The dynamic duo of dynamic revenue estimating

Jack Kemp
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Posted: Feb 13, 2006 9:05 AM

Vice President Dick Cheney is energetically carrying the supply-side banner forward by insisting the bureaucrats perform "dynamic analysis" to properly estimate the effects of changing federal tax policy. In his address to the Conservative Political Action Conference in Washington recently, Cheney began to push back against decades of bureaucratic inertia  when he put the bureaucracy on notice that the days of "static analysis" are coming to an end:

"The president's tax policies have strengthened the economy, as we knew they would.  And despite forecasts to the contrary, the tax cuts have translated into higher federal revenues.  To take just one example, in 2003 the Joint Committee on Taxation in the Congress projected, or scored, a fall-off in capital gains tax revenues in 2004 and 2005.  In fact, since the 2003 capital gains tax rate was reduced to 15 percent, tax revenues from capital gains have been up substantially."

 Back at the White House, President Bush set into motion a re-examination of the bureaucracy's estimating methods by requesting $513,000 from the Congress to establish a six-person office at the Treasury Department to subject major tax proposals to dynamic analysis. At the Treasury Department, a statement was released saying, "Dynamic analysis, which incorporates the full gamut of behavioral responses, including how tax policy changes affect total output, has the advantage of emphasizing the economic benefits of many of the president's tax policy initiatives."

Bravo!  After decades of the Washington Establishment's ignoring the dynamic effects of tax policy changes on the economy, the Bush administration has finally made a commitment to getting economic and revenue estimates correct. As the Treasury statement pointed out, "Dynamic analysis will also help frame the public dialogue on tax reform by highlighting its economic benefits."

To appreciate just how wrong Washington bureaucrats have been over the years with their static revenue estimating methodology, check out the section on dynamic scoring at the Web site of the Institute for Policy Innovation, which houses more than 40 examples of dynamic scoring in action.

Consider a few of the more outrageous instances.  One infamous episode occurred during the last major tax reform in 1986, when the tax rate on capital gains was increased from 20 percent to 28 percent.  Congressional revenue estimators hugely overestimated capital gains revenues because their static analysis failed to take into account investors' behavioral response to the hike in the tax rate.  Not only did capital gains revenues not increase as much as the Joint Committee on Taxation estimated, they actually declined.

  The source of the error was the Congressional Budget Office's static assumption that the rate at which investors realized capital gains would not be adversely affected by the tax hike.  As a result, CBO overestimated capital gains realizations by $527 billion between 1989 and 1992.  By 1992, CBO's estimate of capital gains realizations was off by almost 60 percent annually, $287 billion vs. actual realizations of only $118 billion.

Congressional bureaucrats repeated their static-analysis fallacy in reverse when the Joint Committee on Taxation estimated the effects of the 1997 reduction of the top capital gains tax rate back down to 20 percent from 28 percent.  The JCT projected that tax rate reduction would "cost" the government $21 billion over 10 years.  In fact, capital gains tax revenue went through the roof, rising from $62 billion in 1996 to more than $100 billion in 1999.

The absurdity of static revenue analysis was best illustrated in 1988, when former Sen. Robert Packwood, R-Ore., then ranking Republican on the Senate Finance Committee, requested the JCT to estimate what would happen if the federal government levied a 100 percent tax on all income over $200,000 annually.  The JCT revenue estimators cranked up their goofy static-revenue-estimating machine and concluded that such a confiscatory tax would raise $104 billion the first year, $204 billion the second year, $232 billion the third year, and $263 billion and $299 billion in the fourth and fifth years, respectively. Packwood pointed out the irrationality of the JCT's assumptions when he observed that the JCT's calculation "assumes people will work if they have to pay all their money to the government ... when clearly anyone in their right mind will not."

 President Bush has started the ball rolling. I urge House Majority Leader John Boehner and Speaker Dennis Hastert to instruct the Congressional Budget Office and the Joint Committee on Taxation to scrap static analysis and replace it with a dynamic analysis that takes into account how people respond to incentives and disincentives to work, save, invest and take entrepreneurial risks.