Members of Congress and key leaders of the
Bush Administration find themselves wrestling with one of the more
important, though obscure, issues currently in public debate: how
to change the process of estimating the revenue effects of budget
policy changes in a way that will incorporate the effects of those
changes on the U.S. economy. Though this issue seems to be narrowly
defined, it is playing a central role in the larger debate over
which tax policy changes would best promote economic growth and
While most economists would address this
issue by estimating the effects of policy changes using a
statistical model of the U.S. economy, the current practice of
Washington-based budget estimation is to assume that taxes have no
effect on the macroeconomy. In other words, the federal
government's principal tax analysis groups do not use a model of
the U.S. economy in creating their estimates of revenue change.
practice, however, runs counter to real-world experience, in which
the level of taxes is critical in determining how businesses
organize and how people allocate the resources available. Instead
of assuming these effects away, the structure of any model used in
budget analysis must, at the very least, allow taxes to enter the
relevant economic decisions.
still disagree with the whole idea of evaluating tax policy changes
in terms of their macroeconomic effects, but most parties to this
"dynamic scoring" debate are actually engaged in arguments over
which assumptions to make when using a model of the U.S. economy.
The assumptions of any model are key to the results it will
produce. For example, if a model assumes that employees will not
change their hours worked whether take-home pay goes up or down,
one should not be surprised that the model
will predict no economic effects from increasing payroll tax rates.
Similarly, if a model assumes that taxes play no role in how much
capital is made available by investors, it will conclude that
changing tax rates will have no effect on economic activity.
economic properties of macroeconomic models are the crucial
elements in creating an accurate forecast of how tax policy changes
affect economic activity. Getting these properties right matters
more to the information the model produces than how many economic
concepts or years the model can report. In other words, if the
economics are not right, the model will produce output that may
lead the model user to the wrong conclusions.
Policy leaders in Congress and the
Administration must insist on a higher, more sophisticated, and
more informative level of analysis from the tax staffs that support
the government's important policy work. The Joint Committee on
Taxation and the Treasury Department's Office of Tax Analysis
should be required to adopt immediately the practice of routine
macroeconomic modeling for all important tax policy changes.
Key Elements of an Economic Model for
Policymakers are right to wonder what
major building blocks a model of the U.S. economy should have.
Selecting these building blocks, or key elements, is important; the
ones selected will largely determine the results of a model run, or
simulation, of a policy change. Thus, the users of a model's output
need to know the important assumptions of the model if they are to
make a sensible assessment of what it reports.
following are examples of some of the most important economic
relationships that should be incorporated into a model that is used
for budget and tax analysis but that are now overlooked.
- Labor and
capital combine to produce private output.
More labor and more capital available to business should
result in more output. As the rewards to labor and ownership of
capital increase, workers and investors are willing to increase
their respective supplies. This is how it works in the real world,
and any budgetary model should exhibit this result. How capital and
labor inputs relate to output is a matter of existing technology.
Any budgetary model should be able to
demonstrate that its representation of technology can replicate the
historical record and comport with observed facts.
- Labor and
capital respond to changes in marginal tax rates.
Workers supply labor based on real after-tax wage rates. In
considering whether to work additional hours, workers will evaluate
how much they will keep of the extra wages they earn, after taxes
and inflation. Therefore, what matters are marginal, not average,
tax rates. Studies that look only at the effect of average taxes on
economic decisions miss the mark both on theoretical grounds and
with respect to real-world experience.
Similarly, the supply of capital is based
on the return paid to owners of capital after inflation,
replacement costs, and taxes. Again, it is tax rates at the margin
that matter. Furthermore, the analysis must cover all taxes, not
just selected federal taxes.
Historically, the real after-tax return to
capital has been extremely stable. More important, this
stability has persisted despite many substantial changes in the way
investment is taxed. The reason for this stability is that the
stock of U.S. capital adjusts very quickly in response to changes
in the real after-tax return on capital. For example, lowering the
marginal tax rate on capital brings forth more investment until the
stock of capital increases enough to lower the rate of return to
where it was before the tax cut. These adjustments occur fairly
quickly; indeed, the historical record of the past 50 years
indicates that the supply of capital is very adjustable after the
first 5 to 10 years following a significant change in marginal tax
The constancy of the real after-tax return
to capital implies that stock adjustments occur through changes in
domestic saving and the placement of capital worldwide. Experience
of the past 50 years shows that a 10 percent increase in the
real after-tax return to capital will produce a similar increase in
domestic saving. The reverse is true for a decrease in after-tax
return. An acceptable budget model would incorporate the
relationships among marginal tax rates, the supply of and demand
for goods and services, and the supply of and demand for the
factors that produce them.
- The United
States operates in a global economy.
Changes in the volume of domestic saving, however, are
usually not enough to drive the after-tax return to capital back to
its historically stable level within the typical adjustment period.
The rest of the change in supply must come from changes in
international capital flows. Specifically, increases (decreases) in
the real after-tax return result in less (more) U.S. investment
More generally, an increase in the rate of
return to an asset due to lower U.S. taxes on capital is shared
with all investments, including those not directly affected by the
tax change. For example, suppose taxes are cut for U.S. citizens
owning physical assets in the United States. As these individuals
rearrange their portfolios to take advantage of the increased
returns on the newly favored assets, the rate of return on other
assets that they liquidate also will increase, making them
attractive to investors who cannot directly take advantage of the
tax change. In other words, a tax change that initially appears
limited to the United States is in reality shared worldwide. Absent
this linkage, the real after-tax return to capital would not
exhibit the constancy that it has exhibited.
