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News Releases on Taxes

May 31, 2002

May 31, 2002 | News Releases on Taxes

Analyst: Changes in Tax Policy Should Take "Real World" Effects Into Account

WASHINGTON, May 31 2002-Few businesses would consider raising their prices without trying to figure out how customers might react to such a change. Most realize that raising prices won't boost profits if sales decline.

But, according to Heritage Foundation economist William Beach, this common-sense calculation appears lost on the federal government, which routinely changes its "prices"-that is, taxes and regulations-with little or no regard for how taxpayers will respond.

"They act as though we'll all keep 'buying'-spending and investing, to be more precise-no matter how much they charge us, but that's not how it works," said Beach, director of Heritage's Center for Data Analysis.

And with lawmakers preparing to consider if the tax cuts approved last year should be sped up and made permanent, Beach said, it's time for Washington to start basing policy changes on realistic projections of how they will affect people outside the Beltway.

The problem is that government bureaucrats tend to rely on "static" economic models, which assume changes in tax policy won't lead to changes in the economy, he said. A "dynamic" model, on the other hand-one that accounts for predictable differences in consumer and business spending, as well as interest rates, income and savings-produces a more accurate estimate.

Static models, Beach said, predicted the tax cuts enacted in 1963 under President Kennedy and in 1981 under President Reagan would reduce federal revenues. In reality, both produced substantial increases.

Former Sen. Robert Packwood provided a telling illustration of just how ridiculous "static" model estimates can be back in 1988, when he asked Congress's Joint Committee on Taxation (JTC) to estimate what would happen if the government confiscated all income over $200,000 annually.

The JTC's static analysis concluded that such a tax would raise $104 billion the first year, $204 billion the next year, $232 billion the year after that, and $263 billion and $299 billion in its fourth and fifth years. "This estimate was clearly nonsense, but it's about as accurate as other static projections," Beach said. As Packwood noted at the time, the JTC assumed people will "work forever and pay all of [their] money to the government when clearly anyone in [his] right mind will not."

A new Heritage Foundation paper, which Beach co-authored with Gary and Aldona Robbins-the president and vice president, respectively, of Fiscal Associates in Arlington, Va.-argues that, to make more informed and realistic decisions about tax and other proposals, the federal government should start using "dynamic" or "reality based" computer programs-economic models similar to those that have been used successfully for many years by businesses and state governments.

The paper notes that many different types of dynamic analyses are available and identifies nine "major building blocks"-economic truisms that should be reflected in whatever dynamic model Congress ultimately decides to adopt. Among them:

  • Federal mandates and regulations create a drag on the economy. "They require businesses and individuals to engage in economic transactions they otherwise would avoid and act like a shadow tax on the economy," the Heritage authors noted.
  • Workers respond to changes in marginal tax rates. "In considering whether to work extra hours, workers will evaluate how much they will keep of the extra wages they earn, after taxes and inflation," they wrote. And any real-world model must take all taxes into account, not just selected federal taxes.
  • Federal subsidy programs distort prices. "They artificially reduce certain prices, which shifts demand away from other goods and services toward the favored items," the Heritage authors said. "The price of the subsidized good rises with demand, and the prices of other goods drop. An acceptable model would show this effect."

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