What Effects Have the 2001 to 2003 Tax Cuts Have on the Economy?

Prepared for Members and Committees of Congress

Recession concerns have led policymakers to consider economic stimulus legislation. These
proposals have raised questions about the economic effects of past policy changes. Congress
enacted major tax cuts in 2001, 2002, and 2003. The acts reduced marginal income tax rates;
reduced taxes on married couples, dividends, capital gains, and on estates and gifts; increased the
child tax credit; and accelerated depreciation for business investment. The tax cuts resulted in an
estimated revenue loss of 0.4% of GDP in 2001, 1.1% in 2002, and 1.6% in 2003. Since
government spending rose as taxes were cut, the cuts can be characterized as deficit financed.
It is hard to be certain what effects the tax cuts have had on the economy because there is no way
to compare actual events to the counterfactual case where the tax cuts were not enacted. The most
common method of estimating a tax cut’s effect is to feed it into a macroeconomic model of the
economy and see what the model predicts. Note that this is typically done before the fact:
economic estimates of the tax cut’s effect are not based on actual ex post data. These estimates are
highly uncertain because there is no one macroeconomic model that adequately captures all of the
economy’s dynamics, no consensus among macroeconomists as to which one model is most
suitable for policy simulations, and no model with a strong track record in accurately projecting
economic events.
Most estimates predicted that the tax cuts would increase economic growth in the short-term and
reduce it in the long run. For example, the Joint Committee on Taxation predicted that the 2003
tax cut would increase GDP by an average of 0.2% to 0.5% in the first five years and decrease it
by -0.1% to -0.2% over the next five years. Keynesian models find the largest positive short-term
effect of the tax cuts on the economy. But these effects are completely temporary because they
focus on how tax cuts boost aggregate spending; in the long run, prices adjust, and production
rather than spending determines the level of output. In neo-classical (Solow) growth models,
deficit-financed tax cuts reduce national saving, thereby reducing national income because capital
investment can only be financed through national saving or foreign borrowing. If the latter
occurs, the result will be an increased trade deficit. In intertemporal models, a deficit-financed tax
cut is unsustainable: it must be offset in the future by a tax increase or spending cut to prevent the
national debt from growing indefinitely. Thus, in these models, tax cuts followed by tax increases
lead individuals to shift work and saving into the low-tax period, increasing growth then, and out
of the high-tax period, reducing growth then.
The period encompassing the tax cuts featured a recession of average duration but below-average
depth, an initially sluggish recovery, a deep and unusually long decline in employment, a small
decline in hours worked, a sharp and long lasting contraction in investment spending, a
significant decline in national saving, and an unusually large trade deficit. Opponents see this as
evidence that the tax cuts were ineffective; proponents argue that the economy would have
performed worse in their absence. Also consider that some, perhaps most, of the recovery was due
to monetary rather than fiscal stimulus.

Introduc tion ..................................................................................................................................... 1
A Brief Description of the Tax Cuts................................................................................................1
Pitfalls in Estimating the Economic Effects of Tax Cuts.................................................................3
A Tax Cut’s Predicted Effects Depend on the Model Used.............................................................5
Demand Side Effects of a Tax Cut in a Keynesian Model........................................................5
Economic Growth and Employment...................................................................................6
“Bang for The Buck”..........................................................................................................9
How Much Stimulus Was Attributable to Monetary Policy?..............................................9
Inflation ............................................................................................................................. 10
Consumption ...................................................................................................................... 11
Effects of a Tax Cut in Long-Term Growth Models...............................................................12
Neoclassical Solow Growth Model.........................................................................................12
Saving and Investment......................................................................................................13
The Trade Deficit..............................................................................................................14
Supply-Side Effects of a Tax Cut on Labor and Saving..........................................................15
Intertemporal Models..............................................................................................................17
Overview of Simulations...............................................................................................................19
Simulations of EGTRRA’s Effects..........................................................................................19
Macroeconomic Advisers..................................................................................................19
DR I-WEFA ....................................................................................................................... 20
Auerbach ....................................................................................................................... .... 20
Gale and Potter..................................................................................................................20
Economic Effects of the 2001 Rebate...............................................................................21
Simulations of JGTRRA’s Effects...........................................................................................22
J CT .................................................................................................................................... 22
CBO ............................................................................................................................ ...... 22
Macroeconomic Advisers..................................................................................................24
Global Insight...................................................................................................................24
Conclusion ..................................................................................................................................... 25
Economic Growth in a Keynesian Model...............................................................................25
Investment, National Saving, Interest Rates, and Growth in the Solow Model......................25
Trade Deficit...........................................................................................................................26
Employment and Unemployment in a Keynesian Model.......................................................26
Supply-Side Effects on Labor Supply and Private Saving......................................................26
Table 1. Estimated Revenue Loss from the Tax Cuts......................................................................2
Table 2. Average Marginal Tax Rates Under EGTRRA/JGTRRA in 2011.....................................3
Table 3. GDP Growth in Historical Recessions...............................................................................7
Table 4. Decline in Employment during Historical Recessions and Recoveries.............................8
Table 5. Lowest Federal Funds Rate in Each Recessionary Episode, 1958-2003.........................10

Table 6. Growth Rate of GDP, Consumption, and Investment, 2000-2004....................................11
Table 7. Budget Deficits, Trade Deficits, Saving, and Investment................................................14
Table 8. Labor Supply and Saving Indicators, 2000-2004............................................................17
Author Contact Information..........................................................................................................27

Concerns that the economy might be heading toward a recession have led some policymakers to
consider economic stimulus legislation. To judge the efficacy of such proposals, some
policymakers have expressed a desire to look back at the economic effects of past policy changes.
Proponents of the tax cuts passed in 2001, 2002, and 2003 argued that they would have salutary
effects on the economy. Particular emphasis was placed on economic stimulus in the short-term.
This report traces out the channels through which the tax cuts are thought to affect the economy
and assesses the performance of those economic indicators, including gross domestic product
(GDP), employment, interest rates, inflation, labor supply, saving, capital investment, and the
trade deficit. The report uses theory and data to evaluate the tax cuts’ effects through 2004. (This
report does not analyze economic developments since 2004. Presumably, individuals had adjusted
their behavior to the tax changes by then, and economic developments since have not been
significantly influenced by tax cuts enacted several years earlier.) The report also offers an
overview of the forecasts of their effects made at the time the tax cuts were passed. Most
estimates predicted that the tax cuts would increase economic growth in the short-term and reduce
it in the long run. Despite the wide diversity of the models used, all of the results are relatively
small, as would be expected of tax cuts that are relatively small in relation to GDP in the years

Three tax cuts have been signed into law in recent years. This report focuses on provisions of
those bills that caused significant revenue loss from 2001 to 2003. In 2001, the Economic Growth
and Tax Relief Reconciliation Act was signed into law (EGTRRA, P.L. 107-16). Its major
provisions for 2001-2004 were a reduction in marginal income tax rates, an increase in the child
tax credit, “marriage penalty” tax relief, and elimination of the estate tax. All of these provisions
were phased in gradually over several years, and then scheduled to expire due to budget rules 1
(although it was the framers’ stated intent that they become permanent). In 2002, the Job
Creation and Worker Assistance Act (JCWAA, P.L. 107-147) was signed into law. Its major
revenue-side provision was accelerated depreciation for business investment. In 2003, the Jobs
and Growth Tax Relief Reconciliation Act (JGTRRA, P.L. 108-27) was signed into law. It
accelerated the phase in of the main EGTRRA provisions, with the exception of the estate tax
provisions, and extended and expanded the accelerated depreciation in JCWAA. It also reduced
the tax rates on dividend and capital gains income. In addition, the 2004 Working Family Tax
Relief Act (WFTRA, P.L. 108-311) extended some provisions of the earlier acts that were slated
to expire. It had no revenue effect in 2004.
Table 1 gives the estimated revenue loss of the tax cuts and their key provisions as scored by the
Joint Committee on Taxation at the time the tax cuts were enacted. Estimates of the cost of the tax 2
cuts based on ex post data do not exist. EGTRRA was the largest of the tax cuts and most of

1 Proposals to make part or all of EGTRRA/JGTRRA permanent can be found in the Administrations budget proposal
for FY2007 and several dozen congressional bills.
2 Actual tax receipts fell significantly more than predicted by the ex ante scores, even after controlling for economic
conditions. This suggests that the tax cuts may have resulted in more revenue loss than predicted. See CRS Report
RS21786, The Federal Budget Deficit: A Discussion of Recent Trends, by Gregg A. Esenwein, Marc Labonte, and

EGTRRA’s costs are to occur in the out years. Most of the costs of JGTRRA and JCWAA
occurred in the short-term. In fact, because accelerated depreciation is a revenue loser in the
short-term and revenue raiser in the medium-term, the 10-year cost of JCWAA is smaller than the
short-term cost. In the long run, it was by far the smallest of the three, but of comparable size in
the time period considered here. JGTRRA’s costs are mainly short-term because it mostly
accelerates tax cuts that would have occurred later under EGTRRA. All of the tax cuts are
temporary and scheduled to expire, although it was the intention of their supporters that
EGTRRA/JGTRRA be permanent.
Table 1. Estimated Revenue Loss from the Tax Cuts
(billions of dollars)
2001 2002 2003 2004 10 Year Total
Tax Acts
EGTRRA, 2001 40 71 91 102 1,349
JCWAA, 2002 - 42 39 29 30
JGTRRA, 2003 - - 50 135 320
WFTRA, 2004 - - - - 122
Provisions (cumulative totals for all tax acts)
Marginal Rate Reductions 40 55 61 69 875
Child Tax Credit 1 9 24 17 204
Marriage Penalty Relief 0 0 6 26 98
Estate and Gift Tax Reductions 0 0 7 6 138
Dividend and Capital Gains Tax Reduction - - 4 17 148
Accelerated Depreciation - 35 44 65 26
Source: Joint Committee on Taxation.
Notes: Estimates do not include outlay provisions or cost of additional debt service. Table omits effects of date
shifting on yearly revenue loss. Cumulative costs for JCWAA and accelerated depreciation provisions are lower
than the years shown because of revenue offsets in outyears.
Consistent with the goal of short-term stimulus, this report focuses on the effects of the tax cuts
through 2004. Certain provisions that are large in the long run are small to date and will not be
explored, most notably the repeal of the estate tax. Other provisions, such as accelerated
depreciation, were large in the short run, but not in the long run. Although the costs of the tax cuts
are large as a fraction of total receipts, particularly in the out years, the costs as a percentage of
gross domestic product (GDP) in the years of interest are small. The small size of the tax cuts
places a low ceiling on their potential economic effects. This is especially the case when
evaluating demand-side effects, where their incremental increase from year to year, rather than
their absolute value, is the relevant figure. In 2001, the tax cuts (revenue provisions only) were
equal to 0.4% of GDP, all of which occurred in the second half of the year. In 2002, they
increased 0.7 percentage points to 1.1% of GDP. In 2003, they increased 0.5 percentage points to

1.6% of GDP. In 2004, they increased 0.7 percentage points to a projected 2.3% of GDP.

