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Posts Tagged ‘Laffer Curve’

On the issue of so-called progressive taxation, our left-wing friends have conflicting goals. Some of them want to maximize tax revenue in order to finance ever-bigger government.

But others are much more motivated by a desire to punish success. They want high tax rates on the “rich” even if the government collects less revenue.

Some of them simply pretend there isn’t a conflict, as you might imagine. They childishly assert that the Laffer Curve doesn’t exist and that upper-income taxpayers are fiscal pinatas, capable of generating never-ending amounts of tax revenue.

But more rational leftists admit that the Laffer Curve is real. They may argue that the revenue-maximizing rate is up around 70 percent, which is grossly inconsistent with the evidence from the 1980s, but at least they understand that successful taxpayers can and do respond when tax rates increase.

So the question for grown-up leftists is simple: What’s the answer if they have to choose between collecting more revenue and punishing the rich with class-warfare taxation?

And here’s some new research looking at this tradeoff. Authored by economists from the University of Oslo in Norway, École polytechnique de Lausanne in France, and the University of Pennsylvania, they look at “Tax progressivity and the government’s ability to collect additional tax revenue.”

The recent massive expansion of public debt around the world during the Great Recession raises the question how much debt a government can maximally service by raising the level of taxes. Or, to phrase this classic public finance question differently, how much additional tax revenue can the government generate by increasing income taxes?

And since they’re part of the real world (unlike, say, the Joint Committee on Taxation or the Obama Administration), they recognize that higher tax rates impose costs on the economy that lead to feedback effects on tax revenue.

Our research (Holter et al. 2014) investigates how tax progressivity and household heterogeneity impacts the Laffer curve. We argue that a more progressive labour income tax schedule significantly reduces the maximal amount of tax revenues a government can raise…under progressive taxes heterogeneous workers will face different average and marginal tax rates. …the answer to our question is closely connected to the individual (and then properly aggregated) response of labour supply to taxes. The microeconometric literature, as surveyed e.g. by Keane (2011), has found that both the intensive and extensive margins of labour supply (the latter especially for women), life-cycle considerations, and human capital accumulation are important determinants of these individual responses. …households make a consumption–savings choice and decide on whether or not to participate in the labour market (the extensive margin), how many hours to work conditional on participation (the intensive margin), and thus how much labour market experience to accumulate (which in turn partially determines future earnings capacities).

The above passage has a bit of economic jargon, but it’s simply saying that taxpayers respond to incentives.

They also provide estimates of tax progressivity for various developed nations. They’re only looking at the personal income tax, so these numbers don’t include, for instance, the heavy burden of the value-added tax on low-income people in Europe.

The good news (at least relatively speaking) is that the American income tax is not as punitive as it is in many other nations.

But the key thing to consider, at least in the context of this new research, is the degree to which so-called progressivity comes with a high price.

Here is some additional analysis from their research.

Why does the degree of tax progressivity matter for the government’s ability to generate labour income tax revenues…? changes in tax progressivity typically affects hours worked…increasing tax progressivity induces differential income and substitution effects on the workers in different parts of the earnings distribution. …a more progressive tax system may disproportionately reduce labour supply for high earners and lead to a reduction in tax revenue. …more progressive taxes will reduce the incentives for young agents to accumulate labour market experience and become high (and thus more highly taxed) earners.

Now let’s look at some of the results.

Remarkably, they find that the best way of maximizing revenue is to minimize the economic damage of the tax system. And that means…drum roll, please…a flat tax.

For its current choice of progressivity (the green line), the US can sustain a debt burden of about 330% of its benchmark GDP, by increasing the average tax rate to about 42%. Thus, according to our findings the US is currently still nowhere close to its maximally sustainable debt levels…we also observe that larger public debt can be sustained with a less progressive tax system. Converting to a flat tax system (the black line) increases the maximum sustainable debt to more than 350% of benchmark GDP, whereas adopting Danish tax progressivity lowers it to less than 250% of benchmark GDP.

Here are a couple of charts from their study, both of which underscore that punitive tax rates are very counterproductive, assuming the goal is to either maximize revenue or to sustain a larger public sector.

Notice that if you want to punish “the rich” and impose Danish-type levels of progressivity (the dashed line), you’ll get less revenue and won’t be able to sustain as much debt.

Now let’s shift from discussing intellectual quandaries for the left and talk about challenges for believers in limited government.

We like a flat tax because it treats people equally and it raises revenue in a relatively non-destructive manner.

But because it is an “efficient” form of taxation, it’s also an “efficient” way to generate revenues to finance bigger government.

Indeed, this was one of the findings in a 1998 study by Professors Gary Becker and Casey Mulligan.

So does this mean that instead of supporting a flat tax, we should a loophole-riddled system based on high tax rates solely because that system will be so inefficient that it won’t generate revenue?

Of course not. At the risk of stating the obvious, this is why my work on fundamental tax reform is intertwined with my work on constitutional and legal mechanisms to limit the size and scope of government.

And it’s also why Obama’s class-warfare approach is so perversely destructive. If you think I’m exaggerating, watch this video – especially beginning about the 4:30 mark.

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Regular readers know that I don’t approve of drug use, but that I also favor legalization because the Drug War has been a costly and ineffective failure.

