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July 25, 2006
HP-25

A Dynamic Analysis of Permanent
Extension of the President’s Tax Relief

Executive Summary

This Report presents a detailed description of Treasury's dynamic analysis of the President's proposal to permanently extend the tax relief provisions enacted in 2001 and 2003 that are currently set to expire at the end of 2010. These enacted provisions include:

• Lower tax rates on ordinary income;
• Lower tax rates on dividends and capital gains;
• A ten-percent individual income tax rate bracket;
• Doubling of the child tax credit; and
• Reducing marriage tax penalties.

The purpose of the report is to provide a more in-depth, transparent understanding of dynamic analysis, while also illustrating the positive contributions the tax relief, together with spending reductions, can be expected to continue to make to the U.S. economy. In addition, the analysis shows the importance of making the tax provisions permanent for the U.S. economy's long-term economic growth.

Dynamic Analysis

Dynamic analysis goes beyond traditional analysis of tax policy by focusing on the broad

economic effects in both the short and long term. Simply, dynamic analysis provides a more comprehensive and complete approach to analyzing tax policy by including its effects on the overall size of the economy and other major macroeconomic variables. The President's FY 2007 Budget proposes to create a division of dynamic analysis within the Department of Treasury's Office of Tax Analysis.

The Economic Benefits of Tax Relief

As evidenced by key economic indicators such as increased capital investment and Gross

Domestic Product (GDP), and strong job growth, the President's tax relief played an important role in strengthening the U.S. economy as it was coming out of the recent recession, and in the longer-term by increasing the after-tax rewards to work and saving. Lower tax rates enable workers to keep more of their earnings, which increases work effort and labor force participation. The lower tax rates also enable innovative and risk-taking entrepreneurs to keep more of what they earn, which further encourages their entrepreneurial activity. The lower tax rates on dividends and capital gains lower the cost of equity capital and reduce the tax biases against dividend payment, equity finance, and investment in the corporate sector. All of these policies increase incentives to work, save, and invest by reducing the distorting effects of taxes. Capital investment and labor productivity will thus be higher, which means higher output and living standards in the long run.

Treasury has conducted its dynamic analysis using a model that accounts for the effects of this greater work effort, increase in savings and investment, and improved allocation of resources on the size of the economy. While this model captures many aspects of a modern economy and economic behavior, others are not reflected in the model. For example, the model assumes that resources are fully employed in the economy and that capital is only somewhat mobile internationally. These are areas for future development.

REPORTS

• Treasury Report on Dynamic Analysis of Permanent Tax Relief