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Dynamic Deja Vu on Tax Policy

September 26th, 2011 . by economistmom

The “dynamic scoring” debate is back again. Last week the House Ways and Means Committee—chaired by Dave Camp (R-MI), who also happens to be a member of the debt-limit deal’s “super committee”—held a hearing on the subject, calling on the Joint Committee on Taxation’s chief of staff, economist Tom Barthold, to explain why that committee still estimates the revenue effects of tax legislation using “static” methods.

The Washington Post’s Lori Montgomery reported on this “old battle,” wondering out loud whether the super committee will resort to dynamic scoring as a “magic elixir that greases the skids to a more far-reaching compromise.”

Well, unfortunately for certain policymakers, dynamic scoring is not so magical.

“Dynamic scoring” refers to revenue estimates that would be adjusted to account for expected effects of tax policies on the aggregate size of the economy. As Barthold explained, conventional revenue-estimating methods account for how changes in tax policy might cause households and businesses to substitute lightly taxed activities for more heavily taxed ones. But the assumption is that the total level of economic activity stays constant. One thing to note is that this debate is about how tax cuts affect growth over the longer term and is different from the debate over short-term tax cuts designed to stimulate demand in a recessionary economy.

This is a déjà vu moment for tax policy experts. The issue comes up whenever politicians want to claim that tax cuts don’t cost that much and are fiscally responsible.

Those who push for dynamic scoring don’t necessarily adopt the extreme position that certain tax cuts “pay for themselves.” But their line of reasoning goes as follows: Tax cuts produce economic growth; growth enlarges the tax base; a larger tax base means more government revenue and less borrowing.

The first part of this chain is the weak link. If it is deficit-financed, a tax cut’s effect on economic growth will be relatively small; the harmful impact of the deficit financing is only partially offset by higher private savings.

On net, national saving is reduced — and that reduces rather than increases supply-side economic growth. (UC Berkeley professor Alan Auerbach did this analysis that precisely demonstrates that point.) So all the other potentially positive effects of the tax rate cut on economic incentives would have to do even better to make it an on-net “good” thing for the macro-economy.

We’ve been through this lesson before—most recently during the George W. Bush Administration when the Republicans in Congress last pushed for “dynamic scoring” to become part of the budget process. In 2003 they called for then-CBO director Doug Holtz-Eakin (freshly picked from the Bush White House) to make the case for it. He didn’t. (See the 2003 CBO macroeconomic analysis of President Bush’s budgetary proposals and the 2004 CBO analysis of a generic 10 percent tax cut.) Instead, as Alan Murray reported in the Wall Street Journal at the time, the CBO’s “dynamic analysis” of these tax cuts showed that:

Some provisions of the president’s plan would speed up the economy; others would slow it down. Using some models, the plan would reduce the budget deficit from what it otherwise would have been; using others, it would widen the deficit.

But in every case, the effects are relatively small. And in no case does Mr. Bush’s tax cut come close to paying for itself over the next 10 years.

Fast forward to today, and some Republicans are still hoping Holtz-Eakin will tell them that dynamic scoring is the magic elixir. He was one of their witnesses called to the same Ways and Means hearing at which Tom Barthold testified. Now unencumbered by the pressure to be nonpartisan (as a CBO director), Doug appeared diplomatically friendlier to the idea of dynamic scoring, but nevertheless he came to the same bottom line:

For many reasons, dynamic scoring will not provide a panacea for the policy decisions regarding the U.S. fiscal outlook, the most important of which is that the dynamic impact over 10 years can be relatively small.

In 2006, the Bush administration’s own Treasury Department conducted their own “dynamic analysis” of the proposed permanent extension of the Bush tax cuts. The lead official on Treasury’s analysis, then Deputy Assistant Secretary Bob Carroll, published a Wall Street Journal op-ed with President Bush’s former Council of Economic Advisers chair, Greg Mankiw, in which they tried to put as positive a spin as possible on the potential economic effects of the Bush tax cuts. But they were forthcoming enough to emphasize that “not all taxes [or tax cuts] are created equal” and “how tax relief is financed is crucial for its economic impact.” (Here is a Washington Post story that came out at that time.)

So we’ve been here before: Endorsing tax cuts by hoping that accounting for the feedback economic effects will make the cuts look less expensive and more “fiscally responsible.”

But the state of the art in terms of economic modeling, and the lessons we learn from the models, haven’t really changed. They have even been underscored by actual experience: the “dynamic” effects of tax cuts are pretty small. And with the kinds of tax cuts Congress has actually been passing and extending in recent years (the deficit-financed variety that doesn’t always improve economic incentives), accounting for the macroeconomic feedback effects might actually increase the cost of those tax cuts rather than decrease them.