(And it’s led to horrible policies such as intrusive money-laundering laws and Orwellian asset-forfeiture laws).

So I was happy when folks in Colorado voted to decriminalize marijuana use, even if part of me didn’t like the idea that politicians would gain a new source of tax revenue.

If nothing else, what’s happening in Colorado (and Washington state) will be an interesting social experiment.

And even though we only have a modest bit of data, I’m going to be bold and assert that we can already learn two lessons from what’s happened.

1. Politicians are so greedy that they set taxes too high.

In the real world, there’s this thing called the Laffer Curve. And what it shows is that excessive tax rates don’t generate big piles of tax revenue because people change their behavior.

I’ve made this point before when dealing with personal income tax rates, corporate tax rates, capital gains taxes, and tobacco taxes.

Simply stated, the political class is so anxious to get more of our money that they impose punitive tax rates that fail to generate the desired amount of revenue.

And it’s also true with taxes on marijuana.

But don’t believe me. Let’s look at some news sources about what’s happened in Colorado.

Here are some excerpts from a Daily Beast report.

According to the Colorado Department of Revenue, the state collected $44 million in taxes from recreational marijuana in 2014, $25 million less than predicted.  …why did recreational marijuana sales in Colorado fall short? …Coloradoans bought less recreational marijuana than they could have… Looking at the taxes on cannabis in the state, it’s not hard to see why. Pot taxes in Colorado are steep. In Denver, for example, an eighth of cannabis can come with four taxes: an excise tax, regular sales tax, special sales tax (for pot retailers), and a special city tax. That equals a markup of roughly 30 percent. …many pot aficionados looked at the numbers and decided to stick with their medical marijuana programs or their other dealers.

Here’s some similar analysis from a New York Times article.

Colorado’s tax results underscore a big conflict facing public officials considering marijuana legalization. Taxes should be kept low if the goal is to eliminate pot’s black market. …Colorado has also shown that pot-smokers don’t necessarily line up to leave the tax-free black market and pay hefty taxes. If medical pot is untaxed, or if pot can be grown at home and given away as in Colorado, the black market persists.

And here are some passages from the Mic’s analysis.

David Huff…from Aurora, told the AP that the state’s taxes on marijuana, which increase the price of pot by 30 percent or more, are too, um, high. “I don’t care if they write me a check, or refund it in my taxes, or just give me a free joint next time I come in. The taxes are too high, and they should give it back,” Huff said. …only 60 percent of Coloradans obtained their marijuana through a legal exchange in 2014. Some buyers are using the state’s legal medical marijuana, which is untaxed, as a source for green, while others take advantage of Amendment 64’s provision allowing the personal use of as many as six marijuana plants. The products of those plants have flooded the black market, depriving Colorado of more taxable pot.

The bottom line is that politicians better figure out how to limit their greed if they truly want the legal market to function properly.

2. A spending cap ensures that new revenue won’t finance bigger government.

I’m a big fan of restraining the growth of government. Needless to say, this means I don’t like giving politicians new sources of revenue.

That’s my view on all of the proposals for new revenue that are percolating in the corridors of power, including energy taxes, financial taxes, value-added taxes, and wealth taxes.

But if there’s actually some sort of binding limit on the growth of government, then politicians can’t use new revenue to finance a more bloated public sector.

And thanks to the nation’s best expenditure limit, that’s the case in Colorado.

Here’s what Mic wrote on the topic.

Colorado’s state constitution limits how much tax money the state treasury can receive before having to return it to taxpayers. The provision, known as the Taxpayer Bill of Rights, or TABOR… Since Colorado’s economy has been growing as a faster rate than expected, the state underestimated its total revenue, which means Centennial State residents may soon get a cut of the estimated $50 million in taxes collected from the sale of recreational marijuana during its first year of legalization. …TABOR, passed in 1992, dictates that Colorado can’t spend revenue made from taxation if those revenues grow faster than the rate of inflation and population growth. That money, known as a TABOR bonus, must be refunded to taxpayers unless voters approve a revenue change. This amendment has netted Colorado taxpayers about $3.3 billion since 1992.

Let’s return to the Daily Beast story.

In a state with one of the strictest tax and expenditure limitations in the country, Colorado operates under a Taxpayer Bill of Rights called TABOR. According to the bill, refunds are to be considered when state tax revenues don’t match up to the state estimates. This year, owing to a slight rise in the economy, the overall revenue was higher.

Though you won’t be surprised to learn that politicians want to figure out a way of spending the money. Check out these passages from the aforementioned piece in the New York Times.

Colorado will likely have to return to voters to ask to keep the pot tax money. That’s because of a 1992 amendment to the state constitution that restricts government spending. The amendment requires new voter-approved taxes, such as the pot taxes, to be refunded if overall state tax collections rise faster than permitted. Lawmakers from both parties are expected to vote this spring on a proposed ballot measure asking Coloradans to let the state keep pot taxes.

So both Republicans and Democrats will join hands in an effort to spend the money.

Gee, knock me over with a feather. What a surprise!

But let’s not focus on whether politicians want more of our money. Let’s learn from TABOR.

What it teaches us is that you get better policy when you limit the growth of government spending. And the closest thing we have to TABOR at the national level is the Swiss Debt Brake.

