Macroeconomic Implications of Modeling the Internal Revenue Code in a Heterogeneous-Agent Framework

Abstract

Fiscal policy analysis in heterogeneous-agent models typically involves the use of smooth tax functions to approximate present tax law and proposed reforms. We argue that the tax detail omitted under this conventional approach has macroeconomic implications relevant for policy analysis. In this paper, we develop an alternative approach by embedding an internal tax calculator into a large-scale overlapping generations model that explicitly models key provisions in the Internal Revenue Code applied to labor income. While both approaches generate similar policy-induced patterns of economic activity, we nd that the similarities mask dierences in key economic aggregates and welfare due to variation in the underlying distribution of household labor supply responses. Absent sucient tax detail, analysis of specic policy changes particularly those involving large, discrete eects on a relatively small group of households using heterogeneous-agent models can be unreliable.JEL Codes: C63, E62, H30

Dynamic Scoring: An Assessment of Fiscal Closing Assumptions

“…7. The possibility of sovereign debt default has been ruled out by assumption in the overlapping generations model of Moore and Pecoraro (2020). See Evans, Kotlikoff, and Phillips (2013) for incorporating sovereign debt default as an alternative long-run state to fiscal sustainability.…”

“…The MP-OLG model is a large-scale overlapping generations model developed specifically for the macroeconomic analysis of tax policy proposals. Since the modeling framework, calibration, and solution algorithm used for the analysis in this article is completely specified in Moore and Pecoraro (2020), details are omitted here for brevity. The core characteristics of the MP-OLG model are common to general equilibrium models of this class, such as those in Nelson et al (2019): finitely lived cohorts of households make labor supply, saving, and consumption choices, discounting utility generated by future choices relative to current choices.…”

“…This contrasts with the tax treatment of household income typically specified in overlapping generations models, where smooth tax functions are used to approximate the federal income tax system. 4 Using the MP-OLG model, we repeat a tax policy change performed in Moore and Pecoraro (2020). We simulate a permanent 10 percent reduction in the US federal statutory tax rates applied to ordinary income-which includes wage income, interest income, short-term capital gains, nonqualified dividends, and pass-through business income-relative to 2018 present tax law, assuming that any expiring tax provisions in our steady-state baseline are permanent.…”

“…2 Since a goal of policy analysis is to model a current proposal as closely as possible to the legislation as written, which generally does not provide future guidance for resolving long-run fiscal imbalances, we choose to examine the use of two nondistortionary fiscal instruments for adjustment: lump-sum net transfer payments and nonvalued government consumption. As these fiscal instruments are commonly used (Zodrow and Diamond 2013;Page and Smetters 2016;DeBacker, Evans, and Phillips 2019;Moore and Pecoraro 2020), our assessment aims to provide for increased confidence in budget-window analyses that attempt to mitigate the bias introduced by fiscal closing assumptions.…”

“…In our analysis, we use the overlapping generations model of Moore and Pecoraro (2020), henceforth referred to as MP-OLG, to repeatedly simulate a tax policy change, each time varying only the fiscal instrument used for adjustment and the implementation timing of the closing assumption. We find that while quantitative differences in key macroeconomic aggregates and prices projected over the budget window can be observed across alternative fiscal instruments, these differences tend to shrink as the closing date is delayed.…”