December 22, 2015 | Issue Brief on Taxes
The Joint Committee on Taxation (JCT) provides estimates of the budgetary effects of tax legislation for Congress. In 2015, for the first time, Congress mandated that the JCT provide dynamically scored estimates of major legislative changes. Dynamic scoring takes into account the macroeconomic feedback effects of changes in tax policy on revenues and spending. In other words, dynamic scoring measures how policy changes affect economic growth, which in turn affects the budget. Traditional static scoring, however, assumes that polices do not increase or decrease economic growth
The JCT has long resisted providing dynamic estimates on any regular basis. Now that Congress requires the JCT to provide dynamic scores for major policy changes, it is imperative that the JCT use the proper research and assumptions, otherwise the scores are not as useful to Congress as they should be. Evidence is mounting that the JCT is underplaying the beneficial effects of pro-growth tax policy. In part, it is doing so by improperly using hypothetical changes to the Federal Reserve’s (the Fed’s) monetary policy to arbitrarily reduce the positive effect of pro-growth policies.
The JCT should be cautious in making assumptions about how the Fed will respond to changes in tax policy and the influence the Fed has in the first place.
Recently, the JCT dynamically scored a bill that would make bonus depreciation—better referred to as 50 percent expensing—permanent. The JCT found that the bill would have minimal economic benefits and a small amount of positive revenue feedback despite the importance of the policy. Another analysis of the bill found a much stronger positive benefit on the economy and a significantly larger revenue feedback.
The JCT’s muted result is explained in part by its model not being sufficiently open to the global economy, as well as the related assumption that an increase in the deficit would crowd out private investment. Being open to the global economy is a measure of how much investment would flow into the U.S. from foreign sources as a result of improved U.S. economic policy.
For instance, the JCT assumes that foreign investment would rise minimally due to 50 percent expensing. The Tax Foundation, which found that 50 percent expensing would be more economically beneficial, assumes that considerably more investment would flow into the U.S. In an economic model, more foreign investment shows more growth because that inflow allows more new investment to be funded, which also reduces, or eliminates, the negative effect of crowding out.
The JCT’s lower estimate is also explained by its illogical decision to explicitly model the Fed’s reaction to the implementation of 50 percent expensing. From that report:
Monetary policy conducted by the Federal Reserve Board is explicitly modeled, with lagged price adjustments allowing for the economy to be temporarily out of equilibrium in response to fiscal and monetary policy changes. Under an “Aggressive Fed” policy, it is assumed that the Federal Reserve Board would work to counteract any demand incentives resulting from fiscal policy. “Neutral Fed” policy simulations assume that the Federal Reserve Board targets a fixed monetary growth rate, and does not try to counteract fiscal policy. The macroeconomic revenue effects provided in the estimate were generated using the assumption that the Federal Reserve Board would be neutral toward the policy in the beginning of the budget period, consistent with current Federal Reserve policy, and gradually begin to counteract the expansionary effects of growing deficits over the budget period.
There are multiple problems with the JCT incorporating the Fed’s response to changes in fiscal policy in its dynamic scoring. Importantly, the Fed does not alter monetary policy because of changes to fiscal policy. It looks at numerous pieces of economic data, some of which may be indirectly influenced by changes in fiscal policy, to make its decision about what interest rate it wants to target.
Furthermore, deficits do not grow the economy in the long run. Rather, removing penalties for engaging in productive activities that create economic growth (such as working, saving, investing, and taking risks) increase economic growth.
Most importantly, however, the JCT’s decision to explicitly model the Fed’s reaction to changes in tax policy biases its results based on parameters that cannot reliably be modeled.
In its dynamic score of 50 percent expensing, the JCT reduces the positive effect of the policy because it assumes the Fed will counteract that effect by raising its target interest rate. This introduces a negative bias to the JCT’s results because it reduces the economic growth that the JCT estimates will result from 50 percent expensing. It also reduces the revenue feedback from the enhanced growth, both because of that lower growth effect and because the government’s borrowing costs rise when market interest rates rise, over which the JCT wrongly assumes the Fed has strong control.
In reality, interest rates reflect what people expect to earn on investments; they are not simply a lever the Fed pulls. In other words, interest rates rise when profit opportunities expand in the economy, no matter what the Fed does.
The JCT estimated in its score of 50 percent expensing that government spending would rise by $17 billion because of increased government borrowing costs. This reduced its estimate of dynamic revenue feedback from $30 billion to $13 billion, or by more than half. Part of that $17 billion comes from the crowd-out effect that the JCT assumes; the other comes from the purported action of the Fed.