Philip D. Winters.

As discussed below, when considering the effects of tax cuts on labor supply and saving, the key
measure is marginal tax rates. As seen in Table 2, the change in average marginal tax rates under
EGTRRA and JGTRRA is modest for wages and interest income when fully phased in; however,
EGTRRA/JGTRRA leads to a larger decline in marginal rates on capital gains income and a more
than 50% decline in marginal rates on dividend income.
Table 2. Average Marginal Tax Rates Under EGTRRA/JGTRRA in 2011
Wage Interest Dividend Capital Gains
Income Income Income Income
Prior Law 26.0 25.3 28.8 19.9
EGTRRA/JGTRRA 24.4 23.2 13.2 15.5
Source: CRS calculations based on data from Office of Tax Analysis and Joint Committee on Taxation.
Notes: Marginal tax rates under EGTRRA/JGTRRA vary by year as various provisions are phased in and out.
The table shows marginal tax rates in 2011 when the tax cuts are fully phased in. Marginal tax rates include only
the individual income tax system; they do not include marginal rates on, for example, wages from the payroll tax
system or the corporate tax system. Marginal rates on capital income do not apply to capital income held in tax
preferred accounts.
Because government spending rose as a percentage of GDP in the years when taxes were cut,
these tax cuts can be characterized as wholly deficit-financed tax cuts (financed by increasing the
deficit or decreasing the surplus). This is important to note because deficit-financed tax cuts have
a different economic effect than tax cuts financed by reducing spending or raising other taxes in
the models described below.

It may be surprising to learn that there is no straightforward way to evaluate how a tax cut has
affected the economy. Economists can observe how the economy performed after a tax cut, but
because they cannot observe the counterfactual—how the economy would have performed in the
absence of a tax cut—there is no direct way to tell what contribution the tax cut made to the
economy’s performance. If the economy boomed after a tax cut, there is no way of telling
whether the economy would have boomed even if the tax cut had not been passed. If the economy
grew sluggishly after a tax cut, there is no way of telling whether the economy would have grown
even more slowly without a tax cut.
Econometric research is based on observing variation between data observations to determine
correlation between variables. For studies of individual behavior, variations in the tax cut that
individuals receive can be used to establish correlation. If recipients of a tax cut systematically
behave differently than nonrecipients, all else equal, it can be deduced that the tax cut caused that
behavior. Unfortunately, in the case of tax cuts, variation between individuals is not independent
of other control variables needed to hold all else equal. The size and eligibility of a tax cut is
based on criteria that may strongly influence an individual’s behavior. For example, the size of
the marginal tax rate reduction received under EGTRRA is determined by factors such as income.
Yet if the experience of individuals in one income cohort is systematically different than in a

different cohort, a tax cut could be erroneously attributed as the cause when some other factor
was the cause. For example, income inequality has been growing in the United States in recent
decades because the income of upper-income cohorts has been rising more quickly than lower-3
income cohorts. Because EGTRRA gave larger tax cuts to upper-income cohorts on average, the
portion of faster income growth caused by growing inequality, unless properly controlled for, 4
would be spuriously attributed to the larger tax cut.
For economy-wide studies, the variation studied is typically over time rather than across
individuals. In the case of a tax cut, this would entail comparing how the economy performed in
periods with the tax cut compared to periods without the tax cut. But because other factors are
also changing over time, different control variables are not independent, and causation runs in
both directions, it is very difficult to isolate the effect of tax cuts. For example, consider a tax cut
implemented to stimulate the economy in response to a downturn. Comparing economic activity
before and during the tax cut, simple correlation could lead to the conclusion that tax cuts cause
recessions since the timing of the tax cut is associated with a decline in growth. Some other factor
is necessary to control for this “endogeneity” problem. Some econometric methods can overcome
the endogeneity problem, but greatly limit the number of control variables that can be employed
because of insufficient “degrees of freedom.” Some time series analysis has been criticized for
assuming that individuals do not change their reactions in response to changes in the behavior of
policymakers (known as the “Lucas critique”). Because there have been relatively few major tax 5
cuts or increases in recent history, there are relatively few observations to consider.
In this situation, economists typically predict a tax cut’s economic effects by building
econometric forecasting models, calibrating the models to match actual economic data, and then
running the model with and without a tax cut. The difference between the two outcomes is said to
be the tax cut’s economic effects. Notice that this approach does not rely on actual, after the fact
data to determine the tax cuts’ effects. These simulations are typically run before the tax cut is
implemented, and it is rare for the modeler to go back after the fact and test the accuracy of the
prediction. As shown in the section below, none of the predictions made for EGTRRA and
JGTRRA were based on actual ex-post data. (Using ex-post data would improve the accuracy of
the results, but not avoid all of the problems discussed above.)
This method of estimating a tax cut’s effects would be less problematic if there were widespread
consensus that one particular econometric model could accurately predict economic activity. In
fact, econometric models are sometimes poor predictors of economic activity, even over short
periods of time. Although some models have proven capable of making reasonably accurate
short-term projections during expansions, no model has proven able to correctly predict turning
points in the business cycle on a regular basis. For example, every month the company Blue Chip
surveys 50 private forecasters. Not one of the 50 forecasters predicted the 2001 recession until
April 2001—a month after the recession had started. There is little consensus over the correct
approach in theory to modeling macroeconomic activity, so there are many competing models

3 Distributional analysis for all recent tax cuts have been estimated by the Tax Policy Center,
http://www.taxpolicycenter.org/TaxModel/tmdb/TMTemplate.cfm. Distributional analysis for some tax cuts are also
available online from the U.S. Treasurys website at http://www.treas.gov/press/taxes.html.
4 Austan Goolsbee, “Its Not About the Money,” in Joel Slemrod, ed., Does Atlas Shrug? The Economic Consequences
of Taxing the Rich, (Cambridge, MA: Harvard University Press, 2000), p. 143.
5 An endogenous variable is one that simultaneously affects other variables and is affected by those variables. Degrees
of freedom are calculated as the number of observations minus the number of explanatory variables. It must be positive
for statistical inference. Higher degrees of freedom lead to more robust analysis.

that radically differ in basic and fundamental ways. The Congressional Budget Office (CBO) and
Joint Committee on Taxation (JCT) have responded to this problem by using several different
models to offer a range of predictions of a proposal’s effects. As shown below, these models
predict that tax cuts will have widely different—sometimes contradictory—economic outcomes.
Given these circumstances, it is difficult to argue that model-based predictions offer a reliable
proxy for the tax cuts’ actual effects.

As discussed above, there is no consensus as to which type of macroeconomic model best
describes reality. Each model captures certain aspects of economic behavior well, but no model
adequately synthesizes all the different aspects at once. Because economists differ on which
aspects of economic behavior are most important, they also differ on which model is preferable
for evaluating policy. No model described below is right or wrong; each has unique strengths and 6
weaknesses. But the predicted effects of a tax cut will be highly sensitive to the assumptions of
the model used to evaluate it. Because the models are not integrated, a major problem with the
estimates is that if there are effects caused by properties that the model being used neglects, the
effects will be incorrectly attributed to other properties that are included in the model being used.
For example, if a tax cut boosted aggregate demand, a supply side model would attribute the rise
in output to an increase in labor or saving, even though the increase would not necessarily be
induced by incentives, would not necessarily be permanent, nor would it necessarily be replicable
at a different point in the business cycle.
Keynesian models focus on aggregate demand, or the spending side of the economy, rather than
the aggregate supply, or the production side of the economy. Because recessions are typically
thought to be shortfalls in aggregate spending relative to potential supply (production if all of the
economy’s labor and capital resources were fully employed), Keynesian models are popular for
short-term policymaking and forecasting purposes. Professional forecasters, including CBO,
Office of Management and Budget (OMB), the Federal Reserve, Global Insight, and
Macroeconomic Advisers, use models with Keynesian attributes in the short run to predict
economic activity. However, the richness of the models’ development of the demand side of the
economy comes at the expense of their ability to explain the supply side. This makes these
models of more limited usefulness for explaining and prescribing policies when the economy is
fully employed. Because aggregate demand can fall below aggregate supply only in the short run,
before prices adjust, Keynesian models are also of limited usefulness in explaining the long run.

6 Commercial forecasting models, such as Global Insight and Macroeconomic Advisers, incorporate aspects of supply
side and Solow Growth models in their results, but Keynesian effects dominate the results over the first few years of
the projection.

