4186.49,4003.69,4025.207
2023,4304.727,4205.257,4228.933
2024,4443.577,4354.841,4380
2025,4607.435,4485.084,4511.418
2026,4785.021,4636.894,4664.562
2027,4943.502,4770.248,4799.399
2028,5097.531,4914.712,4945.268
2029,5334.823,5143.747,5176.353
2030,5517.49,5324.007,5358.359
2031,5722.073,5522.234,5558.697
2032,5938.067,5732.125,5770.671
2033,6095.544,5887.223,5927.796
2034,6275.205,6060.157,6102.856
2035,6501.969,6282.137,6327.499
2036,6743.465,6514.788,6563.177
2037,6923.028,6691.259,6742.127
2038,7092.348,6857.516,6910.938
2039,7322.454,7086.811,7143.418
2040,7511.951,7273.357,7333.44
Year,Current Law,Dynamic Low Rate of Return,Dynamic High Rate of Return
2016,14334.72,14334.72,14334.72
2017,15055.84,15055.84,15055.84
2018,15886.63,16141.98,16134
2019,16870.4,17355.17,17339.45
2020,17955.3,18665.83,18641.04
2021,19214.11,20146.44,20111.56
2022,20607.92,21762.22,21716.25
2023,22169.1,23468.05,23409.1
2024,23910.53,25350.72,25277.35
2025,25796.44,27416.06,27327.33
2026,27844.65,29676.76,29571.58
2027,30071.73,32150.33,32027.14
2028,32467.6,34811.66,34669.13
2029,35058.14,37686.34,37522.59
2030,37841.18,40766.32,40579.85
2031,40815.83,44055.98,43844.92
2032,43960.36,47529.64,47292.12
2033,47313.19,51225.79,50959.78
2034,50891.86,55166.54,54870.08
2035,54699.87,59354.84,59025.28
2036,58756.29,63813.86,63448.44
2037,63027.27,68499.75,68096.36
2038,67560.23,73464.84,73020.97
2039,72395.34,78747.99,78260.63
2040,77532.91,84350.87,83816.72
Year,Current Law,Dynamic Low Rate of Return,Dynamic High Rate of Return
2016,18624.5,18624.5,18624.5
2017,19341.35,19341.35,19341.35
2018,20169.53,20272.85,20357.39
2019,20948.38,21061.14,21149.28
2020,22006.79,22117.95,22212.51
2021,22745.31,22850.59,22951.45
2022,23412.72,23512.02,23618.2
2023,24198.41,24291.76,24404.04
2024,24992.21,25085.69,25203.27
2025,25943.04,26037.97,26163.23
2026,26897.92,26993.08,27124.67
2027,27795.03,27888.12,28025.96
2028,28616.13,28704.16,28848.87
2029,29884.99,29968.13,30121.39
2030,30900.51,30976.06,31138.11
2031,31991.41,32058.15,32229.66
2032,33179.72,33237.11,33417.75
2033,34133.36,34179.09,34368.92
2034,35177.36,35208.64,35410.13
2035,36470.3,36485.82,36699.29
2036,37789.69,37786.55,38013.68
2037,38933.4,38909.66,39149.35
2038,40003.17,39955.92,40209.38
2039,41450.13,41375.14,41643.85
2040,42688.56,42580.12,42865.66
Year,Current Law,Dynamic Low Rate of Return,Dynamic High Rate of Return
2016,11248.6,11248.6,11248.6
2017,11654.04,11654.04,11654.04
2018,12175.01,12160.47,12211.44
2019,12701.09,12766.4,12816.95
2020,13425.96,13488.88,13543.9
2021,13973.9,14033.48,14093.33
2022,14505.64,14561.82,14625.57
2023,15118.21,15171.32,15239.55
2024,15718.08,15771.18,15843.8
2025,16396.99,16451.21,16528.8
2026,17056.44,17110.72,17193.23
2027,17654.21,17706.99,17793.86
2028,18175.74,18225.01,18316.47
2029,18981.66,19027.37,19125.48
2030,19626.68,19668.02,19770.68
2031,20319.57,20354.69,20464.13
2032,21074.33,21103.38,21218.74
2033,21680.04,21701.03,21822.73
2034,22343.15,22355.24,22483.94
2035,23164.37,23165.81,23303.46
2036,24002.39,23991.13,24137.56
2037,24728.83,24704.44,24859.19
2038,25408.3,25369.33,25532.33
2039,26327.35,26269.68,26443.02
2040,27113.95,27035.37,27219
Year,Current Law,Dynamic Low Rate of Return,Dynamic High Rate of Return
2016,100,100,100
2017,101.0875,101.0875,101.0875
2018,104.2759,105.2798,106.5506
2019,106.7604,107.6313,108.9946
2020,108.9984,109.8062,111.254
2021,113.4821,114.2274,115.7891
2022,113.6284,114.2947,115.9005
2023,115.8428,116.4367,118.115
2024,117.5815,118.1702,119.9223
2025,119.5369,120.1369,121.9537
2026,122.3987,123.0016,124.8971
2027,124.5781,125.1433,127.1205
2028,126.5747,127.086,129.1359
2029,127.9876,128.4311,130.5378
2030,132.7226,133.0844,135.312
2031,133.5402,133.8108,136.0959
2032,136.9883,137.1608,139.5409
2033,139.3613,139.4129,141.8859
2034,140.6416,140.5651,143.1064
2035,142.9926,142.7646,145.403
2036,146.1299,145.738,148.483
2037,148.7665,148.1748,151.027
2038,150.4223,149.6202,152.5759
2039,152.0428,151.0022,154.0654
2040,155.7647,154.4261,157.6576