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Posts Tagged ‘Static Scoring’

I’ve written several times about the importance of appointing sensible people to head the Congressional Budget Office (CBO) and Joint Committee on Taxation (JCT). Heck, making reforms to these Capitol Hill bureaucracies is a basic competency test for Republicans.

That’s because CBO and JCT are the official scorekeepers when politicians consider changes in fiscal policy and it has a big (and bad) impact if they rely on outdated methods and bad analysis.

The CBO, for instance, puts together economic analysis and baseline forecasts of revenue and spending, while also estimating what will happen if there are changes to spending programs. Seems like a straightforward task, but what if the bureaucrats assume that government spending “stimulates” the economy and they fail to measure the harmful impact of diverting resources from the productive sector of the economy to Washington?

The JCT, by contrast, prepares estimates of what will happen to revenue if politicians make various changes in tax policy. Sounds like a simple task, but what if the bureaucrats make the ridiculous assumption that tax policy has no measurable impact on jobs, growth, or competitiveness, which leads to the preposterous conclusion that you maximize revenue with 100 percent tax rates?

Writing for Investor’s Business Daily, former Treasury Department officials Ernie Christian and Gary Robbins explain why the controversy over these topics – sometimes referred to as “static scoring” vs “dynamic scoring” – is so important.

It is Economics 101 that many federal taxes, regulations and spending programs create powerful incentives for people not to work, save, invest or otherwise efficiently perform the functions essential to their own well-being. These government-induced changes in behavior set off a chain reaction of macroeconomic effects that impair GDP growth, kill jobs, lower incomes and restrict upward mobility, especially among lower- and middle-income families. …Such measurements are de rigueur among credible academic and private-sector researchers who seek to determine the true size of the tax and regulatory burden on the economy and the true value of government spending, taking into account the economic damage it often causes.

But not all supposed experts look at these second-order or indirect effects of government policy.

And what’s amazing is that the official scorekeepers in Washington are the ones who refuse to recognize the real-world impact of changes in government policy.

These indirect costs of government, in particular or in total, have not been calculated and disclosed in the Budget of the United States or in analyses by the Congressional Budget Office. The result of this deliberate omission by Washington has been to understate many costs of government, often by more than 100%, and grossly overstate its benefits. …It is on this foundation of disinformation that the highly disrespected, overly expensive and too often destructive federal government in Washington has been built.

Christian and Robbins look specifically at the direct and indirect costs of the income tax.

The income tax is a two-part tax, one acknowledged and one deliberately concealed. First, almost $2 trillion of income tax is collected by the IRS for government to spend for presumably beneficial purposes. Then there is the tax-induced economic damage, a stealth tax, indirectly picked from people’s pockets in the form of fewer jobs and lower incomes. This stealth tax is $3.2 trillion each year. …economists often refer to the stealth tax as a deadweight loss. …When the $2 trillion of income tax taken directly out of the economy by the IRS is added to the $3.2 trillion of indirect economic cost, the total private-sector cost of the income tax is $5.2 trillion — and the government has only $2 trillion of income tax revenues to spend in trying to repair the damage.

By the way, I must disagree with the last part of this excerpt.

Government doesn’t “repair the damage” of high taxes when it spends money. Most of the time, it exacerbates the damage of high taxes by spending money in ways that further weaken the economy.

Let’s now get back to the part of the editorial that I like. Ernie and Gary make the very important point that some taxes do more damage than others.

…when the IRS collects a dollar of income tax from corporations, the damage to the overall economy is about $4. Similarly, a dollar of tax on capital gains sets off a ripple effect that does about $6 of damage. Poison pills such as capitalizing (instead of expensing) the job-creating cost of machinery and equipment, taxing dividends, double-taxing personal saving and imposing high tax rates result in stealth taxes ranging from $3 to $8 per dollar of revenues. …Low tax rates do less damage to economic growth per dollar of revenues raised and are preferable to high tax rates, which have the opposite effect.

Here’s a chart based on their analysis.

I’m not overly fixated on their specific estimates. Even good economists, after all, have a hard time making accurate forecasts and correctly isolating the impact of discrete policies on overall economic performance. Moreover, it’s very difficult to factor in the economic impact of America’s tax-haven policies for foreign investors, which help offset the damage of high tax burdens on American citizens.

But Christian and Robbins are completely correct about certain taxes doing more damage than other taxes.

And the lesson they teach us is that the tax bias against saving and investment is extremely destructive.