Using fiscal policy to boost aggregate spending is often popularly referred to as “stimulating the
economy,” and evaluating a “stimulus package” is best done by looking at its effects on aggregate
spending using a Keynesian model. In these models, the government can boost spending in the
economy by increasing the budget deficit. If the deficit is the result of increased government
spending, aggregate spending is boosted directly because government spending is a component of
aggregate demand. Because the deficit is financed by borrowing from the public, resources that
were previously being saved are now being used to finance government purchase or production of
goods and services. If the deficit is the result of tax cuts, aggregate spending is boosted by the tax 7
cut’s recipient to the extent that the tax cut is spent (not saved or invested in financial securities).
In this case, resources that were previously being saved are now at the disposal of the tax cut
recipient, and to the extent that the recipient decides to increase his consumption, aggregate
spending will rise.
In this model, the increase in aggregate spending does not stop there. When spending increases,
idle labor and capital resources are brought back into use, leading to an increase in employment
and decrease in unemployment. This generates new production, and income accrues to those
previously idle resources, which can then be spent by the worker or owner of capital. This process
is repeated, producing a “multiplier effect” so that the eventual increase in aggregate spending
exceeds the initial increase in the budget deficit. It is assumed that it will take some time for the
full effects of the stimulus to be felt. Some prominent Keynesian models predict most of the
effects are felt within two years.
The effects of fiscal stimulus can be visualized in terms of a simple supply and demand diagram,
where the boost in demand brings the economy to a new, higher equilibrium with supply. Because
the supply curve is sloped upward, the ultimate increase in output is less than the boost in
demand; if the supply curve were vertical the boost in demand would ultimately lead to zero
increase in output. Economists cannot directly observe distinct supply and demand curves; they
can observe only the single point of equilibrium between them, and this is recorded as gross
domestic product. Thus, there is no direct way to determine whether a change in GDP is demand
or supply driven. Simple Keynesian models assume, in essence, that all changes in GDP are
demand-side phenomena and can be explained by the process above. (The other models
considered below assume that all changes in GDP are supply-side phenomena.) In recessions, this
assumption is often valid (unless the recession is caused by a “supply shock,” such as an increase
in the price of oil). In expansions, the assumption is problematic because aggregate spending
already matches potential production, in which case the process described above may be a poor
guide for explaining reality. Thus, the same tax cut implemented at full employment will result in
a significantly smaller boost to aggregate spending and employment than during a recession.
Since the 2001 tax cuts took place during a recession and the 2002-2003 tax cuts took place
during a period of sluggish recovery characterized by an economy operating below full
employment, the Keynesian framework is a valid one to capture, at least in part, the effects of
these tax cuts on the economy. In this framework, these tax cuts would be predicted to stimulate
aggregate demand, which would be manifested in the data as an increase in GDP growth. The size

7 A tax cut that was financed by lower government spending would not stimulate aggregate spending because the
increase in private spending among the tax cuts recipients would be offset by the decrease in government spending. In
the Keynesian model, the key to a stimulus is the larger deficit, not the tax cut.

of the stimulus would be small relative to GDP since the incremental increase in the budget
deficit was small (less than 1% of GDP) each year.
How did the economy react following the tax cuts? In evaluating the effect of the tax cuts on
aggregate demand, the unusual nature of the economic recession and recovery poses a serious
problem. Keynesian models predict that tax cuts will boost GDP growth and employment (and
other measures of capacity utilization). Beginning in the fourth quarter of 2001, growth and
employment moved in opposite directions.
Based on GDP data, this recession and subsequent recovery was characterized by its mildness: the
decline in GDP during the recession was relatively brief and shallow, and economic output
returned to its previous peak quickly—although growth was not initially rapid in the recovery,
GDP was not far below its peak. This is illustrated in Table 3. Based on these data, the argument
could be made that EGTRRA prevented a deeper and longer recession from taking place.
Alternatively, it could be argued that, despite very large tax cuts, the recession was a comparable
length to (although it was clearly shallower than) other recessions in which taxes were not cut.
Furthermore, there is the question of whether the tax cuts that came after EGTRRA were useful in
stimulating aggregate spending, even if it is believed that the earlier ones were. Historical
experience shows that eventually recessions end on their own through market adjustment and
monetary expansion. Every recession in the post-war period has lasted less than a year and a half.
By the time JGTRRA was implemented—two years after the recession had ended—it can be
argued that the economy was in little need of further stimulus. And unlike most recoveries, GDP
growth was sluggish for the first six quarters of this recovery, despite three tax cuts. This view
would lead to the conclusion that the tax cuts, particularly the latter two, made no impression on
the normal market forces that determine expansion and contraction. The counter-argument would
stress the initially sluggish nature of the recovery as evidence that further stimulus was required.
Table 3. GDP Growth in Historical Recessions
Duration of Percent Decline Quarters After Recession Until GDP Growth in First Four
Period Recession in GDP GDP Reached Quarters of
(months) (cumulative) Previous Peak Recovery
1949:1 - 1949:4 8 -1.6 1 13.4
1953:3 - 1954:1 10 -2.7 1 6.2
1957:4 - 1958:1 8 -3.7 3 7.3
1960:2 - 1960:4 10 -1.6 2 6.3
1969:4 - 1970:1 11 -0.6 2 0.2
1973:3 - 1975:1 16 -3.0 3 6.4
1980:1 - 1980:3 6 -1.9 2 4.3
1981:4 - 1982:3 16 -2.9 3 5.5
1990:3 - 1991:1 9 -1.5 3 2.3
2001:1 - 2001:3 9 -0.2 2 2.2
Source: National Bureau of Economic Research, Bureau of Economic Analysis.

Based on employment, unemployment, capacity utilization rates, and related measures, the recent
recession was deep and extremely long, and the recovery was unusually sluggish, as shown in
Table 4. Of the 10 post-war recessions, the 2001 recession had the seventh largest employment
decline during the recession. But if the employment decline after the recession ended is included,
it becomes the fifth largest, and the second largest in the past four decades. The unemployment
rate did not begin to fall until mid-2003. Altogether, this was the longest period of employment in
the post-war period. Likewise, the industrial capacity utilization rate was still below average
through 2003.
Table 4. Decline in Employment during Historical Recessions and Recoveries
Number of Date
Percent Decline Percent Decline in Employment Months That Employment
Recession Dates in Employment After Recession Employment Surpassed
During Recession Ended Declined After Previous Peak
Recession Ended
Nov. 1948-Oct. 1949 6.2 0.0 0 Aug. 1950
July 1953-May 1954 3.8 0.5 3 July 1955
Aug. 1957-Apr. 1958 4.9 0.4 2 July 1959
Apr. 1960-Feb. 1961 2.1 0.0 0 Feb. 1962
Dec. 1969-Nov. 1970 1.8 0.0 0 Dec. 1971
Nov. 1973-Mar. 1975 2.7 0.4 1 June 1976
Jan. 1980-July 1980 1.4 0.0 0 Feb. 1981
July 1981-Nov. 1982 3.4 a 1 Oct. 1983
July 1990-Mar. 1991 1.3 0.6 11 May 1993
Mar. 2001-Nov. 2001 1.9 1.2 21 Feb. 2004
Source: U.S. Bureau of Labor Statistics data from the establishment survey for non-farm private sector
employment; recessions dated by NBER.
a. less than 0.1%.
By these measures, making the case that the tax cuts boosted aggregate spending is more difficult.
At best, it could be argued that the tax cuts prevented the decline in aggregate spending from
being even longer and deeper. But why would this recession have been worse than others in the
tax cuts’ absence? To make this case, circumstances in this recession that made it unique would
have to be identified. Some recent events can be used to make this case, such as the September 11
attacks (although they did not occur until the recession was almost over) and the stock market
crash. However, this case is weakened by the role of monetary policy. The depth and duration of
the “double dip” recessions of the early 1980s are widely attributed to the monetary contraction
that preceded them; in recent years, monetary policy has played the opposite role, sharply
mitigating any recessionary forces, as discussed below.
Does the employment or GDP data give a more accurate picture of the recession’s depth and
breadth? Although no single data set gives a complete picture of the economy, one compelling
argument is that the GDP data understate the recession’s severity. The strong growth in
productivity throughout the recession and recovery suggests that the higher rates of productivity
growth first registered in the late 1990s have continued to the present. If this is the case, then the
economy’s long-term sustainable growth rate has risen, in which case the 0.8% and 1.6% GDP

growth rates achieved in 2001 and 2002, respectively, place the economy farther below full
employment than would be the case if the economy grew at similar rates in earlier downturns.
As discussed above, the key to evaluating a tax cut’s effect as a stimulus is the extent to which it
boosts aggregate spending. By definition, to boost aggregate demand, a stimulus package must
lead to spending rather than saving. Any policy-induced increase in the deficit would lead to some
increase in aggregate spending, all else equal. But one criticism that was made about the recent
tax cuts was that they would deliver relatively little “bang for the buck” as a stimulus measure.
That is, while they would boost aggregate spending in the economy, because of their design they
would have a very low multiplier effect relative to alternative policy options.
Several arguments have been made for why the recent tax cuts provided relatively little “bang for 8
the buck” compared to the alternatives. First, government spending has a greater multiplier effect
than tax cuts because some portion of a tax cut is saved rather than spent. Second, it is believed
that tax cuts for upper income cohorts—the primary recipients of the recent tax cuts—provide
less bang for the buck than tax cuts for lower income cohorts because upper income cohorts have
higher saving rates. Third, some argue that more of a tax cut will be saved if it is temporary rather
than permanent. By law, major parts of EGTRRA and JGTRRA are scheduled to expire after 10
years. However, this factor may be inconsequential because individuals may view the tax cuts as
permanent since the legislators who supported the tax cuts indicated their intention to make them
permanent. Finally, certain provisions of the recent tax cuts are intended to promote saving rather
than spending, such as the reduction in the taxation of dividends and the elimination of the estate
tax. By definition, these provisions would not be stimulative.
Although the tax cuts could have been designed to have a larger bang for the buck for the reasons
listed above, it is an open question as to whether the difference would have been substantial or
negligible. Econometric models are typically not detailed enough in the modeling of fiscal policy
to answer this question definitively. Further complicating the question, the alternative economic
models discussed below predict different—in some cases, contradictory—factors that would
make a tax cut more effective. For example, in the Solow growth model, a tax cut that promoted
saving and discouraged consumption would have a more positive effect on growth. In any case, it
is fair to say that the most important factor in determining the effect of fiscal stimulus on the
economy is its size (the incremental increase in the budget deficit), not the specific form that the
stimulus takes.
When considering the short-run effects of the tax cuts on GDP, one should also net out the
stimulative effects of changes in monetary policy. Most economists believe that monetary policy
has a strong effect on aggregate demand growth in the short run, and that lower interest rates were
a more important factor than tax cuts in tempering the depth and length of the recession. Indeed,
there was a large decline in the federal funds rate from 2000 to 2003. As can be seen in Table 5, in

8 See CRS Report RS21126, Tax Cuts and Economic Stimulus: How Effective Are the Alternatives?, by Jane G.
Gravelle; CRS Report RS21136, Government Spending or Tax Reduction: Which Might Add More Stimulus to the
Economy?, by Marc Labonte,Fiscal Stimulus,” Economy.com Regional Financial Review, February 2003.

