Key Points
- Penn Wharton Budget Model’s new comprehensive Tax Policy Simulator allows users to build tax reform plans and see the budgetary and economic impact of those plans.
- Users can vary 16 key tax provisions, for a total of 4,096 policy combinations.
- The model accommodates a much wider range of tax policy options, which are not shown to conserve space. Policymakers, major media outlets and thought leaders who want to test different tax reforms can contact us for estimates.
Penn Wharton Budget Model’s Tax Policy Simulator
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Introduction
Policymakers and the public can use Penn Wharton Budget Model’s new comprehensive Tax Policy Simulator to build their own tax plans from the bottom up. Users can see the projected impact of their plan on the economy and federal budget, including tax revenues and debt held by the public. PWBM’s previous analysis of the 2016 presidential campaign plans and the 2017 White House tax plan focused on the effects of existing tax plans. The new comprehensive Tax Policy Simulator allows users to construct new tax plans, fill in missing details in existing tax plans and modify existing tax plans.
Updated Microsimulation Model
The static version of Penn Wharton Budget Model, indicated by the solid red line on Tax Policy Simulator graphs, uses an updated state-of-the-art microsimulation model and new tax module that PWBM developed over the past two years. It shows the direct impact that each key tax provision will have on federal revenues, federal outlays and debt. A detailed white paper is forthcoming, but a simple overview can be found here.
Hundreds of thousands of individuals and families representative of the U.S. population across a wide range of subgroups are calibrated using Census-level data and a variety of additional data sources. Households are assigned key economic and demographic attributes including fertility, mortality, immigration, labor-force participation rates, education acquisition, marriage, divorce, capital acquisition, disability, wages and non-wage compensation and more. Households are subject to various life events: They grow older, go to school, get married, maybe divorce, get jobs, work and earn, pay taxes and eventually retire, receive government benefits (both before and after retirement) and die. Families are formed through marriage, grow larger through childbirth and dissolve through divorce, emigration and death.
Our updated static model makes several advances in the field of microsimulation analysis, each of which will be described in forthcoming technical publications. Despite being static in nature, an aggregate production function ensures that household-level variables match aggregate variables. The basic unit of observation is the household (married and single), not just individuals, which allows for more accurate tax analysis. The tax module “cross walks” between IRS Statistics of Income data and Census data to allow us to capture rapidly changing demographics. The model is validated using an extensive battery of tests on U.S. historical data.
New Static Tax Policy Module
PWBM’s static tax policy module is built on top of our updated microsimulation model. For individual tax provisions, our tax calculator accounts for all major portions of the Form 1040, U.S. Individual Income Tax Return, and its related forms and schedules. It can handle a comprehensive catalog of tax provisions such as changes to tax rate structures and income thresholds for various credits and deductions. The model automatically calculates, for example, if a filer is better off itemizing or claiming the standard deduction, and how policy changes might impact that choice. For corporate tax provisions, the tax calculator is built using multiple sources of government data. It can handle a broad assortment of tax provisions, including changes to corporate rates, tax expenditures and immediate expensing of investment. The methods used to produce our tax calculator will be documented in a forthcoming technical paper.
The tax module recognizes that individuals and businesses respond to changes in relative tax rates by reclassifying or shifting their income in order to minimize their tax liabilities. For example, individuals may convert wage income to business income by forming a pass-through business (S corporation, partnership or sole proprietorship). Corporations may also convert to a pass-through business. Income might also be shifted internationally. More information about our assumptions of income reclassification and shifting can be found here.
Our tax calculator is integrated with our new updated microsimulation model. This advance allows PWBM to observe married and single households rather than tax filing units. Our results capture both the rich information about demographic shifts found in Census-level data and the rich information about federal revenues found in IRS tax filer-level data. The combination allows us to make tax policy reform projections beyond the typical 10-year budget window to show long-term effects. Taking the projections farther than the standard 10-year budget window reveals a fuller picture of where the underlying demographic forces are pointed and their implications for policy outcomes. The new simulator shows the budgetary and economic effects of each reform on its own or with any combination of reforms. This breakthrough allows PWBM’s comprehensive Tax Policy Simulator to advance our understanding of how the effects of each reform change when combined with different packages of tax policy reforms.