It’s worked very well in Switzerland because it puts the focus on the underlying problem of too much government. Notwithstanding the name, it limits the annual growth of spending, not the growth of debt.

The moral of the story is that when you address the real problem of too much spending, you automatically address the symptom of red ink.

And politicians presumably won’t have much incentive to impose higher taxes if they can’t use the money to buy votes with bigger government, so it’s a win-win situation!

P.S. Though there are some who favor higher taxes solely for reasons of spite and envy.

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Since I’m a big advocate of the Laffer Curve, that means I favor dynamic scoring. This is the common-sense observation that you can’t figure out the effect of tax changes on revenue without first estimating the impact on taxable income.

And I’ve shared some very persuasive data and analysis in favor of the Laffer Curve and dynamic scoring.

The huge increase in taxes paid by upper-income taxpayers after Reagan slashed the top income tax rate.

The fact that the overwhelming majority of CPAs believe in significant feedback effects.

Even left-wing economists admit that you lose revenue if tax rates get too high.

International bureaucracies even admit that there are “Laffer Curve” limits that make some tax hikes self-defeating.

Notwithstanding all this evidence, we have a system in Washington that is based on static scoring, which simplistically assumes a linear relationship between tax rates and tax revenue.

The Joint Committee on Taxation makes the revenue estimates, and reformers argue the status quo is biased in favor of higher tax and have long urged the system to be modernized to get more accurate numbers.

Needless to say, establishment leftists don’t want to see any changes.

Edward Kleinbard, a former Staff Director for the Joint Committee on Taxation, writes with disapproval in the New York Times that Republicans want to change the existing methodology for estimating the revenue impact of changes in tax policy.

…at the top of their to-do list is changing how the government measures the impact of tax cuts on federal revenue: namely, to switch from so-called static scoring to “dynamic” scoring. While seemingly arcane, the change could have significant…consequences.

Here’s his description of the issue, which is reasonably fair.

…conventional estimates do not…incorporate macroeconomic behavioral changes. Dynamic scoring does. Proponents point out, correctly, that if a tax proposal is large enough, then those sorts of feedback effects can aim the entire economy on a slightly different path. Such proponents argue that conventional projections are skewed against tax cuts, because they do not consider that cutting taxes could lead to higher economic output, which would make up at least some of the lost revenues. They maintain that dynamic scoring will, therefore, be both more neutral and more accurate than current methodologies.

He then gives two reasons why he doesn’t like dynamic scoring.

First, he argues that a modernized system will be imprecise.

Economists disagree on the answers, and different models’ predicted feedback effects vary wildly, depending on the values selected for those uncertain assumptions.  …Consider the nonpartisan scorekeepers’ estimates of the consequences of a tax-reform bill proposed last year by Representative Dave Camp, Republican of Michigan. Using different models and plausible inputs, the scorekeepers estimated that, under the bill, total gross domestic product might rise between 0.1 percent and 1.6 percent over the next decade — a 16-fold spread in projected outcomes. Which result should be the basis of congressional scorekeeping?

He’s certainly right that economic models will generate a range of predictions.

And I’ll be the first to admit that models are woefully inadequate in their attempts to measure millions of people making billions of decisions. Heck, I’ve even pointed out that economists are terrible forecasters.

But Kleinbard is basically arguing that it’s better to be exactly wrong than inexactly right.

Under the current system, for instance, the JCT will simplistically calculate that a doubling of tax rates will lead to a near-doubling of tax revenue.*

That’s very precise, but it’s also very wrong. In reality, a doubling of tax rates would have a very large and very negative impact on economic performance. Shouldn’t lawmakers have a system that at least gives them an estimate, or a range of estimates, to suggest the possible real-world consequences?

This video explains what is wrong with the Joint Committee on Taxation’s methodology.

Kleinbard’s second argument against dynamic scoring is based on his assumption that bigger government is good for the economy since the government spends money wisely.

I’m not joking.

Federal deficits are on an unsustainable path (as it happens, because of undertaxation, not excessive spending). Simply cutting taxes against the headwind of structural deficits leads to lower growth, as government borrowing soaks up an ever-increasing share of savings. …these models are political statements. They show the biggest economic effects by assuming that tax cuts are financed by unspecified future spending cuts. The smaller size of government, not the tax cuts by themselves, largely drives the models’ results. …the models are not a step toward more neutral revenue estimates, because they assume that, while individuals make productive investments, government does not. In reality, government spending contributes significantly to economic output. …When revenues do in fact decline and deficits rise, those same proponents will push for steep cuts in government insurance or investment programs, because they will claim that the models demand it.

Wow. I hardly know where to start. So many wrong assertions in so little space.

I guess I’ll begin by pointing out that it’s absurd to argue America’s fiscal problems are the result of taxes being too low. But if you don’t believe me, just look at the White House’s own numbers.

But the most important point to address is that Kleinbard thinks government spending is more efficient than private spending.

That arguably might be true if government was consuming only 2 percent of GDP and certain core “public goods” weren’t being provided.

But that’s hardly the case today, or at any time in recent history.

The burden of government spending is well beyond the growth-maximizing level in the United States. This video elaborates.

The evidence strongly indicates we need less government rather than more. Unless, of course, you think the United States would grow faster if we were more like France or Greece.

