Did the Supply Siders Just Get Sideswiped?
Are supply-side economists and Keynesians living on the same planet? It's hard to tell from their wildly different readings of a Congressional Budget Office analysis of President George W. Bush's 2004 budget proposal. The office's Mar. 25 report concluded that the Bush plan, as originally proposed, would produce deficits totaling $1.2 trillion over the next five years -- even after taking into account the impact of the budget on economic growth.
Keynesian economists, who are more skeptical of the benefits of low taxes, read the CBO's report as a crushing blow to supply siders. The Democratic Leadership Council even issued a statement arguing that the CBO's study "pretty much pronounced the death of...supply-side economics." Not so quick, say supply siders. They claim the CBO analysis supports their argument that lowering taxes -- especially on dividends -- would unleash stronger economic growth. They blame spending increases and other tax breaks that aren't growth-oriented for creating a large share of the projected deficits.
Spinmeisters on both sides are guilty of exaggeration, though the CBO study has provided more support for critics of the Bush budget. What's more important is that the CBO's report is a watershed in budgetary analysis. For the first time since its inception in 1975 as a nonpartisan adviser to Congress on budget matters, the CBO estimated how budget decisions would affect the economy. Called dynamic analysis, the process injected some economic realism into a budgeting process that has come to resemble a sterile and artificial accounting exercise.
Dynamic analysis stands in sharp contrast to the CBO's usual method of static analysis. In the latter, the CBO projects surpluses or deficits by pretending that the various tax and spending measures in the budget won't have any effect on the overall economy. For instance, it ignores the possibility that a tax cut will stimulate more economic activity. Static scoring has helped Congress avoid paralyzing debates between warring economic camps because it leaves out the impact tax cuts have on the broader economy.
Laudably, dynamic analysis does take into account the economic impact of budget decisions. For years, supply siders have lobbied the CBO and its sister panel, the Joint Committee on Taxation, which analyzes tax bills, to use this method. Their goal is to increase the supply of labor and capital through tax cuts -- and dynamic analysis is the best way to measure their effect, they argue. They figure that tax cuts would be easier to pass if Congress could see that they at least partially paid for themselves by stimulating economic growth. The tax committee is about to begin dynamic analysis of tax bills at the request of House leaders.
The CBO's pioneering effort was led by Douglas J. Holtz-Eakin, a respected economist with supply-side leanings who was most recently chief economist of the President's Council of Economic Advisers and is on leave from Syracuse University. Yet he's the first to admit that dynamic analysis is a work in progress. "What we did is a first step, not the final word," he says. "I believe there are virtues to policymakers' thinking through the economic impacts of their policies."
For now, the CBO's study does appear to be a setback for supply siders, who had hoped that dynamic analysis would make the Bush budget look better than traditional static analysis did. In fact, its impact was quite small and not necessarily positive. Under static analysis, the CBO had estimated that -- including the Bush tax-cut proposal -- the cumulative federal deficit for the next five years would be $1.16 trillion, vs. less than $400 billion under the baseline assumption of no changes in tax and spending policies. Using dynamic analysis, the CBO concluded that the deficit would be at best a little smaller than the static outcome ($1.04 trillion) and at worst a little larger ($1.24 trillion).
Supply siders have a ready explanation for why the Bush budget came off rather poorly in the CBO's analysis. They say that growth-enhancing tax cuts, such as the elimination of taxes on most dividends, are offset by the parts of the Bush plan that could hurt growth. Examples: targeted tax cuts such as refundable credits for health insurance, which wouldn't stimulate the labor supply, and spending increases such as the Medicare prescription-drug benefit. "This simply makes the case that the Democrats' idea of just spending more money is the most cockamamie idea of all," says Stephen Moore, president of the Washington-based Club for Growth.
Supply siders have a harder time swallowing another conclusion of the CBO's study -- namely, that increased government borrowing as a result of Bush's deficits would "crowd out" private-sector borrowing, ultimately harming consumers. Gary Robbins, president of supply-side-oriented consultant Fiscal Associates, argues that there would be no crowding out because the U.S. can import all the capital it needs.
Trouble is, importing more foreign capital obligates the U.S. to send dividends and interest to foreign investors, says William G. Gale, a senior fellow at the Brookings Institution. That's money that won't be available for domestic needs. Harvard University economist Dale W. Jorgenson, who generally favors tax cuts, says "the weight of professional opinion" is against the supply siders' position on crowding out. Adding insult to injury, the CBO says that the biggest contribution to growth will be ordinary Keynesian stimulus to the demand side of the economy. That is, cutting taxes will give people more to spend, revving up the economy and putting people back to work.
Set aside the heated debate, and the main value of the CBO's dynamic analysis is to end the fiction that budgeting is purely an accounting exercise without economic repercussions. Sensibly, the CBO didn't try to produce a single number for the budget deficits that would result from Bush's budget package -- a technique called dynamic scoring. Instead, it used dynamic analysis, which offers a range of scenarios. This serves as a supplement to the traditional static analysis -- and not as a replacement.
A good next step would be for the CBO and other forecasters to make dynamic analysis even more dynamic by incorporating more factors into its econometric models. The New Economy is predicated on a surge of productivity growth coming from entrepreneurship, technology, and globalization. To capture that, the CBO should try to predict what's called total factor productivity, the kind of growth made possible by inventions and new ways of working. The models used today by the CBO treat total factor productivity as fundamentally unpredictable.
Holtz-Eakin is interested in challenging such assumptions. He is eager to explore how government policy affects total factor productivity growth. He has the qualifications: As an academic, he conducted groundbreaking research on how tax rates affect entrepreneurship. "In the '90s, there was a productivity boom that is missed in these models," he says. "Going forward, you'd want to make every effort to understand that better."
That sort of humility is warranted in any economic prediction, especially one that spans 10 years.
By Peter Coy in New York