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Appendix
BThe Potential Economic Effects of Selected Proposals in the President’s 2009 Budget
Considerable uncertainty surrounds the possible economic impact of four of the President’s budgetary proposals for 2009—those that would extend beyond 2010 the lower tax rates on dividends and capital gains, expand the availability of tax-free savings accounts, extend the repeal of the estate tax, and establish individual accounts as part of Social Security. The factors that the Congressional Budget Office (CBO) considered and the methods it used in assessing that impact are explained below. (CBO’s analysis of the overall economic effects of the President’s budgetary proposals is described in Chapter 2.)
Extend the Lower Tax Rates on Dividends and Capital Gains
Enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) reduced through 2008 the tax rates on dividends and capital gains. Until the end of last year, those rates comprised a bottom bracket of 5 percent and a top bracket of 15 percent; in 2008, the bottom bracket dropped to zero. The Tax Increase Prevention and Reconciliation Act of 2006 extended the zero and 15 percent rates through 2010. Before JGTRRA was enacted, dividends were subject to the same tax rates as ordinary income—ranging from 10 percent to 35 percent—and most capital gains were subject to rates of 8 percent, 10 percent, or 20 percent (depending on a filer’s income tax bracket). In his 2009 budget, the President has proposed making permanent the zero and 15 percent rates.
Reduced rates on capital gains and dividends lower the overall taxation of corporate profits, some of which are taxed twice: once under the corporate income tax and again when people receive dividends and realize capital gains—brought about by a business’s reinvestment of its profits—on sales of stock. Lowering the tax rates that individuals face on the two types of income would reduce the total rate of taxation.
In addition to decreasing tax rates on corporate income, JGTRRA reduced taxes on some income that is currently taxed only once. A substantial portion of taxable capital gains arises from investments whose earnings are not subject to the corporate income tax, such as gains on real estate held by individuals. The lower capital gains tax rate reduced the level of taxation on those investments as well.
Many types of productive capital are sufficiently long-lived that investments in them today will continue to earn returns long after JGTRRA’s rate changes are scheduled to expire. Permanently extending those rates would enhance the incentive to invest in long-lived capital stock by increasing the expected returns.
One effect of extending the tax rates on dividends and capital gains involves the cost of financing for businesses. Lower tax rates on capital gains and dividends might be expected to lower the cost of financing, because businesses could pay investors less before taxes to yield the same after-tax return. But how much the cost of capital might fall is unclear. Some analysts argue that only the decrease in taxes on capital gains will act to reduce that cost. Others hold that both the decrease in taxes on dividends and the decrease in taxes on capital gains will reduce the cost of capital.1
A related difference of views among analysts involves how much the value of businesses’ stock might rise if the lower rates of taxation became permanent. (Share values rise because the decrease in taxes increases the after-tax return to shareholders, making the investments more valuable to them.) The view of corporate finance that predicts a relatively large increase in those values predicts a relatively small decrease in the cost of capital, and vice versa.
In the absence of a consensus about which view is correct, CBO has adopted middle-ground estimates of the effects of the President’s proposal on the cost of capital for firms and on share values.
Higher values for shares of stock raise the net wealth of shareholders and encourage more spending on goods and services; this is the so-called wealth effect. Through that channel, the President’s proposal would boost overall demand in the short run. But the more it enhanced demand by raising consumer spending in the short run, the more it would reduce national saving and thus national income in the long run.
The enactment of JGTRRA has provided an opportunity to examine how changes in dividend taxes affect a business’s value. Some researchers have found evidence that reductions in dividend taxes raised stock prices, although it is uncertain whether those changes will be permanent or temporary.2 Other researchers have identified no measurable effects on the value of the total U.S. stock market, but their work does not rule out the possibility of a modest positive effect.3
Extending the lower rates on capital gains and dividends is likely to lessen the disadvantage that the corporate sector now faces in competing for capital. For example, although some income from the corporate sector is taxed twice under current law, income from unincorporated businesses is taxed only at the personal level, and income from owner-occupied housing—that is, the value of the housing "services" consumed by the owner—is not taxed at all by the federal government. That disparity in tax treatment could lead to less investment in the corporate sector than is optimal for economic output. Lowering the taxes that businesses face would allow them to attract additional capital from the housing and small-business sectors and could thus improve the economy’s efficiency. Such a shift in investment might, however, conflict with other policy goals, such as supporting owner occupancy of homes or supporting unincorporated businesses.