So even if we decided we wanted to incorporate dynamic scoring into the federal budget process, it wouldn’t make tax cuts so significantly cheaper that they are a reasonable part of a “deficit reduction” strategy. Sorry, super committee, but this (still) isn’t any magic solution to your problem.

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(Post-script:  I’ll have more to say later, here on my blog, about the practical challenges of dynamic scoring in the revenue estimating/budget scoring process–i.e., why JCT and CBO do “dynamic analysis” now but not dynamic scoring–as well as more thoughts on what such dynamic analyses teach us about the macroeconomic effects of various “fundamental” tax reforms.  Stay tuned; we have a few months of such discussions ahead of us while the super committee mulls over how tax reform might or might not become a big part of their strategy.)

10 Responses to “Dynamic Deja Vu on Tax Policy”

  1. comment number 1 by: AMTbuff

    That was an excellent summary of the issues.

  2. comment number 2 by: Brooks

    Yes, important point to make vis a vis the question of how much tax cuts alone — i.e., holding spending equal, thus deficit-financing the tax cuts — will cost the Treasury.

    But there is another argument for using dynamic analysis: for comparing (1) a higher taxes, higher spending scenario with (2) a lower taxes, lower spending scenario, if static analysis calculates the same deficits under each.

    Granted, there are questions of capability and objectivity in dynamic scoring, but is there no place for some prudent use of dynamic scoring for such comparisons, or do we just have to stick with an analytical approach — static scoring — that fails to point out any revenue feedback or incremental GDP that would likely result from moving from Scenario 1 to Scenario 2?

  3. comment number 3 by: SteveinCH

    I’d just extend Diane’s point of view. I think we’ve learned that the “dynamic effects” of government are actually pretty small in an economy where both capital and labor are far more mobile than they were in the past.

    It is that learning that I very dearly wish our political class could absorb

  4. comment number 4 by: Brooks

    Steve,

    Wouldn’t mobility increase dynamic effects? If Nation A increases taxes and makes investment or work less rewarding, doesn’t mobility of capital and labor mean a greater flight to Nation B, ceteris paribus?

  5. comment number 5 by: Vivian Darkbloom

    I agree that we are not ready for dynamic scoring of revenue bills. We simply don’t have the ability to accurately calculate the dynamic effects of tax cuts (or tax increases) and therefore the political dangers of doing so are just too great.

    That said, however, there seems to be little doubt that tax cuts *partially* pay for themselves in most circumstances. And, it appears that the opposite is true that spending increases do *not* pay for themselves in most circumstances. What the delta between the two is depends on the nature of the tax cut or what the money is spent on, but for a variety of reasons the federal government, in particular, is just not very good at allocating capital. So, in general government spending of $100 might actually cost us $110 and a tax cut might actually cost us $90, depending on the particular circumstances, but of course this is a generalization.

    And, I`m a bit tired of the old mantra “tax cuts pay for themselves”. When I hear that phrase, as in this column, I pretty much know that it is someone from the left side of the political spectrum who is uttering it with that straw man clearly in view. I can’t rule out that someone might have uttered that phrase and meant it to be taken seriously, but it in my observation it is not representative of mainstream “conservative” or “libertarian” economic thinking.

    It is telling that prior CBO, OMB or Comptroller Generals usually come down on the side against officially using dynamic scoring for revenue bills. I sense that these persons, who tend to be more realistic and non-ideological than most, realize that to admit dynamic scoring into the process would be the first step in the slippery slope toward (more) politicization of the scoring process. They’ve been there, they have seen first-hand the political manipulations of the budget process and they know how impossible their jobs, particularly that of the CBO director, would be if this type of subjective analysis would be introduced to the process.

    I’m very curious as to what EM will have to say about the “dynamic analysis” issue. In my experience, those who are against dynamic scoring for revenue bills don’t hesitate to claim that deficit stimulus spending will create X number of jobs or increase GDP by $2 for every $1 spent.

  6. comment number 6 by: Brooks

    Vivian,

    Re: I can’t rule out that someone might have uttered that phrase and meant it to be taken seriously

    It is indeed stated emphatically by conservative talk radio hosts (most notably Limbaugh) as supposedly obviously empirically true that “tax cuts increase revenues”, as in claiming that history shows us that every time you cut taxes, it increases revenues.

    Every once in a while a GOP member of Congress makes the same assertion in a very matter of fact or passionate way.

    In the last presidential cycle, McCain made the claim. Obviously that was about 4 years ago, and I think there has been some reduction in how prevalent the myth is now, but now as much as you seem to think (among pundits, politicians, and public).

