February 14, 2006
Dynamic Analysis on Tax Cuts
By Bruce
Bartlett
In this year's budget,
President Bush is requesting an additional $513,000 for the Treasury
Department's Office of Tax Analysis in order to create a new division
of dynamic analysis. The idea is to improve estimates of the revenue
effects of proposed tax changes so that they are more accurate.
But many critics charge that the goal is obfuscation -- making
the revenue losses from tax cuts appear smaller than they really
are.
The debate over dynamic
scoring really goes back almost 30 years. Historically, estimates
of the revenue effect of tax changes were done by accountants,
who simply took the most recent year's tax data, plugged in the
proposed changes and looked at the revenue effect. Then they would
try to estimate the impact on future revenues by making some assumptions
about growth in the number of taxpayers and the tax base. The
estimates were normally done only for a single year.
Eventually, economists
replaced the accountants and computers replaced adding machines.
More sophisticated methods of estimating inflation, economic growth,
employment and other factors were incorporated into the estimates.
However, the economists retained one of the accountants' operating
principles: The tax changes were assumed to have no impact on
behavior or the economy as a whole. Hence, this method of revenue
estimating came to be called static analysis.
One reason for this
is that before the 1970s, economists didn't really have the mathematical
tools to make a dynamic analysis that incorporated all the effects
of tax changes on things like work, saving and investment. Furthermore,
there was really no demand for dynamic analysis because the vast
bulk of proposed tax changes are too small to have any impact
on the economy as a whole.
Another reason is
that until the 1970s, most economic thinking was dominated by
the theories of economist John Maynard Keynes, who believed that
fiscal policy affected the economy only through its impact on
disposable income. Consequently, the incentive effect of taxation
was a matter that few economists had any interest in studying.
The great recession
of 1973-1975 was a severe blow to Keynesian economics because
inflation was high, while at the same time there was significant
unused capacity in the form of unemployment and idle factories.
Theoretically, this wasn't supposed to happen. Also, the failure
of traditional Keynesian medicine, especially the tax rebate of
1975, led economists to search for other causes and cures for
economic malaise.
One group of economists
fingered the capital gains tax as a key problem area because it
had especially pernicious effects on entrepreneurship and risk-taking.
Historically, the tax on long-term capital gains had been fixed
at 25 percent. But in 1969, congressional liberals raised the
rate to 35 percent in order to soak the rich, who realize most
capital gains. The result was that venture capital virtually dried
up, and it was much more difficult to get financing for new business
start-ups.
In 1978, a bipartisan
effort was made in Congress to cut the capital gains rate back
to 25 percent. The problem was that static scoring showed this
to be a big revenue loser because it was assumed that the same
amount of gains would be realized, only taxed at a lower rate.
But one does not need to be a professional economist to see that
when you cut the price of something, sales will probably rise.
Advocates of cutting
the capital gains rate, including Harvard economist Martin Feldstein,
argued that it would produce an unlocking effect that would cause
many more gains on old investments to be realized. This would
both raise federal revenue and create a pool of capital that would
be reinvested in new businesses and industries, thus spurring
growth.
After Congress cut
the capital gains tax in 1978, the Treasury Department studied
the impact and concluded that the tax cut had indeed raised federal
revenue. There was also a huge jump in venture capital financing
that many economists credit for starting the high-tech revolution
we have seen over the last 25 years.
Subsequently, many
so-called supply-side economists argued that there were other
types of tax cuts that might also pay for themselves and those
that would do so partially, thus reducing the actual revenue loss
below those in official estimates. Few economists today would
disagree with the statement that an across-the-board tax rate
reduction would have reflows of about 35 percent. That is, static
revenue loss estimates are 35 percent too high. (Similarly, revenue
gains from tax rate increases would tend to be 35 percent too
high.)
This is a long way
from saying that all tax cuts will pay for themselves, as some
overly exuberant conservatives sometimes argue. In any case, if
a few extra dollars will improve Treasury's tax analysis, it is
all to the good.
Copyright
2006 Creators Syndicate