PWBM’s Dynamic Model
The dynamic version of PWBM, indicated by the dotted red line on Tax Policy Simulator graphs, is based on an overlapping-generations (OLG) model where households maximize their welfare in a forward-looking manner. Households make choices, for instance about how much to work and save, given wages and interest rates. These choices are made given the amount of income, time, assets, technology, and skills that households possess and the prices, wages, interest rates and uncertainties that households face, both today and in the future.
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.
PWBM’s dynamic model has unique features that make it suitable for analyzing tax policy reforms. First, the OLG model includes numerous types of households that vary by income as well as key demographics. Households face uncertainty today and in the future about their income and longevity. Second, the model carefully analyzes key features of the U.S. tax system. On the individual side, the model uses actual IRS tax brackets, combined with various tax adjustments, rather than approximating them. On the corporate side, our tax system includes accelerated depreciation allowances (also known as expensing) that distinguish between old and new capital investments, as well as pass-through provisions relevant to companies that are not organized as C corporations. On the international side, the U.S. system is a hybrid (part residential, part territorial) tax system. Finally, the PWBM model allows for unbalanced tax reforms that increase or decrease government debt.
Our model is calibrated to empirical measures of the responsiveness of labor and savings to changes in after-tax wages and interest rates. The responsiveness of labor to changes in after-tax wages’ default value is 0.5. The responsiveness of savings to changes in interest rates’ default value is 0.5. Users can choose the openness of the U.S. economy to international capital flows. The openness of the U.S. economy to international capital flows’ default value is 40 percent. However, users may use the international capital flow dial control to choose a value of 0, 40, 70, or 100 percent.
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.
Tax Policy Dial Controls
The Tax Policy Simulator allows users to vary 16 key tax provisions to build their own tax reform plans. The simulator includes reforms from recent tax policy proposals, that include sizable changes to the individual and business tax rate structures.
Figure 1 shows the policy options available on the simulator. Users can select from 4,096 different combinations of key tax provisions to see how they affect the economy and the federal budget. However, our tax model includes many additional capabilities that are not shown on the simulator.
Figure 1: Key Tax Provisions
| Tax Provisions | Current Policy | Policy Reform |
|---|---|---|
| Individual Income Tax Rates | 7 Brackets, AMT | 3 Brackets: 12, 25, 35%, No AMT |
| Buffet Rule | No | Yes |
| 4% Surcharge on Income Over $5M | No | Yes |
| Double the Standard Deduction, Repeal Personal Exemptions | No | Yes |
| Limit Itemized Deductions | No | Yes |
| Increase the Child Tax Credit (CTC) | $1,000 | $2,000 |
| Net Investment Individual Income Tax (NIIT) | 3.80% | Repeal |
| Treatment of Carried Interest | Capital Gains | Ordinary Income |
| Corporate Income Tax Rate | 35%, AMT | 20%, No AMT |
| Treatment of Pass-Through Business Income | Individual Income Tax | Top Rate of 25% |
| Full Expensing of Investment, Disallow Net Interest Deduction | No | Yes |
| Repeal Corporate Tax Expenditures, One-Time Repatriation Rate | No | Yes |
Some dial controls incorporate multiple policy reforms to the U.S. tax system. For example, immediate expensing of investment is paired with repealing the deduction for interest expense. Many recent tax reform proposals, such as the Unified Framework proposed on September 27, 2017 pair those policy changes. Including only immediate expensing would increase the incentive for firms to finance investment with debt rather than equity. Tax reform proposals that reduce individual or corporate income tax rates often repeal the Alternative Minimum Tax (AMT). Reducing tax rates alone would lead to many more individuals or businesses being subject to the AMT. Finally, many tax plans both increase the standard deduction from individual income and repeal personal exemptions. Both of these provisions affect which taxpayers pay a zero income tax rate so combining them simplifies taxes for many filers. Descriptions of each key tax provision can be viewed by clicking on information buttons (blue circle with an i) to the left of each dial control.
Conclusion
Penn Wharton Budget Model’s Tax Policy Simulator shows how 16 key tax provisions affect economic growth, work, saving, and the federal budget. Users of the model are encouraged to experiment by building their own tax plans.