2003 the federal funds rate reached its lowest nominal level since the 1957-1958 recession.

(Federal funds rate data are not available for earlier recessions.)
However, this easing of policy is not unusually large by other measures. Adjusting the federal
funds rate for inflation (ex-post) reveals that real interest rates were lower in three of the previous
seven recessions than in 2003. And the recent decline in interest rates was smaller than any other
recession in the previous three decades. Thus, monetary policy did not play a more prominent
role than usual in mitigating the recession. Nor did monetary policy play a large role in causing
the recession: short-term interest rates were raised by 1.75 percentage points between 1999 and

2000. This is much smaller than the episodes of significant monetary tightening in 1969, 1973,

and 1980-1981, which are credited with contributing to the subsequent recessions.
Table 5. Lowest Federal Funds Rate in Each Recessionary Episode, 1958-2003
Rate Change:
Date of Lowest Rate Nominal Interest Rate Real Interest Rate Peak to Trough
(percentage points)
May 1958 0.6% -2.8% 2.9
July 1961 1.2% -0.1% 2.8
February 1971 3.7% -1.0% 5.5
May 1975 5.2% -4.1% 6.8a
July 1980 9.0% -4.2% 8.6
February 1983 8.5% 5.0% 10.5
December 1992 2.9% -0.1% 7.0
June 2003 1.0% -1.2% 5.5
Source: CRS calculations based on Federal Reserve and BLS data.
Note: Real interest rates calculated by subtracting nominal rates less inflation over previous 12 months. Interest
rates measured as a monthly average. Rate change calculated on a nominal basis.
a. In the 1973-1975 recession, interest rates peaked nearly one year into the recession.
In Keynesian models, the inflation rate is determined by the interaction of aggregate demand and
supply. When aggregate demand exceeds supply, inflation rises because there is “too much money
chasing too few goods;” when spending is inadequate to maintain full employment, inflation falls.
Keynesian models are based on the assumption of “price stickiness”: prices are slow to adjust to
changes in aggregate supply and demand.
A tax cut pushes up inflation by increasing aggregate demand, all else equal. Because of sticky
prices, the entire increase in prices does not occur instantaneously. When the economy is already
near full employment, the increase in inflation is likely to be quick and substantial (relative to the
tax cut) because production is incapable of being increased enough to match the increase in
spending. When the economy is below full employment, the increase in inflation would likely be
smaller and slower because there can be a greater increase in production to meet the increase in

When considering the effects of fiscal policy on inflation, it is highly unlikely that all else will
remain equal in reality. Inflation is ultimately determined by the Federal Reserve’s manipulation
of the money supply, and the Fed has shown a strong preference in recent decades for maintaining
a relatively low and stable inflation rate. When evaluating the effects of a change in fiscal policy,
the most realistic assumption to make is that the Fed would take steps to offset any inflationary
effects that the policy change may have. Thus, the most realistic assumption to make about a tax
cut in the abstract is that it will lead to higher short term interest rates (via tighter monetary
policy) rather than higher inflation. This is particularly true if the tax cut takes place when the
economy is near full employment, in which case the monetary response will negate most of the
tax cut’s effect on aggregate spending. If the economy is in a recession, inflationary pressures are
less likely to be a concern, and the Fed is less likely to allow interest rates to rise (i.e., it will
accommodate the fiscal expansion).
In the case of the recent tax cuts, inflation was extremely low. As measured by the consumer price
index, it fell from 3.4% in 2000 to 1.6% in 2002, and then rose to 2.3% in 2003. With the federal
funds rate declining by 5.5 percentage points from 2000-2003, there was no tightening of
monetary policy to offset the inflationary effects of fiscal policy. At most, the easing of monetary
policy that occurred would have been larger in the absence of the tax cut—but the Fed was
limited by how much further monetary policy could have been eased under traditional methods
since short-term interest rates were brought down to 1%, close to the zero bound.
It is often assumed that insufficient aggregate spending, the source of recessions in Keynesian
models, refers to personal consumption spending. In fact, aggregate spending is composed of
personal consumption, private investment, government spending, and net exports, and a shortfall
in any of these components can cause a recession.
In 2001-2003, consumption growth was slightly below normal, but was consistently the strongest
component of GDP growth, as seen in Table 6. Thus, it would be inaccurate to characterize the
2001 recession as being caused by insufficient consumer spending. By far, the weakest
component of the economy was private investment spending, as will be discussed below. This is
not unusual: in all of the post-war recessions, investment spending growth was lower than GDP 9
growth, and consumer spending was higher than GDP growth. At most, consumption spending
indirectly caused the recession if businesses responded to sub-par consumption spending by
reducing investment spending.
Table 6. Growth Rate of GDP, Consumption, and Investment, 2000-2004
Growth Rate: 2000 2001 2002 2003 2004
GDP 3.7 0.8 1.6 2.7 4.2
Consumption 4.7 2.5 2.7 2.9 3.9
Fixed Investment 6.5 -3.0 -5.2 3.6 9.7
Source: BEA.

9 See CRS Report RL31237, The 2001 Economic Recession: How Long, How Deep, and How Different From the
Past?, by Marc Labonte and Gail E. Makinen.

Note: All figures are calculated as percent change from previous year.
The tax cuts may have helped sustain personal consumption by increasing after-tax disposable
income; however, other factors were also at work. The fastest growing quarter for consumption,
the fourth quarter of 2001, seems to have been dominated by one-time automobile sales
incentives. Expansionary monetary policy may also have played a role in sustaining consumption
since much of the growth in spending was concentrated in interest-sensitive durable goods. Note
that the argument that tax cuts boosted consumption spending is mutually exclusive with the 10
supply-side argument, described below, that tax cuts will boost national saving.
Although Keynesian models are useful for understanding short-term fluctuations in the business
cycle, they provide little insight into the causes of long-term growth when the economy is already
at full employment. In other words, Keynesian models emphasize movements in aggregate
demand, and de-emphasize changes in aggregate supply. Although the short-term might appear to
be a more worthy goal of fiscal policy than the long term, many economists would argue that the
short-term effects of fiscal policy have been over-emphasized, and the long-term effects
neglected. That is because the Federal Reserve and market forces have proven able to keep the
economy growing steadily for sustained periods of time without relying on activist fiscal policy.
In which case, when the economy is not in a recession, the advice derived from Keynesian
models will be based on factors that are not particularly relevant at that point in time.
Since the 2001 tax cuts were enacted during a recession, Keynesian models are probably the
single best guide for evaluating its effects at the time. Yet by the time the 2003 tax cuts were
passed, the economy had nearly returned to full employment (at least based on GDP data).
Furthermore, going forward into the future, these tax cuts (if made permanent) will continue to
have an effect on the supply side of the economy, but no effect on the demand side of the
economy. Thus, growth models can play a valuable role in evaluating the long-run effects of these
tax cuts. And when evaluating tax cuts in the abstract, it may be most sensible to assume that the
economy is at full employment—since recessions are rare—and omit demand-side effects from
the analysis.
The standard neoclassical growth model developed by Nobel Laureate Robert Solow explains
growth in terms of the input of resources into production that lead to greater output. In the basic
model, inputs are labor and physical capital (plant and equipment). Any increase in production
that is not attributable to these two inputs (e.g., improved business practices) is caused by 11
productivity growth. Over long periods of time, technological change (which is recorded as
productivity growth) dominates per capita output growth, which suggests that the permanent
economic effects of any tax cut will be limited. Output cannot be influenced by changes in
spending, as in Keynesian models, and there is typically no monetary sector in the model. The

10 The Keynesian prediction of higher consumption is also in contrast to intertemporal models with Ricardian
equivalence (described below), which predict that consumption would fall in response to a deficit financed tax cut.
11 The analogous measure recorded by the Bureau of Labor Statistics is called total factor productivity growth.

government can only indirectly influence labor inputs and productivity through policies that
promote the two. However, it can directly affect capital inputs.
By identity, capital investment is exactly equal to national saving, and saving can be undertaken
by individuals, businesses (through retained earnings), or the government. When the government
runs a budget surplus, it increases national saving; when it runs a deficit, it decreases national
saving because it must borrow to finance expenditures in excess of revenues. Thus, deficit-
financed tax cuts of the type the United States has pursued in the past few years reduce economic
growth in Solow growth models by reducing national saving, which in turn lowers private 12
investment. As national saving falls, interest rates—the cost of borrowing—rise as firms bid for
a shrinking pot of resources to finance their investment spending. This is often referred to as the 13
“crowding out” effect.
The decline in growth caused by the budget deficit predicted by the Solow model is based on two
assumptions. First, private saving (at the household or corporate level) does not rise to offset the
fall in government saving. This possibility will be explored in the section below on supply-side
effects. Second, investment is not financed from abroad to offset the fall in government saving,
which will be considered in the next section.
Table 7 shows what happened to saving and investment after the tax cuts. The budget deficit
shifted by 6 percentage points of GDP between 2000 and 2004. Of this, about 2.3 percentage
points of the shift can be attributed to the tax cuts, according to official ex-ante estimates. Over
the same period, private saving did not rise nearly enough to offset the decline in public saving of
6 percentage points of GDP—private saving rose by 1.4 percentage points, so national saving fell
by 4.6 percentage points of GDP. At the same time, the recession and stock market decline caused
investment demand to decline by 3.1 percentage points of GDP. This partly explains why interest
rates did not rise as a result of the budget deficit—interest rates are determined by supply and
demand, and the supply of saving and the demand for investment happened to fall simultaneously
for unrelated reasons. The reduced investment demand was a temporary factor, caused by the
recession, however. Had investment stayed at its 2000 level, there would have been only three
quarters as much national saving available to finance it.