* There are some “micro-economic” feedback effects in the current system, so even the JCT wouldn’t assert that revenues would double if tax rates rose by 100 percent.

P.S. Here’s my debunking of the straw-man debunking of the Laffer Curve and dynamic scoring.

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Barack Obama and the rest of the class-warfare crowd act as if “tax the rich” is an appropriate answer to every question about fiscal policy.

I’m not joking. Here are some of the President’s main tax hikes that have been enacted or proposed.

Obama imposed higher income tax rates on upper-income taxpayers as part of the fiscal cliff deal.

Obama also succeeded in increasing the double-taxation of dividends and capital gains for successful taxpayers.

Obamacare was a budget-busting nightmare with lots of tax increases, but the biggest tax hike targeted rich taxpayers.

Obama’s proposed solution for Social Security’s huge unfunded liability is a large tax increase on taxpayers making more than $100,000 per year.

Obama also has proposed big tax hikes for American companies trying to compete in global markets.

This list could continue, but I think you get the point. American leftists are like malfunctioning Chatty Cathy Dolls. No matter how many times you pull the string, all that comes out is “tax the rich.”

Needless to say, that’s both tiresome and empty.

At some point, it would be nice for Obama and other statists to actually identify how much is enough.

  1. For instance, should any taxpayer ever have to give more than 40 percent of their income to government? More than 50 percent? Perhaps over 100 percent, like the 8,000 French household that had every penny of earnings confiscated in 2012?
  2. And what’s the “fair share” for the rich? Should they pay 40 percent of the tax burden? Or 50 percent? Or more?
  3. Heck, it might not be a bad idea to actually identify the rich. Is a household “rich” if annual income climbs above $200,000? Or do we simply define rich people as being anyone in the top 10 percent, or top 20 percent?

For what it’s worth, I don’t care about the answers to these questions because I favor a simple and fair flat tax that doesn’t punish people for contributing more to the economy’s output. I simply want the government to treat everyone equally and collect revenue in the least-destructive manner.

That being said, I imagine that Obama and other leftists would hem and haw if any reporters actually acted like journalists and asked tough questions. In their hearts, the class-warfare types probably want to go back to the 70 percent-plus top tax rates of the Jimmy Carter era. But they presumably wouldn’t want to openly confess those views.

Just in case Obama (or Pelosi, Reid, etc) ever are pressed to answer these questions, here are numbers that should help put their answers in context.

First, here’s a chart from the experts at the Tax Foundation and it reveals that the top-10 percent of taxpayers finance about 70 percent of the federal income tax.

The typical left-wing response to this kind of data is to complain that it doesn’t include the Social Security payroll tax and other levies.

That’s a semi-fair point, and it’s true that the so-called “FICA” tax (at least the part that goes to Social Security) is not “progressive.” Instead, it’s a flat-rate levy. Moreover, the portion of the payroll tax used to fund Social Security is only imposed on income up to $118,500, which leads many leftists to say the system is regressive.

That’s inaccurate for the simple reason that Social Security’s benefit formula is far more generous to lower-income taxpayers. It’s also worth pointing out that the program is supposed to be a form of social insurance, not a redistribution scheme (though it’s actually both).

And that point is a perfect segue for the next chart. Mark Perry of the American Enterprise Institute used numbers from the Congressional Budget Office to measure the net effect (taxes and spending) of fiscal policy for the five income quintiles.

As you can see, the bottom 60 percent are net recipients and the top 20 percent are basically pulling the wagon for everyone.

Remember, this chart doesn’t mean that the bottom 60 percent don’t pay any tax. It just means that they get more money from the government, on average, than they put into the system.

Now that I’ve shared some numbers, let’s close with some economic analysis.

Obama’s class-warfare agenda is wrong because it’s unfair and discriminatory. But it’s also terribly misguided because high tax rates are bad for growth and competitiveness.

Besides, there is a point at which high tax rates don’t generate much, if any, additional revenue. Simply stated, rich taxpayers have considerable control over the timing, level, and composition of their income. And that means they can reduce their taxable income when tax rates increase.

My video on class warfare has more information. Make sure to pay extra-close attention at the 4:35 mark.

P.S. If you don’t believe my argument about rich people having the ability to alter their taxable income, check out the IRS data from the 1980s.

P.P.S. Only a fool (or a malicious person) wants to be at the revenue-maximizing point of the Laffer Curve. The right goal is to set tax rates at the growth-maximizing level.

P.P.P.S. For what it’s worth, a poll in 2012 found that 75 percent of Americans think the top tax rate should be no higher than 30 percent. That can’t be very comforting data for the hate-and-envy crowd.

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Many statists are worried that Republicans may install new leadership at the Joint Committee on Taxation (JCT) and Congressional Budget Office (CBO).

This is a big issue because these two score-keeping bureaucracies on Capitol Hill tilt to the left and have a lot of power over fiscal policy.

The JCT produces revenue estimates for tax bills, yet all their numbers are based on the naive assumption that tax policy generally has no impact on overall economic performance. Meanwhile, CBO produces both estimates for spending bills and also fiscal commentary and analysis, much of it based on the Keynesian assumption that government spending boosts economic growth.

I personally have doubts whether GOPers are smart enough to make wise personnel choices, but I hope I’m wrong.

Matt Yglesias of Vox also seems pessimistic, but for the opposite reason.

