Revised August 24, 2006
A SHORT GUIDE TO DYNAMIC SCORING
by Jason Furman
In recent years, official
scorekeepers and academic researchers have devoted increased attention to the
macroeconomic effects of tax cuts. The Treasury also conducted a “dynamic
analysis” of the President’s tax cuts that was included in this year’s
Mid-Session Review of the budget as well as in a separate Treasury report.
The results of much of this work indicate that tax cuts can have positive or
negative effects on the economy, with the “sign” of the effects depending on a
number of variables, the most important of which is whether and how the tax cuts
are paid for.
The Congressional Budget
Office, the Joint Committee on Taxation (JCT), and academic researchers have all
have found that tax cuts that are not accompanied by offsetting revenue
increases or spending reductions — and are financed by borrowing instead — can
harm the economy over the long term. The research, including the
Administration’s own analysis, also indicates that even if tax cuts are paid
for, the economic benefits generally are relatively modest, with any increased
revenues that result from stronger economic growth offsetting only a small
fraction of what conventional cost estimates indicate the tax cuts will cost.
This short guide to dynamic
scoring makes six points:
and Treasury tax estimates already include “dynamic” scoring components.
The official cost estimates that the Treasury and Congress’ Joint Committee on
Taxation produce for tax-cut legislation are “dynamic” scores in that they
incorporate changes in behavior that are expected to occur as a result of the
proposed tax cuts. Such behavioral reactions include, for instance, changes
expected in the timing of the capital gains realizations and changes in the
form of compensation (e.g., from benefits to wages or vice versa). At the
same time, the official cost estimates do not assume that major macroeconomic
conditions like GDP and employment will be altered by tax changes.
Tax cuts do not pay for
themselves. Economists of all stripes have consistently found that tax
cuts do not generate enough growth to fully pay for themselves. In fact, cost
estimates that incorporate macroeconomic feedback from tax cuts are reasonably
close to conventional cost estimates that ignore such feedback. For example,
two recent dynamic-scoring estimates by CBO showed that the President’s
proposal to make the 2001 and 2003 tax cuts permanent, together with the
President’s other tax and spending proposals, would cost anywhere from 3.9
percent less to 0.4 percent more than the conventional cost estimates. This
represents only a small margin of difference from the conventional cost
estimates. The Administration’s own estimates published in the Mid-Session
Review indicate that, even with favorable assumptions, dynamic feedback would
pay for less than 10 percent of the cost of making the tax cuts permanent.
(See box on page 5.)
The long-run macroeconomic
effects of tax cuts can be either positive or negative, depending on how and
when they are paid for. The most critical assumption in an economic model
is how and when tax cuts are paid for. Generally research has found that tax
cuts that are not accompanied by other tax increases or spending cuts — such
as the tax cuts that have been enacted in recent years — will increase the
deficit, reduce national savings, and ultimately reduce economic growth. In
contrast, tax cuts that are paid for contemporaneously can contribute to
economic growth. In neither case are the economic effects very large.
The particular models and
assumptions used by the Joint Committee on Taxation and the Congressional
Budget Office generally find that income tax cuts are more beneficial — or
less harmful — in the short run than the long run. The particular models
and assumptions generally used by JCT and CBO often show modestly positive
effects of income tax cuts in a five- or ten-year period, due in part to
initial stimulus effects, but then show these gains being dissipated or even
reversed in the long run, as the adverse effects of deficit-financing the tax
cuts in the years following their enactment gradually take hold.
You cannot use actual revenue levels from particular years to estimate
macroeconomic feedback effects. Some have argued that positive revenue
surprises in one or two years are evidence of major dynamic scoring effects.
This claim ignores the fact that federal revenues are highly volatile and can
swing from year to year for a variety of reasons unrelated to tax cuts. Over
the past 25 years, actual revenues in a given year have averaged $150 billion
(in today’s terms) above or below the revenue levels that CBO predicted a year
In contrast, even an
optimistic reading of the dynamic effects of the 2003 dividend and capital
gains tax cuts would lead to an estimate of less than $5 billion in added
revenue, relative to the conventional estimates of the costs of these tax
cuts. It thus makes little sense to use data from one or two years to claim
extraordinary dynamic scoring effects for tax cuts.
Moreover, in the 1990s, tax
revenues exceeded expectations in the years that followed large tax
increases. And revenues fell well below expectations in the years of this
decade that followed large tax cuts. Differences between the revenue
forecasts that were made and the subsequent, actual revenue levels could as
easily be used to construct a case that tax cuts have dynamic effects that
harm the economy and slow revenue growth as to construct the rosy case that
tax-cut proponents make.
Distributional analysis of
tax cuts should incorporate the same financing assumptions as dynamic analysis
of tax cuts’ costs. All tax cuts must be paid for eventually, since it is
not possible to explode the deficit and debt without limit. Macroeconomic
models make a variety of assumptions about how tax cuts will be paid for.
These same assumptions should be used in presenting distributional analysis of
For example, some analyses that
show positive economic effects from the recent tax cuts use the assumption
(without highlighting it) that the tax cuts will be fully paid for with
across-the-board reductions in benefits and transfer payments, including Social
Security and Medicare. Whatever assumptions are made in assessing economic
impacts also should be used in assessing the distributional impact that tax cuts
would have. Some tax-cut proponent use models that assume the tax cuts are paid
for when claiming positive dynamic effects, but then use distributional
estimates that are based on the assumption that the tax cuts are not paid for
and are essentially a “free lunch.”
Click here for the full analysis.