12 More precisely, growth in Solow models declines in the medium run when the rate of capital formation declines. In
the steady state, changes in the rate of capital formation have no effect on growth.
13 A similar effect occurs in Keynesian models, for different reasons. In the Keynesian model, the rise in aggregate
spending resulting from the budget deficit causes the demand for money to rise. To restore equilibrium in money
markets, interest rates must rise. When interest rates rise, investment spending and interest-sensitive spending declines.
The primary difference between the Solow model and Keynesian model is that growth cannot fall as the result of a
deficit in the Keynesian model, as it does in the Solow model. That is because interest rates only rise if aggregate
spending rises. At most, the crowding out of investment can entirely offset the rise in aggregate spending, so that
growth does not rise, but it cannot cause growth to fall.

Table 7. Budget Deficits, Trade Deficits, Saving, and Investment
(as a % of GDP)
Budget Trade
Investment National Surplus/ Private Deficit (Net
Spending Saving Deficit (-) Saving Foreign
1995-1999 19.1 17.3 -0.3 15.4 1.8
2000 22.1 18.0 2.4 13.6 4.0
2001 20.0 16.4 1.3 13.8 3.7
2002 18.6 14.2 -1.5 14.9 4.4
2003 18.0 13.4 -3.5 15.1 4.6
2004 19.0 13.4 -3.6 15.0 5.6
Source: Bureau of Economic Analysis.
Note: Investment spending includes private and public investment.
The decline in investment spending is pertinent because certain provisions of JCWAA and
JGTRRA were specifically aimed at boosting capital investment. JCWAA contained temporary
accelerated depreciation provisions for certain types of capital investment (structures were a
notable exception) and this provision was extended and expanded under JGTRRA. JGTRRA also 14
temporarily increased the amount of investment that an unincorporated businesses can expense.
The effectiveness of these provisions depends on whether they caused capital investment to be
higher than it otherwise would have been. In fact, capital investment fell by 2.0 percentage points
of GDP between 2001 and 2003. As with any tax cut, evaluating the efficacy of these provisions
is hindered by uncertainty concerning how much lower capital investment would have been
without the provisions. The efficacy of the provisions may have been partly offset because they
were deficit financed, due to the crowding out effect.
In addition to influencing the overall level of investment spending, these provisions may have
distorted the form of capital investment since not all types of investment were eligible. This may
explain why the decline in capital investment was so concentrated in structures, which were not
generally eligible under the provisions. Between 2001 and 2003, investment in equipment fell by
3%, whereas investment in structures fell by 21%. This pattern is unusual: investment in
structures contracted more than investment in equipment in only two other post-war recessions.
Domestic investment spending can be financed by Americans or foreigners. If the entire decline
in public saving caused by the deficit is offset by an inflow of foreign saving, then there will be
no increase in interest rates and no crowding out of private investment. The deficit will have other
consequences, however. Even if foreign borrowing can be used to finance American investment,
the return from that capital will accrue to foreigners, not Americans. U.S. output will exceed
national income because some income will accrue to foreign lenders.

14 See CRS Report RL32034, The Jobs and Growth Tax Relief Reconciliation Act of 2003 and Business Investment, by
Gary Guenther.

Furthermore, to purchase U.S. financial securities, foreigners must first buy U.S. dollars, and this
pushes up the value of the dollar. As the dollar appreciates, U.S. exports and import-competing
goods become less competitive. This causes exports to fall and imports to rise, increasing the
trade deficit. By definition, the increase in the trade deficit will be equal to the borrowing from
abroad, because the only way the United States can borrow from abroad is if the U.S. purchases 15
more imports than foreigners purchase U.S. exports.
As can be seen in Table 6, there is some evidence that the decline in government saving has been
partly offset by foreign borrowing. Even though private investment fell by three percentage points
of GDP between 2000 and 2004, borrowing from foreigners (the trade deficit) rose by 1.6% of 16
GDP to a record high of 5.6%. Some economists questioned the sustainability of borrowing at
that pace, particularly since the demand for borrowing was depressed over most of that period by
the fall in capital investment spending.
Some argue that tax cuts boost long-run growth by giving individuals a greater incentive to work
and save. If tax cuts caused individuals to extend their work hours or join the labor force, this
would increase output directly. Likewise, if tax cuts caused individuals to save more—assuming
this had no short-run effects on aggregate demand—there would be more saving available for
investment, and growth would rise. There are three main problems with this reasoning.
First, capital investment is determined by national saving, not private saving. National saving
consists of personal saving, business saving, and public saving. When the government runs a
budget deficit, public saving is negative and reduces national saving. Because the recent tax cuts
were deficit financed, any increase in private saving they caused would have to exceed the
increase in the budget deficit to prevent investment spending from falling. Some of the
provisions, such as the dividend tax reduction and repeal of the estate tax, are intended to promote
saving, but others are likely to encourage consumption.
Second, it is not clear theoretically whether tax cuts would increase or decrease growth. Marginal
reductions in income tax rates, elimination of the estate tax, and dividend tax reductions, have a
separate “substitution effect” and “income effect.” By making work and saving more rewarding,
these tax cuts may induce individuals to undertake more of each. This is called the substitution
effect and raises growth. But there is an opposing income effect that lowers growth. By making
individuals more wealthy on an after-tax basis, tax cuts require less work and saving to achieve
their financial goals. For example, with a lower tax rate, less saving is needed to reach a target,
such as retirement or the purchase of a car or vacation. The net effect on growth will depend on
the strength of the substitution effect relative to the income effect. But some of the provisions of
the recent tax cuts have no substitution effect; they only have an income effect, and would

15 These results are identical in a Keynesian “open economy model with perfect capital mobility. In such a model, the
stimulative effects of the tax cut are completely offset by a wider trade deficit. The actual economy is somewhere
between the theoretical cases of an open economy and closed economy since capital does flow in and out of countries
in response to interest rate differentials, but not sufficiently to eliminate differentials entirely. Thus, the tax cuts will
provide some stimulus, but not as much as theclosed economy Keynesian model would predict.
16 Looking at the current account, there was a significant decline in trade during the recession. In 2001 the trade deficit
increased because exports declined more rapidly than imports. In 2002, the trade deficit increased because imports
grew more rapidly than exports.

therefore have a negative effect on growth. These include the child tax credit and marriage
penalty relief for most taxpayers.
Third, there is the issue of how large these supply side effects are empirically. Could the
substitution effect and income effect cancel each other out so that the effect on growth is
negligible? Even if the substitution effect dominates, how much more work will be induced by a
reduction in the marginal tax rate from, for example, 31% to 28%? Why has the working week
first shortened and then stayed relatively constant over the past century when wages and tax rates
were rising?
Empirical research is not conclusive, with some studies finding tax cuts to have a positive effect
on labor supply and some finding a negative effect; most of the estimates are modest and some
are statistically insignificant (not statistically different from zero). There is little consensus on the
effects of tax cuts on personal saving. Reflecting the empirical literature, the Joint Committee on
Taxation assumed in its macroeconomic model a labor supply substitution elasticity of 0.18 and
an income elasticity of -0.13, so that the two almost cancel out for a very small labor response.
This means that a 10% reduction in after-tax income would lead to a 0.5% increase in labor 17
supply (and a smaller increase in GDP). It assumes a long-run saving elasticity of 0.29. CBO
assumed a labor supply elasticity of 0.07 for primary earners and a 0.5 elasticity for secondary 18
earners. Research suggests that working-aged males are not very sensitive to changes in tax
rates: they tend to work full-time regardless of the tax rate. Their ability to alter their hours in
response to a change in tax rates may be limited, at least in the short term. Some married women,
older workers, and younger workers may be more sensitive to tax rates because they are less
attached to the workforce, but estimates of their sensitivity vary significantly from study to study.
The dramatic rise in female labor force participation in the post-war period suggests that cultural
factors may be a far more important determinant of labor supply than tax policy—and, in the case 19
of married women, may have already run their course.
Casual observation does not reveal higher labor supply or national saving since the recent tax cuts
have been enacted. As seen in Table 7, private saving has risen since 2000, but by less than one
third as much as public saving has fallen. While less than half of the decline in public saving is
attributed to the tax cuts, the increase in the deficit caused by the tax cuts alone exceeded the
increase in private saving. Furthermore, some of the increase in private saving could have been
motivated by unrelated factors, such as precautionary saving in response to the recession. Finally,
the composition of the increase in saving casts further doubts on causation. With the exception of
accelerated depreciation, all of the major provisions of the tax cuts affected individuals. Yet the
increase in private saving is entirely attributable to increased business saving—personal saving
actually fell from 1.7% to 1.3% of GDP between 2000 and 2004, as seen in Table 8.
Since 2000, labor supply has fallen, both in terms of total employment and hours worked, as seen
in Table 8. Of course, this decline was overwhelmingly attributable to the recession and sluggish
recovery through 2003. But it suggested that any supply side incentives to work more were
swamped by the weakness of the economy and were not a significant factor even after growth