He has a column criticizing Republicans for wanting to push their policies by using “magic math” and he specifically seeks to debunk the notion – sometimes referred to as dynamic scoring or the Laffer Curve – that changes in tax policy may lead to changes in economic performance that affect economic performance.

He asks nine questions and then provides his version of the right answers. Let’s analyze those answers and see which of his points have merit and which ones fall flat.

But even before we get to his first question, I can’t resist pointing out that he calls dynamic scoring “an accounting gimmick from the 1970s” in his introduction. That is somewhat odd since the JCT and CBO were both completely controlled by Democrats at the time and there was zero effort to do anything other than static scoring.

I suppose Yglesias actually means that dynamic scoring first became an issue in the 1970s as Ronald Reagan (along with Jack Kemp and a few other lawmakers) began to argue that lower marginal tax rates would generate some revenue feedback because of improved incentives to work, save, and invest.

Now let’s look at his nine questions and see if we can debunk his debunking.

1. The first question is “What is dynamic scoring?” and Yglesias responds to himself by stating it “is the idea that when estimating the budgetary impact of changes in tax policy, you ought to take into account changes to the economy induced by the policy change” and he further states that it “sounds like a reasonable idea.”

But then he says the real problem is that conservatives exaggerate and “say that large tax cuts will have a relatively small impact on the deficit  — or even that they make the deficit smaller” and that they “cite an idea known as the Laffer Curve to argue that tax cuts increase growth so much that tax revenues actually rise.”

He’s sort of right. There are definitely examples of conservatives overstating the pro-growth impact of tax cuts, particularly when dealing with proposals – such as expanded child tax credits – that presumably will have no impact on economic performance since there is no change in marginal tax rates on productive behavior.

But notice that he doesn’t address the bigger issue, which is whether the current approach (static scoring) is accurate and appropriate even when dealing with major changes in marginal tax rates on work, saving, and investment. That’s what so-called supply-side economists care about, yet Yglesias instead prefers to knock down a straw man.

2. The second question is “What is the Laffer Curve?” and Yglesias answer his own question by asserting that the “basic idea of the curve is that sometimes lower tax rates lead to more tax revenue by boosting economic growth.” He then goes on to ridicule the notion that tax cuts are self-financing, even citing a column by National Review’s Kevin Williamson.

Once again, Yglesias is sort of right. Some Republicans have made silly claims, but he mischaracterizes what Williamson wrote.

More specifically, he’s wrong in asserting that the Laffer Curve is all about whether tax cuts produce more revenue. Instead, the notion of the curve is simply that you can’t calculate the revenue impact of changes in tax rates without also measuring the likely change in taxable income. The actual revenue impact of changes in tax rates will then depend on whether you’re on the upward-sloping part of the curve or downward-sloping part of the curve.

The real debate is the shape of the curve, not whether a Laffer Curve exists. Indeed, I’m not aware of a single economist, no matter how far to the left (including John Maynard Keynes), who thinks a 100 percent tax rate maximizes revenue. Yet that’s the answer from the JCT. Moreover, the Laffer Curve also shows that tax increases can impose very high economic costs even if they do raise revenue, so the value of using such analysis is not driven by whether revenues go up or down.

3. The third question is “So do tax cuts boost economic growth?” and Yglesias responds by stating “the credible research on the matter is very very mixed.” But he follows that response by citing research which concluded that “a tax cut financed by reductions in wasteful spending or social assistance for the elderly would boost growth.”

But that leaves open the question as to whether the economy does better because of the lower tax burden, the lower spending burden, or some combination of the two effects. But I’ll take any of those three answers.

So is he “sort of right” again? Not so fast. Yglesias also cites the Congressional Research Service (which rubs me the wrong way) and a couple of academic economists who concluded that there is “no systematic correlation between the level of taxation and the level of economic growth.”

The bottom line is that there’s no consensus on the economic impact of taxation (in part because it is difficult to disentangle the impact of taxes from the impact on spending, and that’s not even including all the other policies that determine economic performance). But I still think Yglesias is being a bit misleading because there is far more consensus on the economic impact of marginal tax rates and debates about the Laffer Curve and dynamic scoring very often revolve around those types of tax policies.

4. The fourth question is “How does tax scoring work now?” and Yglesias respond to himself by noting that the various score-keeping bureaucracies measure “demand-side effects” and “behavioral effects.”

He’s right, but CBO uses so-called demand-side effects to justify Keynesian spending, so that’s not exactly reassuring news for people who focus more on real-world evidence.

And he’s also right that JCT measures changes in behavior (such as smokers buying fewer cigarettes if the tax goes up), and this type of analysis (sometimes called microeconomic dynamic scoring) certainly is a good thing.

But the real controversy is about macroeconomic dynamic scoring, which we’ll address below.

5. The fifth question is “Can we take a break from all this macroeconomic modeling?” and is simply an excuse for Yglesias to make a joke, though I can’t tell whether he is accusing Reagan supporters of being racists or mocking some leftists for accusing Reagan supporters of being racist.

So I’m not sure how to react, other than to recommend the fourth video at this link if you want some real Reagan humor.

6. The sixth question is “What do current scoring methods leave out?” and Yglesias accurately notes that what “dynamic-scoring proponents want is a model of macroeconomic consequences. They think that a country with lower tax rates will see more investment in physical and human capital, leading to more productivity, and more economic growth.”