    Re: those who are against dynamic scoring for revenue bills don’t hesitate to claim that deficit stimulus spending will create X number of jobs or increase GDP by $2 for every $1 spent.

    On a similar note, I’ve complained here and elsewhere, and requested an answer that anyone could offer or find, regarding the often heard implication by economists (advocating spending stimulus) that stimulus spending would actually improve our long-term fiscal outlook. In all the times I’ve seen such an implication made in the media, I’ve never seen any economist actually state explicitly that projected long-term debt/GDP would be better with stimulus than without, let alone refer to any supporting analysis.

    We just hear essentially the same vague implication made by those advocating tax cuts: “what we really need to solve the fiscal problem is higher growth, and this stimulus spending [or tax cuts, if the speaker is a Republican] will increase the growth rate.” Even if the latter claim is valid, that doesn’t mean incremental growth would be sufficient to improve the debt/GDP outlook.

    They get away with the implication, and generally pathetic journalists never think of asking if they are actually asserting (and can support with analysis) what they want to get away with implying.

  7. comment number 7 by: SteveinCH

    Sure Brooks if we were discussing policy on business, but we aren’t. We’re discussing policies to expand aggregate demand or the money supply, policies which are muted by globalization as opposed to amplified.

  8. comment number 8 by: Brooks

    Steve,

    So you mean if government hires and pays a lot of people (directly or by contracting out) for, say, infrastructure, or to keep states from laying off teachers or whatever, or sends cash to people most likely to spend a large portion of it immediately, etc., the effect on aggregate demand per dollar government spends is minimal because all those people getting the money spend most of it on imports or invest it overseas, etc.?

    Spell it out a bit for me if you don’t mind. I mean, directionally I see your point. But I’m asking about the matter of degree your asserting and why you assert such a large degree of loss of effect due to globalization, given that the bulk of our economy is still domestic rather than imports (if I’m reading it correctly, imports of goods and services were just $2,352.6 billion http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp4q10_adv.pdf )

  9. comment number 9 by: B Davis

    We’ve been through this lesson before—most recently during the George W. Bush Administration when the Republicans in Congress last pushed for “dynamic scoring” to become part of the budget process. In 2003 they called for then-CBO director Doug Holtz-Eakin (freshly picked from the Bush White House) to make the case for it. He didn’t.

    Yes, I remember looking at the CBO paper and posting the results at this link. As you can see from the first graph, there was little difference between the cost of Bush’s budget proposals using various supply-side models. In fact, the first table shows that those models only provide a lower cost if you make the assumption of higher taxes after 2013. Making the alternate assumption of lower government consumption after 2013 was projected to raise the cost. As I recall, there was little discussion of dynamic scoring after this report. There was some grumbling that the study combined Bush’s tax cut and spending proposals (the spending increases were chiefly in Medicare and defense) but I don’t recall any serious discussion of redoing the study. I suspect that those doing the grumbling knew that a realigning the deck chairs, so to speak, would have little effect.

    But the state of the art in terms of economic modeling, and the lessons we learn from the models, haven’t really changed. They have even been underscored by actual experience: the “dynamic” effects of tax cuts are pretty small. And with the kinds of tax cuts Congress has actually been passing and extending in recent years (the deficit-financed variety that doesn’t always improve economic incentives), accounting for the macroeconomic feedback effects might actually increase the cost of those tax cuts rather than decrease them.

    I’ve likewise run across analyses and studies that suggest that deficit-financed tax cuts may have a negative feedback. That is they may bring in LESS revenue than one would expect via static analysis. They include a statement by economist Laurence Kotlikoff and a study by Christina and David Romer that I’ve posted at this link.

  10. comment number 10 by: SteveinCH

    Brooks,

    My point is directional as, in the end, is Diane’s. I also think that the macro numbers on goods and services are not so compelling. It’s the marginal numbers we need to worry about if we’re talking about goosing spending and the marginal spending (when it happens) tends to be less on staples (food, rent, utilities) which are domestic and more on options (faster car repurchase, new TV, new cell phone) that tend to be more balanced towards imported items.

    Again to me, it’s a question of degree. In the 30s (the parallel that many like to use), the vast majority of marginal purchases would have come from US goods. Today, that is much less true in my view. It’s not a 100% thing but it’s probably more than the 20% or so average statistic you quoted.

    Again, I’m giving more of a feeling than a fact. But I’m trying to square Keynesianism (which I believe in principle) with the observed reality (not much impact from a whole lot of deficit spending). My conclusion is that multipliers are declining across the board in part because the “stimulus” on the margin is far more diffuse across economies than it once was.