The proposal to extend the lower rates on dividends and capital gains might affect commercial financial behavior in two ways: Businesses could choose to finance more investment by issuing stock (equity financing) rather than debt, and they could decide to pay out more in dividends and retain fewer earnings. Currently, businesses may deduct the interest they pay on debt from their taxable income, so those payments are taxed only once. (The individual who receives the payment pays the tax.) But if a business finances a project by issuing stock, some of the returns on the investment that the project generates are subject to personal and corporate taxation. The President’s proposal would narrow that disparity in tax treatment.
The evidence amassed so far is consistent with the view that dividend taxation affects payout policies, at least in the short run. The reduction in dividend taxation in 2003, for instance, was followed by a significant increase in dividends issued, although it is unclear whether that increase will be permanent or whether the tax cut caused businesses to increase their total payout to shareholders or simply to substitute dividends for share repurchases.4 In addition, the factors that explain why some businesses increased dividend payouts more than others did are still being examined. So far, the response to the tax cut appears to be greater among businesses whose top executives held relatively large amounts of company stock (and relatively small amounts of unexercised stock options) and among those whose ownership was dominated by taxable institutions.
The proposed reduction in the future taxation of dividends and capital gains also would interact with some of the President’s other proposals and with current law. For instance, the President’s proposal to boost the amount that people may deposit in tax-free savings accounts (discussed below) would increase the share of personal assets held in such accounts—duplicating some of the effect on the cost of capital and its allocation among sectors of the economy. However, the expanded accounts would partly mitigate the effects of the proposal on dividends and capital gains in bolstering equity financing because the interest earned on assets in the accounts would not be taxed at either the personal or the corporate level. Also contributing to that lessening of the proposal’s impact on equity financing would be the combined effect of the two policies in increasing the proportion of interest-bearing assets in tax-free accounts: Investors’ incentives to hold stocks in such accounts would be weakened if their returns already faced lower tax rates.
In its analysis, CBO incorporated the effects of the proposal regarding dividends and capital gains in two ways. First, it estimated the proposal’s overall effect on the average cost of capital under the terms of the growth models (the "textbook" growth model, life-cycle growth model, and infinite-horizon growth model) and incorporated that calculation. Second, because the models cannot account for the effect of reallocating capital, CBO turned to the research on how reallocation might influence output. It then determined a midrange estimate and added that amount to the models’ underlying estimates of the effect on output. The procedure added an average of 0.07 percent over the 2009–2018 period to the proposal’s projected effect on gross national product, as predicted by the models.
CBO used macroeconometric forecasting models (from Macroeconomic Advisers and Global Insight) to estimate the proposal’s effect on the cost of capital in different sectors of the economy and on the value of stock shares (under the assumption that investors and businesses are forward-looking). It then incorporated those estimates in the models and projected the effect on the economy.
Expand Tax-Free Savings Accounts
The President’s 2009 budget includes a proposal to consolidate and expand the current system of tax-free savings accounts for retirement and other purposes, such as education. Two new kinds of accounts would be created: retirement savings accounts (RSAs) and lifetime savings accounts (LSAs). RSAs would function in some ways like Roth individual retirement accounts (IRAs) in that taxes would not be deferred on contributions, as they are for contributions to traditional IRAs, but returns would accrue tax free. Unlike Roth IRAs, RSAs would be available to all workers (and their spouses) regardless of income. The President’s proposal also would eliminate further tax deferrals for IRA contributions.
The tax treatment of the proposed lifetime savings accounts also would be similar to that governing Roth IRAs. However, unlike Roth IRAs or RSAs, LSAs would be open to everyone, regardless of age, income, or employment status, and participants could withdraw funds at any time for any reason. Taxpayers could use LSAs to consolidate other savings plans, including Coverdell education savings accounts and qualified state tuition plans.