He even cites my blog post from last month and correctly describes me as believing that it is “self-evidently ridiculous that the current CBO model says higher tax rates would lead to faster economic growth via lower deficits.”

I also think he is fair in pointing out that “people sharply disagree about how much tax rates actually influence economic growth” and that “the whole terrain is enormously contested.”

But this is why I think my view is the reasonable middle ground. At one extreme you find (at least in theory) some over-enthusiastic Republican types who argue that all tax cuts are self-financing. At the other extreme you find the JCT saying tax policy has no impact on the economy and actually arguing that you maximize tax revenue with 100 percent tax rates. I suspect that Yglesias, if pressed, will agree the JCT approach is nonsensical.

So why not have the JCT – in a fully transparent manner – begin to incorporate macroeconomic analysis?

7. The seventh question is “Has dynamic scoring ever been tried?” and Yglesias self-responds by pointing out that a Treasury Department dynamic analysis of the 2001 and 2003 tax cuts come to the conclusion that “the resulting budget impact would be 7 percent smaller than what was suggested by conventional scoring methods.” and “ended with the conclusion that the Bush tax cuts substantially decreased revenue.”

In other words, dynamic analysis was not used to imply that tax cuts are self-financing. Indeed, the dynamic score in the example of what would happen if the Bush tax cuts were made permanent turned out to be very modest.

So why, then, are folks on the left so determined to block reforms that – in practice – don’t yield dramatic changes in numbers? My own guess, for what it’s worth, is that they don’t want any admission or acknowledgement that lower tax rates are better for growth than higher tax rates.

8. The eight question is “Why are we talking about dynamic scoring now?” and Yglesias answers his own question by accurately stating that “the Republican takeover of Congress starting in 2015 gives the GOP an opportunity to either change the scoring rules, change the personnel in charge of the scoring, or both.”

He’s not just sort of right. He’s completely right. I have no disagreements.

9. The ninth question is “Why does the score matter?” and his self-response is “the scores matter because perceptions matter in politics.” In other words, politicians don’t want to be accused of enacting legislation that is predicted to increase red ink.

Yglesias is also right when he writes that this “effect shouldn’t be exaggerated. In the past, Republicans haven’t hesitated to vote for tax measures that the CBO says will increase the deficit. That’s because they have a strong preference for low tax rates.”

At the risk of being boring, I also think he’s right about the degree to which scores matter.

The bottom line is that questions #1, #2, #3, and #6 are the ones that matter. Yglesias makes plenty of reasonable points, but I think his argument ultimately falls flat because he spends too much time attacking the all-tax-cuts-pay-for-themselves straw man and not enough time addressing whether it is reasonable for the JCT to use a methodology that assumes taxes have no effect on the overall economy.

But I expect to hear similar arguments, expressed in a more strident fashion, if Republicans take prudent steps – starting with personnel changes – to modernize the JCT and CBO apparatus.

P.S. While tax cuts usually do lead to revenue losses, there is at least one very prominent case of lower tax rates leading to more revenue.

P.P.S. If the JCT approach is reasonable, why do the overwhelming majority of CPAs disagree? Is it possible that they have more real-world understanding of how taxpayers (particularly upper-income taxpayers) respond when tax rates change?

P.P.P.S. If the JCT approach is reasonable, why do international bureaucracies so often produce analysis showing a Laffer Curve?

There’s also some nice evidence from Denmark, Canada, France, and the United Kingdom.

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The Congressional Budget Office (CBO) and Joint Committee on Taxation (JCT) are congressional bureaucracies that wield tremendous power on Capitol Hill because of their role as fiscal scorekeepers and referees.

Unfortunately, these bureaucracies lean to the left. When CBO does economic analysis or budgetary estimates, for instance, the bureaucrats routinely make it easier for politicians to expand the burden of government spending. The accompanying cartoon puts it more bluntly.

And when JCT does revenue estimates, the bureaucrats grease the skids for anti-growth tax policy by overstating revenue losses from lower tax rates and overstating revenue gains from higher tax rates.

Here are some examples of CBO’s biased output.

The CBO – over and over again – produced reports based on Keynesian methodology to claim that Obama’s so-called stimulus was creating millions of jobs even as the unemployment rate was climbing.

CBO has produced analysis asserting that higher taxes are good for the economy, even to the point of implying that growth is maximized when tax rates are 100 percent.

Continuing a long tradition of under-estimating the cost of entitlement programs, CBO facilitated the enactment of Obamacare with highly dubious projections.

CBO also radically underestimated the job losses that would be caused by Obamacare.

When purporting to measure loopholes in the tax code, the CBO chose to use a left-wing benchmark that assumes there should be double taxation of income that is saved and invested.

On rare occasions when CBO has supportive analysis of tax cuts, the bureaucrats rely on bad methodology.

But let’s not forget that the JCT produces equally dodgy analysis.

The JCT was wildly wrong in its estimates of what would happen to tax revenue after the 2003 tax rate reductions.

Because of the failure to properly measure the impact of tax policy on behavior, the JCT significantly overestimated the revenues from the Obamacare tax on tanning salons.

The JCT has estimated that the rich would pay more revenue with a 100 percent tax rate even though there would be no incentive to earn and report taxable income if the government confiscated every penny.

