Dynamic Analysis of Tax Plans: An Update

This paper gives an overview of the TPC’s methodology for dynamic analysis of tax proposals. Following the practice of official government estimators, we use a Keynesian model to estimate the short-term effects of policy changes on output relative to its full-employment level. That model assumes tax policy can influence the economy by changing the demand for goods and services. For example, a tax cut could encourage consumers to spend more and businesses to invest more, raising demand and thus total employment. In the long-run, demand-side stimulus is ineffective because we assume the economy returns to full employment. We estimate the long-run effects on potential output using two models: a neoclassical growth model and the Penn Wharton Budget Model. Both of those models reflect how taxes can affect incentives to work, save, and invest, as well as the effects of budgetary policies on interest rates and the resultant effects on investment decisions.