17 John Diamond and Pamela Moomau, “Issues in Analyzing the Macroeconomic Effects of Tax Policy, National Tax
Journal, vol. LVI, no. 3, September 2003, p. 447.
18 Congressional Budget Office, How CBO Analyzed the Macroeconomic Effects of the Presidents Budget, July 2003.
19 For an analysis and literature review of these issues, see CRS Report RL31949, Issues in Dynamic Revenue
Estimating, by Jane G. Gravelle.

picked up in 2004. This might be expected since the provisions with effects at the margin were
small. For example, the reductions in marginal individual tax, estate tax, and dividend tax rates
caused a combined revenue loss of less than 1% of GDP annually from 2001 to 2004.
Table 8. Labor Supply and Saving Indicators, 2000-2004
Average Weekly Hours Employment/Population Personal Saving Rate
(% change from prior Ratio (% of GDP)
1995-1999 (average) 0.1% 63.7% 2.8%
2000 -0.8 64.4 1.7
2001 -1.3 63.7 1.3
2002 -0.4 62.7 1.7
2003 -0.4 62.3 1.5
2004 0 62.3 1.3
Source: Bureau of Labor Statistics.
It should also be noted that any change in labor supply in response to a tax cut will be a one-time
effect only, as the labor supply moves from the old hours worked to the new hours worked. After 20
that, labor supply will not continue to grow in response to the tax cut. By contrast, the effects of
the deficit on saving are ongoing (until the economy returns to its steady state). If the deficit-
financed tax cuts result in a decline in national saving, as the data would seem to indicate, then
the negative effect on growth would be ongoing.
Although the difference between demand-side effects and supply-side effects are distinct in
theory, it is difficult to disentangle them in practice. Assume taxes are cut in a recession caused by
insufficient consumption, leading to higher aggregate spending as the tax cuts are spent by
individuals. The increase in aggregate spending would bring involuntarily unemployed workers
back into the labor force and increase the hours of involuntarily underemployed workers. In a
supply-side analysis, unless properly controlled for, it would appear that workers were responding
to the incentives of lower tax rates to voluntarily increase their labor supply, and would be taken
as evidence in favor of supply-side economics. This also suggests that many workers will not be
able to take advantage of supply-side incentives that do exist in recessions because they will not
be able to voluntarily increase their hours at a time when labor is underutilized.
Beginning in the 1970s, many economists grew discontented with Keynesian and Solow models 21
because of their ad-hoc, non-theoretical nature. They turned to macroecnomic models based on

20 The only ongoing effect from an increase in the labor supply on economic growth comes from the fact that some of
the additional output generated from the one-time increase in labor supply will be invested, leading to growth in the
capital stock.
21 See, for example, Robert Lucas and Thomas Sargent, After Keynesian Macroeconomics, in Federal Reserve Bank of
Boston, Conference Series 19, June 1978, p. 49. For a defense of Keynesian economics against this critique, see
Benjamin Friedman, Comment, in Federal Reserve Bank of Boston, Conference Series 19, June 1978, p. 73. Neo-
Keynesian models have been developed that make similar assumptions about intertemporal optimization, but feature
sticky prices in the short run.

rational optimization by individuals over time, referred to here as intertemporal models. Infinite
horizon models and overlapping generation models (such as life-cycle models) are some
prominent examples in this category. In these models, individuals plan their lifetime work,
leisure, saving, and consumption choices at present in order to maximize their lifetime utility
(well-being). The advantage of these highly sophisticated, highly mathematical models is that
every decision made by individuals is rooted in a logical, coherent decision. The disadvantages
are that these models make unrealistically complex assumptions about how individuals make
decisions and the models are more grounded in theory than evidence—particularly because their 22
theoretical complexity makes empirical estimation problematic. For example, infinite horizon
models assume that individuals live (and have planned their work, saving, and consumption)
forever. Even if one believes that concern for one’s descendants makes the infinite horizon close
to actual behavior for parents, not everyone has descendants or values their descendants’ well-
being on par with their own. As another example, the models often do not feature uncertainty (or
uncertainty is assumed to cancel out in the aggregate) about future earnings, prices, rates of
return, or government policies when individuals make decisions today.
Because of the long time-frame taken by these models, a deficit-financed tax cut cannot be
evaluated because it is not a sustainable policy—eventually, a tax cut must be offset by higher 23
taxes or lower government spending or else the national debt would become infinitely large.
Thus, when these models are used to evaluate tax cuts, some assumption must be made about
higher taxes or lower spending at some point in the future. Although there is no obvious choice
for when the policy change is likely to occur or what form it is likely to take, these choices are
unfortunately critical to the model’s results. The primary reason why saving and labor supply
change in these models when taxes are cut is because of the wedge they create between after-tax
wages and interest rates now relative to the future. For example, in a life-cycle model individuals
are assumed to keep their lifetime consumption constant. When taxes are cut today and raised in
the future, the model predicts that individuals will work and save more today, when taxes are low,
in order to work and save less when taxes are raised. If the tax cut leads to a seemingly innocuous
change in interest rates, this can affect labor supply today because a higher interest rate makes the
discounted value of leisure in the future greater. As a result, people work more today so they can
save more and work less in the future. If the tax cuts are instead assumed to be financed through
lower future government spending, in many of these models, there is a smaller labor and saving
response induced by the tax cut since private spending cannot be substituted for government
These models also contain, to varying degrees, effects known as “Ricardian equivalence.”
Ricardian equivalence is the theoretical notion that budget deficits would not cause interest rates
to rise because individuals know the deficits will be offset by higher taxes or lower government
spending in the future. As a result, private saving rises today to prepare for future consumption
losses, and replaces the fall in public saving, so that there is no net effect on national saving and
capital investment. In infinite horizon models, there is total Ricardian equivalence because people

22 Intertemporal models have not been without their critics. A group of economists known as behavioral economists
have developed new economic models based on irrational, rule of thumb, andbounded rational” behavior. For an
overview of behavior economics, see Richard Thaler and Sendil Mulianathan, Behavioral Economics, National Bureau
of Economic Research, Working Paper 7948, October 2000. For the application of behavioral economics to tax policy,
see B. Douglas Bernheim, “Taxation and Saving, in Alan Auerbach and Martin Feldstein, eds., Handbook of Public
Economics (Amsterdam: Elsevier Science, 2002), p. 1200.
23 Because of interest costs, the future higher taxes or lower government spending will exceed the size of the original
tax cut.

are assumed to live forever. In overlapping generations models, such as life cycle models, the
Ricardian effect is only applicable to those generations that will still be alive when taxes are
raised or spending is cut, so there is only a partial private saving offset.
The theoretical sophistication of intertemporal models comes at the expense of empirical
accuracy. Because the models are so complex, they cannot be empirically estimated directly.
Instead, the models are simulated with certain key parameters inferred from empirical evidence;
some of the parameters must be inferred because they are also too complex to measure directly.
For this reason, the model results should not be considered direct evidence of a tax cut’s effect.
Most economists believe these models do a poor job of explaining economic activity in the short 24
run. In these models, there are no demand-side effects, such as involuntary unemployment (i.e.,
everyone who wants a job can find one) or excess capacity. There tends to be no modeling of
monetary policy since there are no short term effects. Workers are free to lower or raise their
work hours, or even enter or exit employment, as they desire. Indeed, when these models generate
substantial growth effects in response to a tax cut, it is because they assume that work and saving
patterns (voluntarily) fluctuate greatly because the tax cut changes present and future economic
conditions. Although these models may offer certain insights into behavior over the long run, they
are unsuitable for evaluating a tax cut whose purpose is short-term stimulus in a recession.

Before EGTRRA and JGTRRA were enacted, a number of simulations were performed that
estimated their economic effects using the economic models discussed above. (No estimates of
JCWAA’s effects were found.) As tax cut proposals move through the policy process, details
change. The estimates presented here are based on proposals that may differ slightly from the
policy that was eventually enacted. It should be stressed that all of the estimates were made
before the fact; none of the estimators examined the data retrospectively to check their accuracy.
Nearly all of the simulations showed that the tax cuts would have positive effects in the short run
and negative effects in the long run. Often, the long-run effects did not entirely materialize by the
end of the traditional 10-year forecast window. Thus, the tax cuts cannot be said to be
unambiguously good or bad; the merits of this tradeoff depend on a policymaker’s preferences
over time.
The private forecasting firm Macroeconomic Advisers (MA) used a model with Keynesian
properties for the first few years after a tax cut. Thus, the tax cut mainly affected the economy by
boosting aggregate demand—including large multiplier effects—not supply-side effects. In the
long run, the model had neoclassical properties. MA estimated that EGTRRA would boost growth
by 1.2 percentage points in the second half of 2001 (in other words, 0.6 percentage points for the

24 Real business cycle models are dynamic optimization models used to analyze short-run cyclical fluctuations. They
are not analyzed here because they are not typically used to assess the effects of tax cuts.

