Recent research on President Bush's tax relief in 2001 and 2003 has found that the lower tax rates induced taxpayers to report more taxable income. In particular, the reduction in the top two tax rates induced taxpayers to report more taxable income — an increase in the size of the tax base—to such an extent that this positive behavioral response likely offset roughly 25 percent to 40 percent of the static revenue loss of lowering the top two tax rates. This research illustrates that, while the lower tax rates have not paid for themselves, they do provide important economic benefits and can expand the tax base to such an extent that they cost the federal government substantially less revenue than the casual observer might think.

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The Treasury study also separately analyzed the major parts of the 2001 and 2003 tax relief: 1) the lower tax rates on dividends and capital gains, 2) the reduction in the top four tax rates, and 3) the expansion of the child tax credit, the marriage penalty relief, and the new 10 percent tax bracket. The first two parts—the lower tax rates on dividends and capital gains and the reduction in the top four tax rates—comprised those provisions that helped reduce the distorting effects of taxes the most. Meanwhile, the last part—the child tax credit, marriage penalty relief, and the new 10 percent bracket—provided tax relief important to the economy in the near term and helped ensure the distributional balance of the overall package by targeting benefits to lower- and moderate-income taxpayers, but had little effect on economic incentives. Indeed, this part was found to actually detract from economic growth in the long term.

Consider the estimated effects of each of these major parts of the relief on the size of the economy in the long run:

• Cutting the tax rates on dividends and capital gains was found to increase output in the long run by 0.4 percent, primarily by expanding the capital stock and enhancing labor productivity.
• Cutting the top four wage tax rates caused even a larger increase, 0.7 percent, primarily by increasing labor supply.
• The expansion of the child tax credit, marriage penalty relief and new 10 percent bracket were actually found to reduce the size of the economy in the long run by 0.4 percent.

The last set of provisions increases taxpayers' after-tax incomes, but does not have a significant effect on marginal tax rates. These provisions reduce long-run output because labor supply shrinks in response to the higher incomes.