This means the JCT is more left wing than the very statist economists who think the revenue-maximizing tax rate is about 70 percent.

Unsurprisingly, the JCT also uses a flawed statist benchmark when producing estimates of so-called tax expenditures.

Though I want to be fair. Sometimes CBO and JCT produce garbage because they are instructed to put their thumbs on the scale by their political masters. The fraudulent process of redefining spending increases as spending cuts, for instance, is apparently driven by legislative mandates.

But the bottom line is that these bureaucracies, as currently structured and operated, aid and abet big government.

Regarding the CBO, Veronique de Rugy of Mercatus hit the nail on the head.

The CBO’s consistently flawed scoring of the cost of bills is used by Congress to justify legislation that rarely performs as promised and drags down the economy. …CBO relies heavily on Keynesian economic models, like the ones it used during the stimulus debate. Forecasters at the agency predicted the stimulus package would create more than 3 million jobs. …What looks good in the spirit world of the computer model may be very bad in the material realm of real life because people react to changes in policies in ways unaccounted for in these models.

And the Wall Street Journal opines wisely about the real role of the JCT.

Joint Tax typically overestimates the revenue gains from raising tax rates, while overestimating the revenue losses from tax rate cuts. This leads to a policy bias in favor of higher tax rates, which is precisely what liberal Democrats wanted when they created the Joint Tax Committee.

Amen. For all intents and purposes, the system is designed to help statists win policy battles.

No wonder only 15 percent of CPAs agree with JCT’s biased approach to revenue estimates.

So what’s the best way to deal with this mess?

Some Republicans on the Hill have nudged these bureaucracies to make their models more realistic.

That’s a helpful start, but I think the only effective long-run option is to replace the top staff with people who have a more accurate understanding of fiscal policy. Which is exactly what I said to Peter Roff, a columnist for U.S. News and World Report.

…the new congressional leadership should be looking at ways to reform the way the institution does its business – and the first place for it to start is the Congressional Budget Office. Most Americans don’t know what the CBO is, how it was created or what it does. They also don’t know how vitally important it is to the legislative process, especially where taxes, spending and entitlement reform are concerned. As Dan Mitchell, a well-respected economist with the libertarian Cato Institute, puts it in an email, the CBO “has a number-crunching role that gives the bureaucracy a lot of power to aid or hinder legislation, so it is very important for Republicans to select a director who understands the economic consequences of excessive spending and punitive tax rates.”

Heck, it’s not just “very important” to put in a good person at CBO (and JCT). As I’ve written before, it’s a test of whether the GOP has both the brains and resolve to fix a system that’s been rigged against them for decades.

So what will happen? I’m not sure, but Roll Call has a report on the behind-the-scenes discussions on Capitol Hill.

Flush from their capture of the Senate, Republicans in both chambers are reviewing more than a dozen potential candidates to succeed Douglas W. Elmendorf as director of the Congressional Budget Office after his term expires Jan. 3. …The appointment is being closely watched, with a number of Republicans pushing for CBO to change its budget scoring rules to use dynamic scoring, which would try to account for the projected impact of tax cuts and budget changes on the economy.

So who will it be? The Wall Street Journal weighs in, pointing out that CBO has been a tool for the expansion of government.

…the budget rules are rigged to expand government and hide the true cost of entitlements. CBO scores aren’t unambiguous facts but are guesses about the future, biased by the Keynesian assumptions and models its political masters in Congress instruct it to use. Republicans who now run Congress can help taxpayers by appointing a new CBO director, as is their right as the majority. …The Tax Foundation’s Steve Entin would be an inspired pick.

I disagree with one part of the above excerpt. Steve Entin is superb, but he would be an inspired pick for the Joint Committee on Taxation, not the CBO.

But I fully agree with the WSJ’s characterization of the budget rules being used to grease the skids for bigger government.

In a column for National Review, Dustin Siggins writes that Bill Beach, my old colleague from my days at the Heritage Foundation, would be a good choice for CBO.

…few Americans may realize  that the budget process is at least as twisted as the budget itself. While one man can’t fix it all, Republicans who want to be taken seriously about budget reform should approve Bill Beach to head the Congressional Budget Office (CBO). Putting the right person in charge as Congress’s official “scorekeeper” would be an important first step in proving that the party is serious about honest, transparent, and efficient government. …CBO has several major structural problems that a new CBO director should fix.

Hmm… Entin at JCT and Beach at CBO. That might even bring a smile to my dour face.

But it doesn’t have to be those two specific people. There are lots of well-regarded policy scholars who could take on the jobs of reforming and modernizing the work of JCT and CBO.

But that will only happen if Republicans are willing to show some fortitude. And that means they need to be ready to deal with screeching from leftists who want to maintain their control of these institutions.

For example, Peter Orszag, a former CBO Director who then became Budget Director for Obama (an easy transition), wrote for Bloomberg that he’s worried GOPers won’t pick someone with his statist views.

The Congressional Budget Office should be able to celebrate its 40th anniversary this coming February with pride. …The occasion will be ruined, however, if the new Republican Congress breaks its long tradition of naming an objective economist/policy analyst as CBO director, when the position becomes vacant next year, and instead appoints a party hack.

