How CBO Analyzes the Effects of Changes in Federal Fiscal Policies on the Economy

Analyzing the effects on the overall economy of changes in federal fiscal policies—that is, policies governing taxes and spending—requires complex modeling and a significant amount of time. CBO undertakes such analyses in certain reports and for some major pieces of legislation; some of those analyses include the feedback effects of changes in the economy on the federal budget. CBO estimates the economic effects of changes in fiscal policies in both the short term and the longer term. The agency conducts its analyses using evidence about the effects of similar policies that have been implemented previously and using results from a variety of economic models.

In the short term, changes in fiscal policies affect the overall economy primarily by influencing the demand for goods and services by consumers, businesses, and governments, which leads to changes in output relative to potential (maximum sustainable) output. For example, decreases in taxes and increases in government spending generally boost demand, which encourages businesses to gear up production and hire more workers than they otherwise would; tax increases and spending cuts generally reduce demand, which has the opposite effects. In addition, changes in the supply of labor (the number of hours of labor that workers would like to provide) can affect output in the short term if the labor market is sufficiently tight—that is, if the demand for workers is high relative to the supply.

In the longer term, changes in fiscal policies primarily affect output by altering people’s incentives to work and save as well as businesses’ incentive to invest, thereby changing potential output. For example, policy changes that reduce marginal tax rates—the percentage of an additional dollar of earnings that is unavailable to a taxpayer because it is paid in taxes—generally encourage more work and saving. As another example, policy changes that reduce the federal deficit typically lead to more national saving (the total amount of saving by households, businesses, and governments) and investment, ultimately boosting output and income. Changes to fiscal policies may also affect potential output by altering the amount of government investment (for example, spending or tax subsidies for infrastructure, education and training, or research and development).

How Does CBO Estimate the Short-Term Effects of Changes in Fiscal Policies on the Overall Economy?

CBO assesses the short-term effects of changes in fiscal policies on the overall economy by estimating the impact of those policies on the demand for goods and services and combining those results with estimates of the policies’ impact on the supply of labor. The impact on the demand for goods and services is the product of a policy’s direct effects—the immediate or “first-round” effects on the economy—and indirect effects, which either offset or enhance direct effects. CBO uses evidence about the effects of similar policies to estimate a policy’s direct effects on spending for goods and services and uses the results generated by macroeconomic models to estimate the indirect effects. To estimate a policy’s short-term impact on the labor supply, CBO analyzes the effects of the policy change on incentives to work; the estimated effects on output of those changes in the labor supply depend on the state of the labor market.

A policy’s direct effects on spending result from changes in purchases of goods and services by federal agencies and by the people and organizations that receive federal payments or pay federal taxes. The size of the direct effect of a change in fiscal policy, per dollar of budgetary cost, depends on whether the change is permanent or temporary and on the financial circumstances of those affected by the policy. For example, a temporary tax cut generally has a smaller effect on a household’s purchases than a permanent cut because a temporary cut has a smaller effect on the household’s lifetime disposable (after-tax) income. In addition, increases in disposable income are likely to boost purchases more for lower-income households than for higher-income households.

The indirect effects of changes in fiscal policies can be summarized by a "demand multiplier," defined as the total change in output for each dollar of direct effect on demand. The value of that multiplier is affected by economic conditions; CBO estimates that indirect effects are largest when the Federal Reserve is keeping short-term interest rates close to zero. Because considerable uncertainty surrounds the estimation of the effects of fiscal policy on demand, CBO’s analyses of changes in fiscal policies generally use a range of estimates of the demand multiplier that encompasses a wide array of economists' views about the relevant economic relationships. The full economic impact of a change in demand in the short term is the product of the direct effects and indirect effects. That combined impact can be summarized by an "output multiplier."

In addition, CBO’s short-term analysis incorporates the effect on output of changes in the supply of labor, but the magnitude of that effect depends on the state of the economy. When unemployment is high and output is far from its potential—that is, when the economy has considerable unused labor and capital resources, or "slack"—a policy that increases or decreases the supply of labor will generally have little effect on output. In those circumstances, if a policy leads some people to leave the labor force (which means that they are neither employed nor looking for work), the jobs they vacate or could have filled will probably be filled by other people who will otherwise be unemployed; if a policy leads some people to join the labor force, those people will probably be unable to find a job (or, if they find a job, other people will become unemployed).

How Does CBO Estimate the Longer-Term Effects of Changes in Fiscal Policies on the Overall Economy?

CBO generally uses two models of potential output to estimate the effects of changes in fiscal policies on the overall economy over the longer term—a Solow-type growth model and a life-cycle growth model. In those models, output depends on the amount and quality of the labor that is employed and the stock of productive capital (such as factories, vehicles, and computers that support future production and consumption) available for use in the economy, which, in turn, depend on decisions regarding work, saving, and investment. Output depends also on the efficiency with which those inputs are used to produce goods and services, which depends on government investment and other factors affecting the productivity of the labor and capital inputs. In the Solow-type model, people base their decisions about working and saving primarily on current economic conditions, such as wage levels, interest rates, and government policies; and those decisions reflect people’s anticipation of future policies in a general way but not their responses to specific future developments. By contrast, in the lifecycle growth model, people make choices about working and saving in response to both current economic conditions and their explicit expectations of future economic conditions.

In using both models, CBO employs alternative estimates of some key economic relationships to reflect the high degree of uncertainty that attends them. For example, CBO uses alternative estimates of the responsiveness of labor supply to changes in after-tax wages, the response of international capital flows to changes in national saving, and the return on government investment. The ranges of estimates that CBO uses are based on the research literature in those areas. By using two different models and alternative estimates of some key parameters, CBO generally produces a range of estimated effects of changes in fiscal policies that reflects different views about how the economy operates.

CBO estimates the effects of changes in fiscal policy in the transitional period between the short term and the long term by blending results from the short-term analysis and the long-term analysis using the Solow-type growth model. That blending puts full weight on estimated short-term effects on output in the initial years; increasing weight on the estimated effects on potential output under the Solow-type growth model over the next few years; and then full weight on the estimated effects on potential output in later years. Some recent research suggests that, under certain circumstances, changes in fiscal policies that affect the demand for goods and services in the short term can have significant effects on potential output in the long term apart from the impact of the changes in government borrowing; CBO continues to investigate that issue.