entire year) and 0.3 percentage points in 2002. In 2002, MA projected that the Fed would keep
interest rates 0.75 percentage points higher as a result of the tax cut. MA did not offer information 25
on the tax cut’s long-term effects.
The private forecasting firm DRI-WEFA (now Global Insight) also used a model with Keynesian
properties and multiplier effects for the first few years after a tax cut, and neoclassical properties
over the long run. Although they did not do a full analysis of EGTRRA’s effects, they did predict
that EGTRRA would increase growth in the second half of 2001 by 0.4 percentage points through 26
a boost to aggregate spending.
Alan Auerbach of University of California-Berkley used the Auerbach-Kotlikoff model, an
intertemporal life-cycle model, to evaluate the economic effects of EGTRRA over the next 150
years. This model did not contain short-term business cycle properties. Like all intertemporal
models, a permanent deficit-financed tax cut is inconsistent with the model because it would have
caused the national debt to grow indefinitely. Auerbach assumed that the tax cut would result in
higher taxes at some point in the future and ran simulations in which either the tax on labor or the
tax on capital was raised; an increase in the wage tax reduced output more than an increase in the
capital tax. Faced with lower tax rates in the short run and higher tax rates in the long run, the
model assumed that individuals work and save more while the tax cut is in place, and work and
save less while the permanently higher tax rates are in place. As a result, saving rates and output
were increased while the lower tax rates were in place, and lowered while the permanently higher
tax rates were in place. The eventual increase in taxes reduced GDP; the longer the tax increase
was postponed, the more long run GDP fell. The tax cuts caused output to rise by about 1% by

2004. In the first year of the tax increase, output declined by enough to leave it below the baseline 27

level, and in the long run output was 1%-2.5% lower.
William Gale and Samara Potter of Brookings Institution used a neoclassical Solow model with 28
supply-side effects to estimate the effects of EGTRRA. This model did not capture short-run
business cycle dynamics; instead, it estimated the tax cut’s long-run effect on the economy. It was
estimated that the tax cut would reduce GNP by 0.68% in 2011, because the crowding out effect
of budget deficits is estimated to reduce GNP by 1.63%. This was partly offset, they believe, by 29
incentive effects on labor and private saving (0.95 percentage points).

25 Macroeconomic Advisers, Economic Outlook, vol. 19, no. 5. June 2001, p. 5.
26 DRI-WEFA, Economic Outlook, May 2001, p. 2.
27 Alan Auerbach, “The Bush Tax Cut and National Saving, National Tax Journal, vol. LV, no. 3, September 2002, p.
28 William Gale and Samantha Potter, “An Economic Evaluation of the Economic Growth and Tax Relief
Reconciliation Act of 2001,” National Tax Journal, vol. LV, no. 1, March 2002, p. 133.
29 When considering the welfare effects of a tax cut in a model with capital flows, it may be more useful to look at
GNP, which measures the output of Americans, than GDP, which measures the output in the United States. That is
because the GDP growth stemming from capital inflows accumulates to foreigners rather than Americans. Gale and

One provision of EGTRRA provided what was referred to as a “rebate” of up to $600 as an 30
advanced tax credit in lieu of the 10% tax bracket. Some studies have looked specifically at the
effects of this credit on consumption and saving. Unlike the other studies summarized here, these
studies were estimated from ex post empirical evidence, and were not based on ex ante
simulations using macroeconomic models.
David Johnson, Jonathon Parker, Nicholas Souleles used regression analysis to determine whether 31
the rebate affected the consumption of nondurable goods. They found that 23%-37% of the
rebate check was spent on higher nondurable consumption within the first three months of
receipt. If the remainder of the rebate was saved, then the effect on aggregate demand is likely to
be modest; however, it may have been spent on services, durable goods, or investment goods,
which the study did not include. Evidence showed that most of the remaining rebate was spent
within the next two quarters, although those findings were not statistically significant.
Econometric studies of this type are hampered by several factors, including self-reporting errors
(a problem with most economic data), random fluctuations in high frequency data, insufficient
variation in the data over time because most of the rebate checks were received within two
months, and omitted variable bias, both because the study did not control for other factors
influencing consumption over time (e.g., macroeconomic conditions) and because the control
group of rebate non-recipients may have differed in important ways (e.g., income and marital
status) that influenced consumption, thereby attributing the influence of those omitted variables to
the rebates. When non-recipients were excluded from their calculations, the results became
statistically insignificant.
Joel Slemrod and Matthew Shapiro of the University of Michigan analyzed the results of
telephone surveys before and after the rebate was sent. The survey asked individuals whether they
planned to/had mostly spent the rebate, saved the rebate, or use the rebate to pay down debt.
(From an economic perspective, the last two choices are both a form of saving, and only the first
response would lead to an increase in aggregate spending.) In both surveys, about one-quarter
planned to mostly spend the rebate and about three-quarters planned to save it or used it to pay
down debt, which does not suggest the rebate had strong stimulative effects. Survey results
should be considered with caution because it is well-known among researchers that survey
responses often differ systematically from actual behavior. The authors argued that the sharp
increase in the personal saving rate in the months that the rebate were sent out supports their 32

Potter estimate that GDP would be 0.37 percentage points higher than GNP.
30 See CRS Report RS21171, The Rate Reduction Tax Credit - "The Tax Rebate" - in the Economic Growth and Tax
Relief Reconciliation Act of 2001: A Brief Explanation, by Steven Maguire.
31 David Johnson, Jonathon Parker, Nicholas Souleles, The Response of Consumer Spending to the Randomized Income
Tax Rebates of 2001, Working Paper, February 2004.
32 Joel Slemrod and Matthew Shapiro, Did the 2001 Rebate Stimulate Spending? National Bureau of Economic
Research, Working Paper 9308, October 2002.

The Joint Committee on Taxation estimated the economic effects of JGTRRA as it was passed 33
using three different models. Thus, the committee assumed that JGTRRA would be allowed to
expire in 2013, as scheduled, and the tax cuts (with the exception of new dividend and capital
gains tax cuts) are an acceleration of tax cuts that, in the baseline, would have already gone into
effect in future years.
The JCT used two models with Keynesian short-term properties and neoclassical long-term
properties, a proprietary model and the Global Insight model. Assuming that the Federal Reserve
(Fed) responds aggressively to keep inflation stable—consistent with their actual behavior in
recent years—the proprietary model predicted that GDP would be increased by a cumulative total
of 0.2% after five years. With a less aggressive Fed, the Global Insight model predicted that GDP
would be increased by a cumulative total of 0.9% after five years. In both models, GDP would be
reduced by a cumulative total of 0.1% over the next five years, primarily due to crowding out.
The third model was an intertemporal life cycle model, which, as discussed previously, required
an assumption that taxes will be raised or spending cut in the future to finance the tax cut. The life
cycle model predicted that GDP would be increased by a cumulative total of 0.2% over the first
five years, and decreased by a cumulative total over the next five years by 0.1% if the tax cuts
were financed by reduced government transfer payments (e.g., Social Security) after 2013 and
reduced 0.2% if financed by higher taxes after 2013. In other words, the negative effects on
growth would begin even before taxes are raised or spending is cut.
Because the dividend tax cuts and accelerated depreciation create an incentive to invest in capital
equipment, the models predicted that investment in residential housing would decline as investors
shift from investment in housing to equipment.
The Congressional Budget Office evaluated the economic effects of the President’s overall budget 34
proposal for FY2004. This differed from JGTRRA because it included other spending and
revenue proposals, and the analysis was based on the tax cut that was proposed by the President,
not what he signed into law. Still, the tax cut was the most significant budgetary proposal in
FY2004, and the President’s proposal was arguably close to the version enacted, so CBO’s
analysis was pertinent. (One important difference between the President’s proposal and JGTRRA
was that the President proposed to make EGTRRA/JGTRRA permanent.) Because of the
uncertainty and complexity surrounding macroeconomic modeling, CBO employed five different
econometric models and nine different scenarios to make its projections. Although the results
varied by model and scenario, all were modest relative to GDP. All of the models predicted that
the tax cuts would increase interest rates, except under the open economy assumption where 35
borrowing from abroad completely compensates for the fall in national saving.

33 Joint Committee on Taxation, “Macroeconomic Analysis of H.R. 2,” Congressional Record, Doc 2003-11771, May
8, 2003.
34 Congressional Budget Office, An Analysis of the President’s Budgetary Proposals for FY2004, March 2004.
35 Congressional Budget Office, How CBO Analyzed the Macroeconomic Effects of the Presidents Budget, July 2003.

Using a Solow growth model, the President’s budget proposals were projected to decrease GDP
by an average of 0.2% from 2004 to 2008 and an average of 0.7% from 2009 to 2013. The tax
cuts reduced growth because the increase in labor supply was not sufficient to offset the decrease
in the capital stock caused by the larger budget deficit. In this model, CBO assumed that labor
supply would increase and 65% of the decline in public saving caused by government borrowing
would be offset by higher private saving and borrowing from abroad; without these ad hoc offsets
(which are not empirically estimated), the decline in GDP would be greater.
CBO’s evaluation produced six different results based on intertemporal models. Because
intertemporal models require that the budget eventually return to balance, CBO applied different 36
scenarios, in which lump-sum taxes were raised or spending was cut after 10 years. It produced
results with an infinite horizon model and a life cycle model, both under an open economy (i.e.,
the United States can borrow from abroad) and closed economy assumption. It estimated that the
budget proposals would reduce GNP if financed by lower government spending after 2013 (GNP
would change 0.2% to -0.8% from 2004 to 2008 and -0.6 to -2.0 from 2009 to 2013) but increase
GNP if financed by higher taxes after 2013 (GNP would increase by 0.3% to 0.9% from 2004 to 37
2008 and 0.3% to 1.4% from 2009 to 2013). It may sound counter-intuitive that higher future
taxes are better for the economy than lower government spending, but that is because of the 38
oddities of the intertemporal models. Because individuals are assumed not to value government
spending—a highly unrealistic assumption—there is less incentive to work and save more in the
first 10 years in response to the tax cuts when they are financed through lower government
spending. By contrast, when the tax cuts are financed through higher future taxes, these models
assume that there is a large incentive to work and save more now, in order to work and save less
once taxes are raised.
CBO also estimated the economic effects of the budget proposals using two Keynesian models,
the MA model and the Global Insight (GI) model. For these models, CBO estimated results only
for five years because the models are designed to capture only short-run phenomena. CBO added
larger labor supply responses to the models than the original modelers estimated. On average, the
proposals would increase GDP by 0.2% in the MA model and 1.4% in the GI model. In both
models, the supply-side effects were negative and the demand-side effects were positive over five
years: GDP increased only because of the stimulus to aggregate spending. The increase in GDP
would be possible only if the Fed did not offset it, which it might do to keep inflation from rising.
In the MA model, GDP would be higher for the first three and lower for the next three years. In
the GI model, GDP would be higher for every year of the projection.

