A Way To Test-Drive Tax Policy

By William W. Beach

One of the most significant initiatives of President George W. Bush's 2007 budget proposal has gone virtually unnoticed. And no wonder: How could a move to improve the way the federal government analyzes tax policy compete with news about cutting outdated programs, making the U.S. more competitive, and winning the global war on terrorism?

This little-noted initiative, however, may be historically important. Buried deep in the President's proposals for the Treasury Dept. is a plan to create a Dynamic Analysis Div. within the Office of Tax Analysis. This unit would advise the President and key policymakers on how proposed changes to U.S. tax laws would affect economic activity. Inside the Beltway, this type of work is called "dynamic analysis." Outside the Beltway, this is called "economics."

So why is this news? Hasn't the government been studying the effects of tax policy on the economy all along? (That's the dynamic analysis part.) And aren't Washington policymakers routinely advised about how tax changes will affect jobs and output and how those, in turn, will affect government revenues? (That revenue-estimating function is called dynamic scoring.)

Surprisingly, the answer is often no. Until very recently, no official Washington agency produced estimates of the economic and tax-revenue effects of proposed policies. Congress' official tax-policy scorekeeper, the staff of the Joint Committee on Taxation (JCT), began building this capability a few years ago and since has produced a few dynamic scoring documents. Prior to that, JCT made static estimates or "scores" of how tax changes affect government revenues but didn't gauge effects on the broader economy.

The Congressional Budget Office also recently began publishing estimates of how the President's and Congress' budget plans (which include tax changes) would affect economic activity. However, all of these documents together still fit into a slim file folder. And so far the Treasury Dept. has done almost nothing publicly to contribute to that literature.

Unless policymakers can see that some tax policy changes support more vigorous economic activity while others do not, they may enact laws (indeed, they have) that are at best economically meaningless, at worst downright harmful. Dynamic analysis can help sort the good from the bad.

Take, for example, the child tax credit. Many advocates of the credit (now worth $1,000 per child) argued that it would put money into the hands of consumers, who would spend those funds, thus fueling economic activity. Had those policymakers been advised about the likely economic effects of this tax change, they would have learned that the credit would do nothing to lower the costs of working or investing, two of the biggest drivers of economic activity, and that cash windfalls almost always are saved, especially by taxpayers with children. There's nothing wrong with saving for a child's education, but it won't lead to the bump in current consumption that advocates of the child tax credit expected.

While that credit has not done very much, if anything, for today's economy (as dynamic analysis would have projected), the same cannot be said if you were to raise taxes to reduce the federal budget deficit. Advocates of such "revenue enhancements" appear to argue that tax increases won't affect economic activity but that growing budget deficits do. Standard models of the economy, however, show that income tax increases harm growth in employment, investment, output, savings, and even projected government revenues. They also show that deficits by themselves have little effect on interest rates. In short, raise taxes to reduce deficits, and the result will be higher unemployment, a slower pace of economic growth, and revenues that don't rise as quickly as static scoring predicted.

Dynamic analysis and scoring could help prevent bad tax policy from becoming law. Furthermore, reporting the economic consequences of tax proposals will be enormously helpful in redesigning the tax system. The President has called for fundamental tax reform, and he and Congress will find that a much easier exercise if routine and sophisticated dynamic scoring is in place whenever the task is tackled.

So congratulations to the Bush Administration and to the Treasury Dept. This key change in how tax policy is formulated could well be hidden gold in an otherwise indifferent budget.

William W. Beach is director of the Center for Data Analysis at the Heritage Foundation

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