And the less fortunate are particularly disadvantaged when bad methodology at CBO and JCT perpetuates bad policy.

…it is self-defeating and harmful to require that tax reforms always be revenue neutral in a near-term static sense. Imagine a tax reform that initially costs the IRS $1. Through economic growth, it promptly increases taxable income and well-offness by $2.50. At an average tax rate of 20%, the reform-induced $2.50 increase in taxable income at the outset recoups only 50 cents of the initial $1 cost to the IRS, thereby leaving the IRS 50 cents short in the near term. But who in the White House or Congress would refuse to make mostly lower and middle-income families $2.50 better off at a cost of only 50 cents to Washington’s already overflowing coffers?

The final sentence of the excerpt hits the nail on the head.

I’ve previously cited academic research and expert analysis to show that it is pointlessly punitive to raise tax rates if the damage to the private sector is several times greater than the additional revenue collected by government.

Yet there are plenty of examples of this type of short-sighted analysis, such as Obama’s proposal to expand the Social Security payroll tax (see the 6:43-7:41 section of this video)

And if you like videos, I have a three-part series on the Laffer Curve which is part of this post offering a lesson from the 1980s for Barack Obama.

The bottom line is that we’ll continue to get bad analysis and bad numbers if Republicans aren’t smart enough to clean house at CBO and JCT.

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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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Alan Blinder has a distinguished resume. He’s a professor at Princeton and he served as Vice Chairman of the Federal Reserve.

So I was interested to see he authored an attack on the flat tax – and I was happy after I read his column. Why? Well, because his arguments are rather weak. So anemic that it makes me think there’s actually a chance to get rid of America’s corrupt internal revenue code.

There are two glaring flaws in his argument. First, he demonstrates a complete lack of familiarity with the flat tax and seemingly assumes that tax reform simply means imposing one rate on the current system.

Here’s some of what he wrote in a Wall Street Journal column.

Many useful steps could be taken to simplify the personal income tax. But, contrary to much misleading rhetoric, flattening the rate structure isn’t one of them. The truth is that 100% of the complexity inheres in the definition of taxable income, which takes up millions of words in the tax laws. None inheres in the progressive rate structure. If you don’t believe that, consider the fact that the corporate income tax is virtually flat once a corporation passes a paltry $75,000 in taxable income. Is it simple? Back to the personal tax. Figuring out your taxable income can be quite an effort. But once that is done, most taxpayers just look up their tax bill on an IRS-provided table. Those with incomes above $100,000 must perform a simple calculation that involves multiplying two numbers together and adding a third. A flat tax with an exemption would require precisely the same sort of calculation. The net reduction in complexity? Zero.

I can understand how an average person might think the flat tax is nothing more than applying a single tax rate to the current system, but any public finance economist must know that the plan devised by Professors Hall and Rabushka completely rips up the current tax system and implements a new system based on one tax rate with no double taxation and no loopholes.

Heck, the Hall/Rabushka book is online and free of charge. But Blinder obviously could not be bothered to understand the proposal before launching his attack.

What about his second mistake? This one’s a doozy. He actually assumes that taxable income is fixed, which is a remarkable error for anyone who supposedly understands economics.

…flattening the rate structure won’t make the tax code any simpler. It would, however, make the tax system far less progressive. Do the math. …Someone with $20 million in taxable income pays nearly $7 million in taxes under the current rate structure, with its 35% top rate. Replace that with a 23% flat tax, and the bill drops to just under $4.6 million.

In other words, he assumes that people won’t change their behavior even though incentives to engage in productive behavior are significantly altered.

In a previous post, I showed how rich people dramatically increased the amount of income they were willing to earn and report after Reagan lowered the top tax rate from 70 percent to 28 percent.

To Blinder, this real-world evidence doesn’t matter – even though the rich paid much more tax to the IRS after Reagan slashed tax rates.

For more information, here’s my flat tax video.

And here’s the video on the global flat tax revolution. Interestingly, there are now about five more flat tax jurisdictions since this video was made – though Iceland abandoned its flat tax, so there are some steps in the wrong direction.

Makes you wonder. If the flat tax is such a bad idea, why are so many nations doing so well using this simple and fair approach?

But be careful, as this cartoon demonstrates, simplicity can mean bad things if the wrong people are in charge.

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One of my frustrating missions in life is to educate policy makers on the Laffer Curve.

