Deja vu on tax policy

"Dynamic scoring," or adjusting revenue estimates based on the expected effects of tax policies on the size of the economy, won't fix the deficit problem

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.)