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Tax Reform, Economic Growth and Monetary Policy

May 15, 2014 3 minute Read by Christopher Hanna

For years, economists have attempted to analyze the economic growth impact of comprehensive tax reform.  In 1996, the nonpartisan Joint Committee on Taxation began developing a capacity to model the macroeconomic impacts of tax policy.  Recently, the Joint Committee staff analyzed the macroeconomic impact of House Ways and Means Committee Chairman Dave Camp’s comprehensive tax reform plan, “The Tax Reform Act of 2014,” that was released on February 26, 2014. The 979-page plan was approximately revenue neutral and roughly distributionally neutral over the ten-year budget window of 2014-2023.

In discussing tax reform, it is unusual to bring in a discussion of monetary policy.  Tax reform and monetary policy are typically viewed as two very different areas of economic policy.  If, however, one of the goals of tax reform is greater economic growth, then a discussion of monetary policy seems to be in order.  In analyzing the macroeconomic impact of Chairman Camp’s comprehensive tax reform plan, the Joint Committee staff had to make certain assumptions regarding Federal Reserve Board policy.  The differing assumptions led to quite different estimates of the economic growth impact of Chairman Camp’s tax plan. 

Chairman Camp’s plan would decrease income taxes paid by individuals resulting in an increase in after-tax income.  When the economy is operating below its full employment capacity, increases in after-tax income lead to greater demand for goods and services leading to more economic growth.  In one assumption, labeled “Aggressive Fed” policy, the Joint Committee staff assumed that the Federal Reserve Board would counteract any demand incentives resulting from Chairman Camp’s comprehensive tax reform.  The Aggressive Fed policy would include an immediate increase in interest rates thereby counteracting the demand effects of the tax plan.  In a second assumption, labeled “Neutral Fed” policy, the Joint Committee staff assumed that the Federal Reserve Board would target a fixed monetary growth rate and not try to counteract the demand effects of the tax plan.

Over the ten-year budget window of 2014-2023, the estimated percent change in real gross domestic product (GDP) relative to present law under Chairman Camp’s tax plan varies quite substantially depending on whether Aggressive Fed policy or Neutral Fed policy is assumed.  Using the assumption of Aggressive Fed policy leads to an estimated increase in economic growth of 0.1 percent to 0.3 percent relative to present law at the end of ten years.  Using the assumption of Neutral Fed policy leads to an estimated increase in economic growth of 0.4 percent to 0.6 percent relative to present law.  As a result, the estimates of the increase in economic growth over the ten-year budget window are approximately twice as large assuming a Neutral Fed policy rather than an Aggressive Fed policy.


Image via William Warby


Author

Christopher Hanna
Christopher Hanna

Christopher H. Hanna is a professor of law and a University Distinguished Teaching Professor at Southern Methodist University. Professor Hanna has been a visiting professor at the University of Texas School of Law, the University of Florida College of Law, the University of Tokyo School of Law and a visiting scholar at the Harvard Law School and the Japanese Ministry of Finance. In 1998, Professor Hanna served as a consultant in residence to the Organisation for Economic Co-operation and Development (OECD) in Paris. From June 2000 until April 2001, he assisted the U.S. Joint Committee on Taxation in its complexity study of the U.S. tax system and, from May 2002 until February 2003, he assisted the Joint Committee in its study of Enron, and upon completion of the study, continued to serve as a consultant to the Joint Committee on tax legislation.

Prior to coming to SMU, Professor Hanna was a tax attorney with the Washington, D.C. law firm of Steptoe & Johnson. His primary duties included tax planning for partnerships and corporations on both a domestic and international level and also tax controversy. He has received the Dr. Don M. Smart Teaching Award for excellence in teaching at SMU Dedman School of Law on eight separate occasions. In 1995, he was selected and featured in Barrister magazine, a publication of the ABA Young Lawyers' Division, as one of “21 Young Lawyers Leading Us Into the 21st Century” (Special Profile Issue 1995).

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