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This is one of a series of TaxVox guest blogs discussing dynamic scoring.
Whether dynamic scoring for official revenue estimates is a good or bad idea, it is now a part of scoring rules in the House. As a result, it is more compelling than ever to understand the forces that determine economic effects.
Previous advisory macroeconomic analyses have varied considerably in the magnitude of these effects. For example, a 2005 study by the Joint Committee on Taxation (JCT) found a wide range of revenue losses for various tax changes: 6 percent to 23 percent for an individual rate cut, 0.5 percent to 15 percent for an increase in the personal exemption, and 8 percent to 21percent for a corporate rate cut.
In 2014, JCT estimated that former House Ways & Means Committee Chairman Dave Camp’s tax reform proposal, which was roughly revenue-neutral according to traditional revenue estimating, would increase revenues in a range from $5 billion to $70 billion a year under dynamic scoring.
These variations arise from several sources: different types of effects, different models, different elasticities, and, in the case of the Camp proposal, a rather strange new add-on to one of the models.
In these simulations, JCT used two models: a macroeconomic model (MEG) and an overlapping generations model (OLG). A full explanation of these models is beyond the scope of this discussion, but the MEG model is basically a growth model where labor supply responses are incorporated directly while in the OLG model individuals choose consumption and leisure over their lifetimes.
The MEG model can include three effects: (1) the short run demand side stimulus where tax cuts reduce unemployment, (2) the crowding-out effect where tax cuts increase borrowing and reduce funds available for investment, and (3) supply side effects, where labor and capital supply respond to changes in tax rates.
The OLG model can measure only supply side effects and does not permit deficits, so its estimates must always assume some offsetting policy such as changes in spending, transfers, or future taxes. Each leads to a different outcome.
And each, in turn, has its own uncertainties. For example, if stimulus effects, which accounted for up to a 14 percent feedback effect from the individual rate cut in the MEG model, are offset by Federal Reserve changes in interest rates, they could decline to essentially zero. They are also transitory and, at least in theory, should be negligible in a fully employed economy.
Supply side effects vary depending on the model type, the magnitude of responses explicitly or implicitly built into the model, and how the OLG model is closed. These supply side effects were responsible for the large variation in the Camp analysis.
Labor supply is normally the main effect in the budget horizon. It increases with a decline in marginal tax rates (the substitution effect) but this effect may be offset because workers reduce hours in response to higher incomes (the income effect). The two models measure these effects very differently. Using the larger labor supply elasticity in the MEG model, Gross Domestic Product was higher by 0.2 percent in the budget horizon, while it was 1.5 percent higher in the OLG model.
The two models also differ in how they assume owners of intangible assets, such as patents and copyrights, respond to changes in corporate taxes and how those responses affect economic output. In a recent change, the OLG model assumes that firms will shift ownership of those assets and that this will result in real effects on output. However, since intangible assets can already be used costlessly in every location, a mere shift in ownership should not have an output effect.
Both issues suggest that the supply side effects are more consistent with the 0.1 percent to 0.2 percent in the MEG model. Given the powerful assumptions in the OLG model (perfect information and perfect foresight) and its inability to model a stand-alone tax policy, the use of this model may be questioned.
Finally, the JCT did not take into account the effects of base broadening, such as disallowing state and local income tax deductions, on the marginal effective tax on labor income (although it did account for these effects on capital income).
Due to all these flaws and uncertainties, the results in the JCT analysis are likely overstated.
Jane Gravelle is a Senior Specialist in Economic Policy at the Congressional Research Service. The views expressed here are her own and do not represent the views of the Congressional Research Service.
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