The Costs and Benefits of Dynamic Scoring of Tax Policy

February 12, 2006

Speaking at last week’s Conservative Political Action Conference (CPAC), Vice President Dick Cheney took on the issue of the relationship between tax rates and federal government revenue. Specifically, Cheney argued that the tax cuts passed in 2001 and 2003 were largely responsible for the growing of federal revenues, not revenue losses that were predicted by opponents of the tax cuts. He cites their failure to fully take into account how individuals change their behavior as a result of tax policy, or in other words, their failure to use dynamic economic analysis. From the Washington Post:

Vice President Cheney said Thursday night that the verdict is in before the Bush administration's new tax analysis shop has even opened for business: Tax cuts boost federal government revenue.

That assertion won applause from his audience at the Conservative Political Action Conference, but it is a long-standing source of debate among many economists and tax experts at a time of rising federal budget deficits.

Cheney touted President Bush's recently announced proposal to create a tax analysis division as a move toward providing more evidence for the administration's side of the argument.

"The president's tax policies have strengthened the economy, as we knew they would," Cheney told the conference, according to a text posted on the White House's Web site. "And despite forecasts to the contrary, the tax cuts have translated into higher federal revenues." (Full Story)

Whether the tax cuts have increased or decreased federal revenues requires one ask the question: Would tax revenue be higher or lower today if not for the tax cuts? Merely looking at federal government revenue growing after the tax cuts does not necessarily prove the causation, but could also imply that some other factor also caused the economy to expand, thereby causing revenues to increase.

On the other hand, static analysis will nearly always overstate the costs of tax cuts. Assuming lower taxes cause the economy to expand, there will be revenue that comes out of that expansion that would otherwise have not been there. Whether or not that revenue exceeds the lost revenue from the tax cuts can be uncertain unless proper analysis of the incentives that lower taxes provide is carried out. That is why Cheney’s proposal that dynamic scoring be used in Treasury Department analysis, in addition to the current static scoring, has promise.

Some drawbacks to dynamic scoring do exists such as debate over certain economic assumptions required and the parameters of certain variables in models. One of the biggest pitfalls of dynamic analysis is that we must make assumptions with respect to future policy, often times using current law as the baseline. This requires predicting the behavior of our elected officials, and one need to look no further than this blog's archives documenting the lack of stability in the tax code to see that this can be a difficult task. (For more on the restrictions imposed on dynamic analysis by unstable fiscal policy, click here to view congressional testimony of former CBO Director Dan Crippen discussing this topic in 2002.)

But despite these downsides, many need to recognize that as our understanding of the economy grows, dynamic scoring can indeed be a useful tool. It is already used in most business decision making, as well as the Federal Reserve’s Open Market Committee, whose primary job is to analyze data while making certain assumptions, formulating a model of the macroeconomy, and using the model’s output as a basis for monetary policy. Assuming this analysis could be done in the manner that economists are supposed to analyze issues (without a pre-conceived policy bias), why should fiscal policy be any different?

Overall, while some who are typically opposed to Bush’s economic policies may claim that dynamic scoring is the wrong path as they say it could be used for political purposes, they need to acknowledge two facts. First, static analysis can be just as wrong as dynamic analysis and lead to bad policies that neither side would support. And second, by not having formal dynamic analysis give estimates of revenue gains/losses from proposed policies, many can overstate their case for certain policies. In other words, the dynamic scoring may be able to make more realistic the claims of supporters of certain policies rather than relying on broad statements such as “tax cuts raise revenue” or “tax cuts will increase the deficit.”

For more on the issue of dynamic scoring, check out the summary of a conference on the issue held in 2003 at the American Enterprise Institute, which included commentary from former CBO director Douglas Holtz-Eakin and numerous other economists.

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