Clearly, changes in the ownership mix of
capital sited in the United States have implications for tax
collections. Adjustments from abroad, which involve changes in
factor payments to foreigners, will be incorporated into U.S. tax
bases. Increases in foreign ownership, for example, will lower the
portion of dividends paid to U.S. citizens. However, these changes
will be small in comparison to the increase in tax bases resulting
from the higher growth due to more foreign investment in the United
States. A suitable budgetary model must not assume that the U.S.
economy is closed. It must allow international capital flows to be
affected by changes in budget policy.
- Federal Reserve
An acceptable budget estimation model must assume that monetary
policy significantly influences the general price level and,
thereby, nominal interest rates. Simulations done with the model
should assume that the Federal Reserve would undertake whatever
policies are necessary to maintain prices at their baseline levels.
Guessing the future course of monetary policy, as a function of
alternative budget policies, is simply an added complication. An
acceptable budgetary model would not assume that the Federal
Reserve would misbehave. The return on financial assets--interest
rates--depends on the real after-tax return to capital and on
inflation. Assuming the Federal Reserve holds constant the general
price level, interest rates will change only with the return on
- Tax and spending
policies affect the federal debt.
Changes in tax and spending policies should affect the
level of government borrowing and debt symmetrically. The
requirement that interest rates be primarily tied to the real rate
of return to capital means that changes in borrowing principally
affect domestic portfolios, since there is no incentive for the
portfolios of foreigners to change. For example, while an increase
in spending or a decrease in taxes may put money in peoples'
pockets, it must also take that same amount out of the pockets of
lenders. The model should show little or no first-round income
effect from either tax or spending changes. The major effect of
such changes flows from the initial price effect and subsequent
adjustment to the new prices.
purchases of goods and services affect private output and
Some government purchases of goods and services count as
part of the nation's output. The compensation of government
employees adds directly to the value of the gross domestic product
(GDP). Government employment also raises the total demand for
labor. Thus, expanding government employment bids up the price of
labor in general. Higher labor costs in the private sector reduce
private output, offsetting part of the gain attributable to the
Government capital expenditures should
show a similar effect. In this case, GDP goes up by less than the
value of the expenditure because, under Department of Commerce
accounting rules, government capital yields only asset
depreciation. Again, the direct increases are generally offset by
reductions in private output due to higher factor costs. To the
extent that either of these types of government spending increases
private-sector productivity, the private-sector loss is lower; but
this must be the exception rather than the rule. An acceptable
budget model should show that a dollar increase in government
employment or investment would lead to less than a dollar increase
- Federal subsidy
programs cause price distortions.
Direct and indirect (through the tax system) subsidy
programs artificially reduce certain prices facing consumers and
businesses. The lower price shifts demand away from other goods and
services toward the favored items. As a result, more of the favored
goods and services are produced than would otherwise be the case,
leading to a less efficient allocation of resources. The price of
the subsidized good increases with demand, and the prices of other
goods decrease. In markets where there are supply difficulties--the
usual justification for intervention--subsidies are often
counterproductive. For example, tax credits for higher education
typically lead to increases in tuition that can offset most or all
of the subsidy. An acceptable budget model should show the negative
GDP effect of the price distortions as well as the increased
spending on the subsidized item.
- Federal transfer programs also
affect price levels.
Government transfer programs operate in a manner similar
to subsidies. They generally target a group of individuals rather
than particular goods or services. Increased spending by the
subsidized group raises the price of goods for everyone, producing
a similar GDP effect. An acceptable budget model should show the
negative GDP effect of the price distortions as well as the
increased spending by the subsidized groups.
- Federal mandates
and regulatory programs act like a shadow tax on the economy.
Mandates and regulations require businesses and
individuals to engage in economic transactions they otherwise would
not undertake. This acts like a shadow tax on the economy. To
maintain the rate of return to capital (and in some cases labor),
the marginal value product of capital (or labor) must increase to
comply with the government requirement. This increase in factor
costs should result in reduced GDP. Externalities, such as
pollution from a coal plant, are the typical justification for
government mandates and regulations. The benefits from this kind of
government intervention are generally not measured because they do
not show up in measured GDP. An acceptable budget model should show
the negative effect on GDP and the price distortions caused by
regulations and mandates. Estimates of the value from reducing
externalities could be shown separately as a cost-benefit analysis,
much as the Office of Management and Budget does for major rule
current practice among the federal government's principal tax
analysis groups is to assume that taxes have no effect on the
macroeconomy. In other words, they do not use a model of the U.S.
economy in creating estimates of revenue change based on tax policy
changes. This assumption runs counter to real-world experience; the
level of taxes is critical in determining how businesses organize
and how people allocate their resources. The structure of any model
used in budget analysis at the very least must include the effects
of taxes in relevant economic decisions.
Finding an acceptable set of assumptions
or properties on which to base an economic model for such budget
analysis is not an impossible task. Economics is a well-developed
social science in which a surprisingly large body of theory is
considered generally noncontroversial. Macroeconomics is a
developing branch of economics, but its areas of controversy should
not prevent policymakers from relying on those parts that can shed
light on important policy questions. Indeed, if the fear of making
incorrect assumptions prevents the use of models that contain
accepted economic thinking, the debate over policy change will
become less informed and more confused.
Policymakers and decision-makers in
Washington must insist that those who estimate the effects of a tax
policy change on the federal government's revenues incorporate the
economic effects of such change in their analysis. Unless such
organizations as the Joint Committee on Taxation and the Office of
Tax Analysis include the economic effects of policy change in their
analyses, their estimates of revenue change will be more inaccurate
than they otherwise would or should be.
Gary Robbins is President and Aldona Robbins is
Vice President of Fiscal Associates in Arlington, Virginia. William W. Beach is
Director of the Center for Data Analysis at The Heritage