October 15, 2014
Matt O’Brien had a good discussion in Wonkblog of dynamic scoring of budget proposals, the holy grail of conservatives everywhere. The idea of dynamic scoring is that people respond to changes in incentives. This means that lower tax rates can lead to more growth and therefore more tax revenue to offset the cost of tax cuts.
O’Brien’s point is that this effect is real, but nowhere near as large as many conservatives like to claim. For example, it doesn’t mean that tax cuts will pay for themselves.
However O’Brien might have been a bit too generous to the dynamic scorers in his conclusion when he tells readers:
“But it could change the shape of the fiscal debate. Let’s go back to tax reform. Dave Camp, the Republican head of the Ways and Means Committee, put forward his own plan that was revenue neutral without any kind of big dynamic effects. The CBO said—in footnote 42 on page 30—that, if it had used dynamic scoring, this would have increased its revenue estimate by 0.5 percent of GDP. That’s real money, but not a crazy amount.”
That 0.5 percent of GDP figure (@$85 billion in today’s economy) seems a bit high. If we check this famous footnote we find:
“CBO’s reading of the evidence about how the supply of labor responds to changes in tax rates suggests that such a substantial cut in the tax rate would probably increase the labor supply by 2 percent or less. …Tax restructuring could also boost the capital stock by reducing the effective marginal tax rate on capital income, which would encourage saving, and by generating higher earnings by workers, which would also boost saving. If those effects together increased the long-term capital stock by an amount comparable to the increase in the labor supply, GDP would rise by 2 percent or less.An increase in GDP of that magnitude would boost federal tax revenues by less than half of 1 percent of GDP.”
In other words, the 0.5 percent of GDP figure is a maximum, not CBO’s central estimate. From the footnote it is clear that the central estimate is less than this amount, although it doesn’t directly provide a basis for determining a more precise figure.
Addendum:
CBO scores are generally done from the standpoint of an economy at full employment. This removes the possibility of a demand side effect. (That is not true for their short-term scores of proposals done in the context of an economy that has yet to recover from the downturn.)
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