Modeling the Internal Revenue Code in a Heterogeneous-Agent Framework: An Application to TCJA

Abstract

Macroeconomic models used for tax policy analysis often simultaneously abstract from two features of the US tax code: special tax treatment for preferential capital income, and the joint tax treatment of ordinary capital and labor income. In this paper, we explore the extent to which explicitly accounting for these tax details has macroeconomic implications within a heterogeneous-agent model. We do this by expanding the Moore and Pecoraro (2018) overlapping generations model to include distinct corporate and non-corporate firms so that the business income distributed to households can be separated into ordinary and preferred capital income. Household income tax treatment is then determined by an internal tax calculator that fully accounts for interaction among income bases while conditioning on idiosyncratic household characteristics. Relative to a conventional approach where household income taxation is determined by independent labor and capital income tax functions that do not distinguish between ordinary and preferred capital income, we find that our innovations have implications for household behavior and economic aggregates - especially the tax consequences of changes to the returns to labor and capital - when analyzing a subset of tax provisions from the recently enacted “Tax Cuts and Jobs Act”. Our findings imply that the abstracting from tax detail may come at the expense of correctly accounting for incentives and estimating macroeconomic responses to tax policy changes.

Keywords: dynamic scoring, tax policy modeling, heterogeneous agents

JEL Classification: C63, E62, H30