There is no way to know how much the JCT’s prediction of future Fed actions reduced its growth estimate, but it is certain that less growth and a smaller revenue feedback make 50 percent expensing a less appealing policy to Congress.
By using uncertain future Fed changes in monetary policy in its models, the JCT has set up a no-win situation for pro-growth policy. If a policy results in strong economic growth, then the JCT will assume the Fed will alter monetary policy to snuff out much of that growth. Even more troubling, that mechanism in its model is highly arbitrary because the Fed’s changes to monetary policy are so unpredictable.
Rather than try to predict future Fed policy, the JCT should stick to estimating parameters that are more accurately modeled. In contrast to Fed policy, how much families, businesses, investors, and entrepreneurs change their behavior when tax policy changes are observable, measureable, and therefore reasonably predictable.
Those responses, or elasticities, fall within a range that is typically broadly accepted by researchers. Estimators can then determine where in that range they set the elasticity in their model. Based on that decision, a reasoned debate about the size of the response, and therefore the influence on the economy and revenue, can occur. The potential future actions of the Fed exhibit none of these vital characteristics as it pertains to changes in tax policy.
The purpose of elasticity-based dynamic scoring is not to predict everything that will occur during the budget window. No one, the JCT included, can predict everything that will affect the economy during a certain period.
Instead, dynamic scoring’s purpose is to measure how much the economy will change and how that change will affect federal revenues due to Congress changing policies it controls.
Given its long-held aversion to dynamic scoring, the JCT’s use of Fed policy to dampen the benefit of a pro-growth policy gives the appearance that it has switched reluctance to do dynamic scoring with an arcane and abstruse modeling maneuver as its means for downplaying the benefits of pro-growth tax policy. In addition to improving its methodology to be more accurate, the JCT should stop modeling the Fed in future dynamic scores to remove this appearance of bias against pro-growth policy.
Congress has the option to use more reliable and accurate scores from modelers outside Congress should it choose. If the JCT will not make this common-sense improvement, Congress should exercise that prerogative.—Curtis S. Dubay is Research Fellow in Tax and Economic Policy in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom and Opportunity, at The Heritage Foundation.
 Senate Concurring Resolution 11, 114th Cong., 1st Sess., §3112, http://www.gpo.gov/fdsys/pkg/BILLS-114sconres11enr/pdf/BILLS-114sconres11enr.pdf (accessed November 23, 2015).
 Curtis S. Dubay, “JCT Dynamic Score of Bonus Depreciation: Highly Flawed,” Heritage Foundation Issue Brief No. 4478, November 3, 2015, http://www.heritage.org/research/reports/2015/11/jct-dynamic-score-of-bonus-depreciation-highly-flawed.
 Alan Cole, “Economic and Budgetary Effects of Permanent Bonus Expensing,” Tax Foundation Fiscal Fact No. 478, September 16, 2015, http://taxfoundation.org/article/economic-and-budgetary-effects-permanent-bonus-expensing (accessed November 23, 2015).
 Stephen J. Entin, “Comparing Bonus Expensing Estimates of the Joint Committee on Taxation and the Tax Foundation,” The Tax Policy Blog, November 2, 2015, http://taxfoundation.org/blog/comparing-bonus-expensing-estimates-joint-committee-taxation-and-tax-foundation (accessed November 23, 2015).
 Gavin Ekins, “Assumption About Global Capital Markets Explains the Differences Between the JCT’s and the Tax Foundation’s Estimates of Bonus Expensing,” The Tax Policy Blog, November 12, 2015, http://taxfoundation.org/blog/assumption-about-global-capital-markets-explains-differences-between-jcts-and-tax-foundations (accessed November 23, 2015).
 Joint Committee on Taxation Staff, A Report to the Congressional Budget Office of the Macroeconomic Effects of H.R. 2510, “Bonus Depreciation Modified and Made Permanent,” as Ordered to be Reported by the House Committee on Ways and Means (JCX-134-15), p. 5, October 27, 2015, https://www.jct.gov/publications.html?func=startdown&id=4844 (accessed November 23, 2015).
 Joint Committee on Taxation Staff, A Report to the Congressional Budget Office of the Macroeconomic Effects of H.R. 2510, “Bonus Depreciation Modified and Made Permanent,” p. 3.