The increase in interest rates were largest in the Keynesian simulations and lowest in the intertemporal simulations.
36 CBOs assumption that the President’s Budget proposals would be financed through higher future lump sum taxes
(e.g., a head tax) is curious since the government does not currently collect any lump sum taxes. CBO reports that if it
had instead assumed that the Budget proposals were financed with marginal tax increases, the increase in GDP would
have been smaller.
37 The results for GDP are equal to the GNP results for closed economy models. In the open economy variation, GDP is
slightly higher because it includes the income accruing to foreigners as a result of net capital inflows.
38 Higher taxes reduce GDP in the model outside the reported 10 year projection window.

As mentioned above, the Macroeconomic Advisers (MA) model used Keynesian properties for
the first couple of years of a simulation, and neoclassical properties in the long run. MA, a private
forecasting firm, projected that JGTRRA would boost growth by 0.5 percentage points in 2003
and 1.0 percentage points in 2004. They projected that JGTRRA would reduce growth in later
years, leaving GDP 0.3% lower by 2017. (The long-run effects are largely the result of the
Administration’s proposal to make EGTRRA permanent; a provision that was not included in the
version of JGTRRA signed into law.) Because the economy was already close to full
employment, JGTRRA would cause inflation and interest rates to rise quickly in their model. As a
result, while JGTRRA would reduce unemployment from 2003 to 2006, it would increase
unemployment from 2006 through the rest of the decade. JGTRRA was projected to raise long-
term interest rates by an average of 0.34 percentage points over five years and 0.75 percentage 39
points in the long run due to crowding out.
One important assumption MA made was that the acceleration of tax cuts already scheduled to
take place as a result of EGTRRA were modeled as new tax cuts, rather than accelerated tax cuts; 40
if individuals did not treat them as new, their effect on aggregate demand would be smaller.
As mentioned above, the Global Insight (formerly DRI-WEFA) model used Keynesian properties 41
for the first couple of years of a simulation, and neoclassical properties in the long run. Global
Insight’s model projected that JGTRRA, as proposed by the Bush Administration, would increase
growth by 0.2 percentage points in 2003, 0.9 percentage points in 2004, and 0.1 percentage points
in 2005, primarily by stimulating aggregate demand. After that point, JGTRRA would reduce
economic growth by 0.5 percentage points in 2006, and smaller amounts for a couple of years
after that, primarily through the crowding out effect of the budget deficit. JGTRRA was also
projected to increase inflation by 0.2-0.3 percentage points per year through 2006, with the
inflation rate remaining 0.1 percentage points higher for the remainder of the 10-year projection.
Interest rates were about 0.25 percentage points higher for most of the 10-year projection,
resulting in a stronger dollar and larger current account deficit. The dividend tax cut was
projected to initially boost stock prices by 5%, but prices fell slightly by the end of the 42

39 Macroeconomic Advisers, “A Preliminary Analysis of the President’s Jobs and Growth Proposals, mimeo, January
40 Estimates of a tax cut’s effects are sensitive not only to the model used, but the assumptions entered into the model.
The Heritage Foundation also used the Global Insight model to estimate the effects of JGTRRA and found more
favorable results by using more favorable assumptions. However, even using more favorable assumptions, they
estimated that the tax cut would have a negligible effect on GDP growth after the first two years. Over ten years, they
estimates that on average the tax cut would have no effect on economic growth. William Beach et al., The Economic
and Fiscal Effects of the President’s Growth Package, Heritage Center for Data Analysis, April 2003.
41 The model has been criticized for having extremely long lasting Keynesian effects. For example, even at the end of
the 10-year projection, JGTRRA still causes aggregate demand to exceed the baseline in their model.
42 Cynthia Latta, “The 2003 Stimulus and Growth Plans Compared,” Global Insight, U.S. Economic Outlook, February

This report studied the macroeconomic effects of the tax cuts enacted between 2001 and 2003.
There is no direct way to determine the effects of a tax cut on the economy because there is no
way to observe the counterfactual case where the tax cut did not occur. Estimates were made by
comparing the results of macroeconomic models with and without the tax cuts. These estimates
were made before the tax cut occurred, and were not based on actual ex-post data. Unfortunately,
there is no consensus among macroeconomists as to which one model is most suitable for policy
simulations, and no model with a strong track record in accurately projecting economic events.
The different models vary in fundamental ways, and no one model incorporates every key aspect
of economic behavior. Keynesian models focus on the business cycle but neglect the determinants
of long-run growth. Neoclassical growth models and intertemporal models concentrate on long-
run growth, but do not feature recessions, involuntary unemployment, or monetary policy. The
results generated by intertemporal models are based on assumptions about behavior that most
people would find highly unrealistic. Despite the wide diversity of the models used, all of the
results are relatively small, as would be expected of tax cuts that are relatively small in relation to
GDP in the years considered.
Keynesian models predict that deficit-financed tax cuts would boost output during a recession by
increasing spending so that slack labor and capital resources are brought back into production.
For the individual income tax cuts, higher consumption in response to higher after-tax income is
the channel through which spending is boosted. This boost in growth is temporary because the
growth rate of spending cannot exceed potential production over time. Keynesian macroeconomic
models are the only popular model that allows for short-run business cycle fluctuations. The
effect of growth in other macroeconomic models is considered next.
The economy was in a recession of mild depth and average contraction when EGTRRA was
passed. The recovery was unusually sluggish for the first six quarters, during which JCWAA and
JGTRRA were passed, before a more normal growth rate took root. Proponents point to the short
and mild recession as evidence that EGTRRA boosted growth. Opponents point to the sluggish
recovery as a sign that the tax cuts were ineffective, and credit monetary expansion and normal
market forces for the mild recession. Opponents also point to the performance of labor markets as
evidence that the tax cuts did not appreciably stimulate spending.
Deficit-financed tax cuts reduce public saving; unless this is offset by higher private saving or
borrowing from abroad, national saving will be reduced and interest rates will rise. Most
empirical estimates suggest that the offset will be only partial (because some of the tax cut is not
saved), and national saving will fall. The neoclassical Solow growth model predicts that a
reduction in national saving would reduce economic growth over the medium term by reducing
capital investment. Empirical evidence suggests that marginal tax cuts create incentives to work
and save more (referred to as “supply side effects”), but the increases in work and saving are too
small to offset the reduction in capital accumulation caused by the budget deficit. Thus, on net,

the neoclassical model predicts that growth will be reduced by deficit-financed tax cuts. National
saving fell from 2000-2003, but this did not lead to higher interest rates because investment
demand fell even more sharply.
Accelerated depreciation, which was the major tax provision in JCWAA and was extended and
expanded in JGTRRA, was intended to stimulate capital investment spending. Investment
spending sharply contracted during and following the recession. This is not unusual, but it is
difficult to make the case that investment spending would have been even lower in the absence of
the tax cuts. JCWAA may have distorted investment decisions toward equipment, which qualified
for accelerated depreciation, and away from structures, which generally did not qualify.
Equipment spending contracted by 3% from 2001 to 2003, whereas spending on structures
contracted by 21%. Investment spending recovered in 2004.
Deficit-financed tax cuts can be financed through national saving or by borrowing from abroad.
Net borrowing from abroad must take the form of a trade deficit. Borrowing abroad will mitigate
the rise in interest rates and the “crowding out” of capital investment, but will lead to dollar
appreciation that causes exports and import-competing goods to be “crowded out.” Evidence
shows that this has occurred, as the trade deficit increased from 4% in 2000 to 5.6% in 2004.
Typically, the trade deficit declines when growth has been low.
For a mild recession, the contraction in employment and rise in unemployment was unusually
long lasting—the longest period of employment decline since the Great Depression. Employment
declined throughout and for 21 months after the recession—a post-war record by 10 months.
Since the employment contraction was so prolonged, it is difficult to argue it would have been
even longer in the absence of the tax cuts.
In Keynesian models, tax cuts boost employment and reduce unemployment by boosting
aggregate spending. The other macroeconomic models do not feature involuntary unemployment,
and make no prediction that tax cuts will affect unemployment.
“Supply-siders” focus on the incentives that tax cuts provide to work and save more. However,
marginal tax cuts could theoretically lead to more or less work because tax cuts also reduce the
labor and saving required to meet income targets. (Tax cuts without marginal effects, such as the
child tax credit, unambiguously reduce work and saving.) It is an empirical question as to the size
and direction of these effects. Most estimates for labor supply are positive and very small for
primary earners, and somewhat larger for secondary earners.
No evidence of supply-side effects from the tax cuts exists thus far. Hours worked and labor force
participation both declined after the tax cuts were passed. This was likely due to cyclical factors,
which suggest that supply-side effects are not large enough to outweigh other factors. Even in

2004, when the expansion picked up steam, there was still no aggregate increase in labor supply.

Private sector saving increased after the tax cuts, but this was due to an increase in business

saving. Supply-side analysis predicted that reductions in individual income taxes (particularly
reductions in taxes on dividends and capital gains) would lead to higher personal saving by
individuals, but personal saving fell between 2000 and 2004.
Marc Labonte
Specialist in Macroeconomic Policy
mlabonte@crs.loc.gov, 7-0640