Uncle Sam's Fantasy: Taxes Won't Affect Behavior

In revenue forecasts, Washington forgets that changes in tax rates make people act differently--in buying, hiring, and investing. This leads to disastrous goofs: overestimating gains from tax hikes and the losses from cuts

Senate Democrats have done President Clinton and the economy a great service by axing his BTU tax on energy, but if they want to save his Presidency--and the recovery--they will have to go further and kill the entire tax bill.

The adverse impact of the energy tax on the poor was clear enough to Clinton's advisers, who set aside 40% of the projected revenues to beef up welfare spending to compensate poor Americans for what they would pay. The Senate, concerned with the harm to employment in energy-intensive industries, such as airlines, aluminum, fertilizers, and steel, took this reasoning a step further. Adding up the lost payroll and income taxes, it was clear that the tax was a revenue loser. It made no sense to take on so many special interests for a tax that would cost the government more money than it would bring in.

Since the energy tax's projected revenues of $70 billion were a figment of the estimators' imaginations, newspaper reports that Senate Democrats are struggling to cobble together other taxes to plug the revenue hole are nonsensical. As the tax would have produced no net revenues, there is no hole to plug.

The sorry episode of the life and death of this tax is a prime example of the political damage and public confusion wrought by static revenue estimates. Congress' Joint Committee on Taxation (JCT) and the Treasury's Office of Tax Analysis (OTA) base revenue estimates on the assumption that taxes do not affect behavior, sales, employment, profits, or investment. Consequently, estimators always overestimate the revenue gains from a tax hike and the losses from a tax cut.

SHRINKING SHIPS. Indeed, static revenue estimates are a major cause of the budget deficit. The JCT and OTA keep loading the government up with revenue-losing tax hikes. Examples abound. Remember the luxury tax on yachts, furs, jewelry, and private airplanes? Well, the facts are in: Internal Revenue Service filings show that the resulting job losses alone have cost the government $2.40 for every $1 of revenue. The airplane tax is the most amazing of all. In fiscal 1991, it brought in a mere $53,000 in revenues but cost $5.1 million in unemployment outlays.

Another example is the repeal in the 1986 Tax Reform Act of the tax deferral for earnings reinvested in the shipping industry (Subpart F). Estimators expected an additional $40 million a year, but studies by the General Accounting Office and Evans Economics reveal this to be a fantasy. The tax devastated the U.S. shipping industry. The U.S. fleet tonnage shrank by 28% during 1986-91, while world tonnage rose 25%. The vanished 8,000 jobs have cost the Treasury $60 million a year in lost payroll and income taxes. When multiplier effects and lost state and local revenues are included, the annual cost of the tax rises to $160 million, or $4 lost for every $1 of projected revenue.

SLOW WRITE-DOWN. On occasion, tax estimators do more than ruin companies, industries, and the livelihoods of thousands of workers: They bring the country to the brink of ruin. The real estate provisions in the 1986 tax-

reform legislation cost the U.S. at least four times as much as the $60 billion tab for Desert Storm. The asset lives of commercial real estate properties were lengthened from 19 years to 31 years, which collapsed the present values of the properties. Passive investors were denied normal tax deductions, causing them to walk away from their investments. The 40% increase in the capital-gains tax guaranteed no one would hold on for the long haul.

Ignoring the obvious economic and financial effects of these provisions, the estimators expected to raise approximately $33 billion in new revenues. Instead, real estate values collapsed, pulling down banks, thrifts, and federally insured savings and loan deposits. The cost of the deposit insurance bailout ranges from $200 billion to $500 billion, depending on how it is measured. Simply put, the provisions cost the Treasury 6 to 15 times the projected revenues and are the main reason that the deficit exploded under President Bush. In addition, approximately $1 trillion in real estate values were wiped out, wreaking havoc on the state and local tax base.

Static revenue estimates have proven to be the worst kind of fraud, and it is amazing that no lawsuits have been filed. The JCT and the OTA claim it is too difficult to make the dynamic estimates that take into account the effects of taxes on behavior. No doubt this analysis would be difficult and imprecise, but an imprecisely right analysis is better than a precisely wrong one, as in the cases of yachts, shipping, and real estate.

Certainly, we do not need any more tax hikes that swell the deficit. Yet Clinton's plan is based on the same invalid methodology for producing revenue estimates that predicted Bush's 1990 tax increase would balance the budget. Clinton should note that, after Bush's budget deal was enacted, the Congressional Budget Office raised its five-year deficit projections six times by an average of $220 billion. Unless Clinton wants a bigger deficit, higher unemployment, rising inflation, and a currency crisis to boot, he should hope that special interests deep-six his entire tax bill.

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