In CBO’s estimation, the new savings accounts that the President has proposed would have little effect on the economy, on average, over the 2009–2018 period (the current 10-year budget horizon). Most taxpayers’ use of the new accounts would be similar to their current saving in tax-free accounts. One possible outcome is that people who currently have assets in taxable accounts would reduce their tax liability by selling those assets and putting the proceeds in the new accounts; similarly, over time some people might contribute less to taxable savings accounts because their contributions would go instead to the tax-preferred accounts. To the extent that such shifting of assets occurred, total private saving would be unaffected but the budget deficit would be larger and the net effect on national saving would be negative (because the change in private saving would fail to offset the increase in the budget deficit). Most new private saving would involve small amounts set aside by taxpayers with few taxable assets to shift.
Beyond 2018, the effects of the proposal might be greater than those just described (because increasing numbers of taxpayers would run out of assets that could be shifted). For those later years, CBO estimates, the proposal would have a modestly positive effect on private saving.
Extend the Repeal of the Estate Tax
The President’s proposal to extend the repeal of the estate tax beyond its scheduled expiration at the end of calendar year 2010 could affect consumer spending and saving, depending on people’s motives for leaving bequests. There is no consensus, however, about which motives predominate or how estate taxes affect consumer spending. People might be encouraged to reduce their spending in order to leave larger bequests because of the lower estate taxes their heirs would pay. But a lower estate tax also means that people can spend more and still make the same after-tax bequest. To the extent that a lower estate tax has increased the after-tax size of bequests, potential recipients also might increase their spending. CBO found scant evidence to support the contention of some analysts that the estate tax is a particular impediment to the creation of small businesses.5
CBO’s estimates of the effects of the President’s proposal incorporated the assumption that extending the repeal of the estate tax would increase consumer spending slightly, by about 5 cents for each dollar of tax savings.6 That assumption implies that extending the repeal would reduce the capital stock, but by an amount too small to affect the estimates presented in Chapter 2 of this report. CBO considered alternative assumptions (for example, that the positive effect on consumer spending from increasing after-tax income would be balanced by the incentive effects of lower tax rates, resulting in no net impact on that spending) that would yield similar results.
Establish Individual Accounts in Social Security
The President’s budget proposes that workers be permitted to redirect a portion of their payroll tax payments from the Social Security trust funds to individual accounts and invest those contributions in various financial assets. In CBO’s estimation, the proposal would result in budgetary outlays of $287 billion from 2012 to 2018; however, it would have no appreciable effect on the economy during that period because it would not change people’s projected lifetime income (once the expected returns of the assets in the accounts were adjusted for the risk they carry) and would not alter people’s take-home pay. In addition, the accounts would not significantly affect the investment capital available in the economy, because the additional government borrowing to finance the accounts would be roughly offset by the increase in investable funds in the accounts.
Under the proposal, workers could redirect payroll taxes to individual accounts, but their contributions to the accounts would ultimately be offset by reductions in their traditional Social Security benefits, which would be calculated using hypothetical accounts. In addition to tracking the actual balances in an individual account, the Social Security Administration would follow a hypothetical account that held the same amount of contributions and that grew at a specified real (inflation-adjusted) rate of 2.6 percent per year. When a person claimed traditional Social Security benefits, those benefits would be reduced so that the actuarial value of the reduction over the person’s lifetime would equal the amount in the hypothetical account—regardless of the amount actually in the person’s individual account.
CBO derived the rate of growth for the notional account from projections by the trustees of the Social Security system. In their estimation, Treasury bonds over the long run will earn an average real return of 2.9 percent; individual accounts would incur annual administrative expenses equal to 0.3 percent of assets—for a net real return of 2.6 percent. Because that rate equals the rate of return on the notional account that would be used to calculate the reduction in benefits, diverting payroll taxes to an individual account and investing entirely in government bonds is projected to leave a person’s total benefits (including the account assets) unchanged. If, however, the average rate of return on government bonds turns out to be higher or lower than that projected 2.9 percent, the total benefits of a person who chose to divert some payroll taxes to an individual account and invest in Treasury bonds will also be correspondingly higher or lower.