This means teaching folks on the left that tax policy affects incentives to earn and report taxable income. As such, I try to explain, this means it is wrong to assume a simplistic linear relationship between tax rates and tax revenue. If you double tax rates, for instance, you won’t double tax revenue.

But it also means teaching folks on the right that it is wildly wrong to claim that “all tax cuts pay for themselves” or that “tax increases always mean less revenue.” Those results occur in rare circumstances, but the real lesson of the Laffer Curve is that some types of tax policy changes will result in changes to taxable income, and those shifts in taxable income will partially offset the impact of changes in tax rates.

However, even though both sides may need some education, it seems that the folks on the left are harder to teach – probably because the Laffer Curve is more of a threat to their core beliefs.

If you explain to a conservative politician that a goofy tax cut (such as a new loophole to help housing) won’t boost the economy and that the static revenue estimate from the bureaucrats at the Joint Committee on Taxation is probably right, they usually understand.

But liberal politicians get very agitated if you tell them that higher marginal tax rates on investors, entrepreneurs, and small business owners probably won’t generate much tax revenue because of incentives (and ability) to reduce taxable income.

To be fair, though, some folks on the left are open to real-world evidence. And this IRS data from the 1980s is particularly effective at helping them understand the high cost of class-warfare taxation.

There’s lots of data here, but pay close attention to the columns on the right and see how much income tax was collected from the rich in 1980, when the top tax rate was 70 percent, and how much was collected from the rich in 1988, when the top tax rate was 28 percent.

The key takeaway is that the IRS collected fives times as much income tax from the rich when the tax rate was far lower. This isn’t just an example of the Laffer Curve. It’s the Laffer Curve on steroids and it’s one of those rare examples of a tax cut paying for itself.

Folks on the right, however, should be careful about over-interpreting this data. There were lots of factors that presumably helped generate these results, including inflation, population growth, and some of Reagan’s other policies. So we don’t know whether the lower tax rates on the rich caused revenues to double, triple, or quadruple. Ask five economists and you’ll get nine answers.

But we do know that the rich paid much more when the tax rate was much lower.

This is an important lesson because Obama wants to run this experiment in reverse. He hasn’t proposed to push the top tax rate up to 70 percent, thank goodness, but the combined effect of his class-warfare policies would mean a substantial increase in marginal tax rates.

We don’t know the revenue-maximizing point of the Laffer Curve, but Obama seems determined to push tax rates so high that the government collects less revenue. Not that we should be surprised. During the 2008 campaign, he actually said he would like higher tax rates even if the government collected less revenue.

That’s class warfare on steroids, and it definitely belong on the list of the worst things Obama has ever said.

But I don’t care about the revenue-maximizing point of the Laffer Curve. Policy makers should set tax rates so we’re at the growth-maximizing level instead.

To broaden the understanding of the Laffer Curve, share these three videos with your friends and colleagues.

This first video explains the theory of the Laffer Curve.

This second video reviews some of the real-world evidence.

And this video exposes the biased an inaccurate “static scoring” of the Joint Committee on Taxation.

And once we educate everybody about the Laffer Curve, we can then concentrate on teaching them about the equivalent relationship on the spending side of the fiscal ledger, the Rahn Curve.

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Greetings from frigid Minnesota. I’m in this misplaced part of the North Pole to testify before both the Senate and House Tax Committees today on issues related to the Laffer Curve.

In other words, I will be discussing how governments should measure the revenue impact of changes in tax policy – what is sometimes known as the dynamic scoring vs static scoring debate.

Most governments, including the folks in Washington, assume that tax policy has no impact on the economy. As such, it is relatively easy to measure how much revenue will rise or fall when tax policy is altered. After all, there are only two moving parts – tax rates and tax revenue.

So if tax rates double, revenues climb by 100 percent. If tax rates are reduced by 50 percent, tax revenues drop by one-half.

This is a slight over-simplification, but it does capture the basics of conventional revenue estimating. And it also shows why “static scoring” is deeply flawed. In the real world, people respond to incentives. When tax rates rise and fall, people change their behavior.

When tax rates are punitive, for instance, people earn and/or declare less income to the government. And when tax rates are reasonable, by contrast, people earn and/or declare more income to the government. In other words, there are actually three moving parts – tax rates, tax revenue, and taxable income.

Figuring out the relationship of these three variables is known as “dynamic scoring” and it is much more challenging that static scoring, but it is much more likely to give lawmakers correct information.

It does not mean, by the way, that “tax cuts pay for themselves” or that “tax increases lose revenue,” as GOPers sometimes claim. That only happens in rare circumstances.