By the way, it shows a remarkable lack of self-awareness for someone like Orszag to complain about the possibility of a “party hack” heading up CBO.

In any event, that’s just the tip of the iceberg. I fully expect we’ll also see editorials very soon from the New York Times, Washington Post, and other statist outlets about the need to preserve the “independence” of CBO and JCT.

Just keep in mind that their real goal is to maintain their side’s control over the process.

P.S. There’s another Capitol Hill bureaucracy, the Congressional Research Service, that also generates leftist fiscal policy analysis. Fortunately, the CRS doesn’t have any scorekeeper or referee role, so it doesn’t cause nearly as much trouble. Nonetheless, any bureaucracy that produces “research” about higher taxes being good for the economy needs to be abolished or completely revamped.

P.P.S. This video explains the Joint Committee on Taxation’s revenue-estimating methodology. Pay extra attention to the section beginning around the halfway point, which deals with a request my former boss made to the JCT.

P.P.P.S. If you want to see some dramatic evidence that lower tax rates don’t necessarily lead to less revenue, check out this amazing data from the 1980s.

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In my writings on the Laffer Curve, I probably sound like a broken record because I keep warning that a nation should never be at the revenue-maximizing point.

That’s because there’s lots of good research showing that there are ever-increasing costs to the economy as tax rates approach that level.

So the question that policy makers should ask themselves is whether they’re willing to impose $10 or $20 of damage to the private sector in order to collect $1 of additional revenue.

New we have further evidence. Let’s take a look at a new study by economists from Spain, Arizona, and California. Here’s the issue they decided to study.

As top earners account for a disproportionate share of tax revenues and face the highest marginal tax rates, such proposals lead to a natural tradeoff regarding tax revenue. On the one hand, increases in tax revenue are potentially non-trivial given the income generated by high-income households. On the other hand, the implementation of such proposals would increase marginal tax rates precisely where they are at their highest levels, and thus where the individual responses are expected to be larger. Therefore, revenue increases might not materialise.

And here’s what they found.

…the increase in overall tax collections – including tax collections at the local and state level and from corporate income taxes – is much smaller: 1.6%. Figure 2 shows why. As τ increases there is a substantial decline in labour supply, the capital stock, and aggregate output across steady states. Aggregate output, for example, declines by almost 12% when τ = 0.13. Hence, the government collects taxes from a smaller economy… The message from these findings is clear. There is not much available revenue from revenue-maximising shifts in the burden of taxation towards high earners…and that these changes have non-trivial implications for economic aggregates.

The key takeaways from that passage are the findings about “a smaller economy” and the fact that there are “non-trivial implications for economic aggregates.”

That means less prosperity.

And the authors even acknowledge that the damage to the productive sector is presumably larger than what they found in this research.

…it is important to reflect on the absence of features in our model that would make our conclusions even stronger. First, we have abstracted away from human capital decisions that would be negatively affected by increasing progressivity. Since investments in individual skills are not invariant to changes in tax progressivity, larger effects on output and effective labour supply – relative to a case with exogenous skills – are to be expected. Second, we have not modelled individual entrepreneurship decisions and their interplay with the tax system. Finally, we have not modelled a bequest motive, or considered a dynastic framework more broadly. In these circumstances, it is natural to conjecture that the sensitivity of asset accumulation decisions to changes in progressivity would be larger than in a life-cycle economy. Hence, even smaller effects on revenues would follow.

Richard Rahn’s latest column in the Washington Times also looks at this issue, reviewing the work of James Mirrlees, an economist who was awarded a Nobel Prize in 1996.

Back in 1971, a Scottish economist by the name of James A. Mirrlees wrote a groundbreaking paper, in which he attempted to answer the question of what an optimum income-tax regime would look like… Mr. Mirrlees had been an adviser to the British Labor Party, which supported the high tax rates in effect at that time. He did a careful analysis of the variation of people’s skills and the effect tax rates had on their incentives to earn. Much to his surprise, he found the optimum tax rate on high earners was about 20 percent… In his 1971 paper, Mr. Mirrlees concluded, “I must confess that I had expected the rigorous analysis of income taxation in the utilitarian manner to provide an argument for high tax rates. It has not done so.”

In other words, tax rates above 20 percent ultimately are self-defeating – even if you’re a statist and you want to maximize the size of the welfare state.

And there’s plenty of data from around the world on specific case studies that show the negative impact of class-warfare taxation, including research from the United States, Denmark, Canada, France, and the United Kingdom.

And here’s Part II of my video series on the Laffer Curve, which provides additional evidence.

P.S. If you want some good data showing why Krugman and other class warriors are wrong about tax rates, Alan Reynolds did a very good job of skewering their analysis.

P.P.S. The right tax rate is the one that finances the legitimate functions of government, and not one penny more.

P.P.P.S. Since we’re discussing the Laffer Curve and class-warfare taxation, it’s appropriate to share this very encouraging survey of economists. They were asked whether they agreed with the fundamental premise of Thomas Piketty’s work on inequality and taxation.

Wow. This is about as close as you can get to unanimous rejection as you can get.

By the way, even if 2-3 percent of economists are right, that still doesn’t justify Piketty’s policy prescriptions.

P.P.P.P.S. In addition to writing about taxation, Richard is the creator of the famous Rahn Curve.

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