On average, greater returns would be expected from investing in other assets, such as corporate bonds or equities. However, those investments would also be riskier than government bonds. The prices of various assets and their expected returns are determined by the preferences and judgments of financial market participants who attempt to balance the risks of various assets against their extra expected returns. An individual account holding assets, such as stocks (with expected returns above 2.6 percent), would yield expected lifetime Social Security benefits whose value was greater than it would be under the traditional system; however, that higher anticipated income would not be expected to change the account holder’s behavior (by, for example, inducing the account holder to increase spending now) because the higher expected return would be balanced by additional risk. Shifting some payroll taxes to an individual account also would not be likely to affect the consumption patterns of people who spend all of their income because it would not alter their take-home pay.7
Economists do not agree about how the taxation of dividends affects the economy. Two views prevail: The first (or "traditional") view holds that reducing the tax on dividends lowers the cost of capital and increases investment. In the short run, stock prices rise because expected after-tax returns to investors increase. But, over time, the additional investment drives back down the pretax return to capital, so the effect on stock prices is temporary. The second (or "new") view holds that reducing the tax on dividends permanently raises the value of a business, and therefore its stock price, but leaves unaffected both the cost of capital and investment by the business. For an overview of those issues, see Alan Auerbach, "Taxation and Corporate Financial Policy," in Alan Auerbach and Martin Feldstein, eds., Handbook of Public Economics, vol. 3 (Amsterdam: North-Holland, 2003); Roger Gordon and Martin Dietz, Dividends and Taxes, Working Paper 12292 (Cambridge, Mass.: National Bureau of Economic Research, June 2006); and George R. Zodrow, "On the ‘Traditional’ and ‘New’ Views of Dividend Taxation," National Tax Journal, vol. 44, no. 4, part 2 (December 1991), pp. 497–509.
Alan J. Auerbach and Kevin A. Hassett, "The 2003 Dividend Tax Cuts and the Value of the Firm: An Event Study," in A. Auerbach, J. Hines, and J. Slemrod, eds., Taxing Corporate Income in the 21st Century (Cambridge, England: Cambridge University Press, 2007), Chapter 3; Alan J. Auerbach and Kevin A. Hassett, "Dividend Taxes and Firm Valuation: New Evidence," American Economic Review, vol. 96, no. 2 (May 2006), pp. 119–123.
Gene Amromin, Paul Harrison, and Steven Sharpe, How Did the 2003 Dividend Tax Cut Affect Stock Prices? Working Paper 2006-17 (Chicago: Federal Reserve Bank of Chicago, October 2006).
Jennifer Blouin, Jana Raedy, and Douglas Shackelford, Did Dividends Increase Immediately After the 2003 Reduction in Tax Rates? Working Paper 10301 (Cambridge, Mass.: National Bureau of Economic Research, February 2004); Jeffrey Brown, Nellie Liang, and Scott Weisbenner, Executive Financial Incentives and Payout Policy: Firm Responses to the 2003 Dividend Tax Cut, Working Paper 11002 (Cambridge, Mass.: National Bureau of Economic Research, December 2004); Raj Chetty and Emmanuel Saez, "Dividend Taxes and Corporate Behavior: Evidence from the 2003 Dividend Tax Cut," Quarterly Journal of Economics, vol. 120, no. 3 (2005), pp. 791–833, and "The Effects of the 2003 Dividend Tax Cut on Corporate Behavior: Interpreting the Evidence," American Economic Review, vol. 96, no. 2 (May 2006), pp. 124–129.
See Congressional Budget Office, Effects of the Federal Estate Tax on Farms and Small Businesses (July 2005).
CBO assumed that consumer spending would increase slightly because recipients of after-tax bequests would be unlikely in any given year to raise their spending by a significant amount and because the effect on recipients might be offset to some degree by increased saving among those planning to leave bequests.
See Congressional Budget Office, Evaluating Benefit Guarantees in Social Security (March 2006).
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