If you want to understand this issue and be more knowledgeable than 99 percent of the people in government (not very difficult, so don’t let it go to your head), watch this three-part series on the Laffer Curve.

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In the private sector, no business owner would be dumb enough to assume that higher prices automatically translate into proportionately higher revenues. If McDonald’s boosted hamburger prices by 30 percent, for instance, the experts at the company would fully expect that sales would decline. Depending on the magnitude of the drop, total revenue might still climb, but by far less than 30 percent. And it’s quite possible that the company would lose revenue. In the public sector, however, there is very little understanding of how the real world works. Here’s a Reuters story I saw on Tim Worstall’s blog, which reveals that Bulgaria and Romania both are losing revenue after increasing tobacco taxes.

Cash-strapped Bulgaria and Romania hoped taxing cigarettes would be an easy way to raise money but the hikes are driving smokers to a growing black market instead. Criminal gangs and impoverished Roma communities near borders with countries where prices are lower — Serbia, Macedonia, Moldova and Ukraine — have taken to smuggling which has wiped out gains from higher excise duties. Bulgaria increased taxes by nearly half this year and stepped up customs controls and police checks at shops and markets. Customs office data, however, shows tax revenues from cigarette sales so far in 2010 have fallen by nearly a third. …Overall losses from smuggling will probably outweigh tax gains as Bulgaria struggle to fight the growing black market, which has risen to over 30 percent of all cigarette sales and could cost 500 million levs in lost revenues this year, said Bezlov at the Center for the Study of Democracy. While the government expected higher income from taxes in 2010 it has already revised that to the same level as last year. “However, this (too) looks unlikely at present,” Bezlov added. Romania, desperately trying to keep a 20 billion-euro International Monetary Fund-led bailout deal on track, has a similar problem after nearly doubling cigarette prices in 2009 then hiking value added tax. Romania’s top three cigarette makers — units of British American Tobacco, Japan Tobacco International and Philip Morris — contributed roughly 2 billion euros to the budget in taxes in 2009, or just under 2 percent of GDP. They estimate about a third of cigarettes in Romania are smuggled and say this could cost the state over 1 billion euros.

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I know I’ve beaten this drum several times before, but the Wall Street Journal today has a very good explanation of why class-warfare tax policy will backfire. The Journal’s editorial focuses on what happened after the 2003 tax rate reductions. And below the excerpt, you’ll find a table I prepared showing what happened with tax revenues from the rich following the Reagan tax cuts. The simple message is that lower tax rates are the best way to soak the rich.
Congress’s Joint Committee on Taxation recently dropped a study claiming that millionaires will pay $31 billion of the $36 billion in revenue that it expects will be raised next year if tax rates rise as scheduled on January 1. …If you believe that, you probably also believed Joint Tax when it predicted that the rich would gain a huge tax windfall when tax rates were cut in 2003. Let’s go to the videotape. According to the most recent IRS data on actual tax payments, total revenues collected over the period 2003-07 were about $350 billion higher than Joint Tax and the Congressional Budget Office predicted when the 2003 tax cuts were enacted. Moreover, the wealthiest taxpayers paid a larger share of all income taxes from the beginning to the end of this period. The IRS data show that in 2003 those with incomes above $200,000 paid $313 billion in income tax. By 2007 they paid $610 billion. …Guess what income group paid the most in higher taxes after tax rates were cut? Millionaires. From 2003 to 2008, millionaires increased their tax payments to $249 billion from $132 billion. One reason for the big increase in payments: the number of returns declaring $1 million or more in income increased 76% to 319,000 from 181,000 as the economy expanded. The IRS data are a useful reminder of how dependent Uncle Sam is on the rich to pay the government’s bills. …We’re not saying that tax cuts “pay for themselves.” What we are saying is that the 2003 tax cuts proved again, as we should have learned in the 1960s and 1980s, that rich people are the most responsive to changes in tax rates. When tax rates are high, the wealthy invest less, hire accountants to protect more of their income from the IRS, and park more of their money in tax shelters, such as municipal bonds. …That’s why it’s a fantasy to think that raising income and capital gains and dividend tax rates on the rich is going to pry $31 billion out of millionaire households. History teaches that the best way to soak the rich and reduce the deficit is to promote rapid economic growth. But that’s less likely to happen in 2011 if the economy is rear-ended with the biggest tax increase in at least 16 years.

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