Dynamic scoring is here to stay and it's huge

For the past year or so, I've been talking about how dynamic scoring was on track to fundamentally change the way the Congressional Budget Office evaluates legislative proposals. Today it was made official, as Ed Lazear notes in tomorrow's WSJ:

The House of Representatives on Tuesday adopted a rule that will change Washington and lawmaking for the better. When legislation is proposed, the Congressional Budget Office is tasked with estimating its fiscal consequences. In most cases, the CBO assumes there is no effect on economic growth, positive or negative. In the future, the House will instruct the CBO to take macroeconomic effects into account when estimating the cost of legislation.

With this, a long-time dream of supply-siders has been realized. It will surely mark a turning point in the economic history of the U.S. economy.

Predictably, some Democrats denounced the change. In my view, this issue should transcend politics because it is simply a question of basic economics. If you raise or lower taxes, you will change people's behavior. If these dynamics are not properly considered, then legislation can and most likely will suffer from negative and "unforeseen" consequences.

As Scott Hodges of the Tax Foundation today noted:

Dynamic scoring is not a plot to cut taxes without paying for them, rather it is an important tool for raising the tax IQ of members of Congress so that they understand the different effects that various tax increases or tax cuts have on the economy. The ultimate goal is to enact tax policies that improve the lives of all Americans, which won’t happen if we continue to protect Washington’s status quo.

Read the whole thing.

There is reason to be optimistic.

The CBO bombshell

In the world of public policy, the Congressional Budget Office's recent finding that Obamacare will weaken economic growth and reduce future employment is like an earthquake of magnitude 8. Finally, finally, the CBO has introduced dynamic assumptions into its models of how the economy responds to existing and proposed policies. (Supply siders have been waiting for this moment for decades.) Before, the CBO would assume that a 10% increase in tax rates would translate into a 10% increase in tax revenues. Now and forevermore, we hope, they will calculate how much the higher rate is likely to depress economic activity (e.g., higher marginal tax rates are likely to cause a reduction in the tax base that could offset all or part of the increase in tax rates). The CBO now acknowledges that Obamacare will hurt the economy because it creates incentives for people to work less. The phasing out of Obamacare subsidies will act as a new marginal tax on work, and whenever you raise taxes on some activity, you should expect to see less of it.

We've known about the higher marginal tax rates hidden within Obamacare's complexity for a long time. What's new is that they are now officially acknowledged by the CBO.

The back story of how this sea change came about can be found in a fascinating WSJ interview of Casey Mulligan, "The Economist Who Exposed Obamacare." Clip this story and file it away so you can show your descendants that you were there when the course of public policy and economic history changed for the better.

The chart above (from the Mulligan interview) is one answer to the question "Why has this been the weakest recovery ever?" Average marginal income tax rates have increased by 15% since 2008, from 40% to 46%, and will increase to 47% next year thanks to the ARRA's "stimulus" spending (over 75% of which consisted of income redistribution) and Obamacare. This comes on top of the huge increase in regulatory burdens occasioned by Dodd-Frank and Obamacare.

The average working-age person in the U.S. now faces the prospect of keeping only 54% of any additional income he or she earns. It's no wonder the economy has lost a lot of its vitality. Some workers today even face the harsh reality of keeping less income despite working and earning more (i.e., they will face marginal tax rates in excess of 100%). My own effective marginal tax rate is over 65%, and that is a powerful force that keeps me from working: I have no desire to hand over two-thirds of any additional income I make to the government.

A few excerpts from the interview:

... the CBO ... reported that by 2024 the equivalent of 2.5 million Americans who were otherwise willing and able to work before ObamaCare will work less or not at all as a result of ObamaCare.

Mr. Mulligan's empirical research puts the best estimate of the contraction at 3%.

... "implicit marginal tax rates" in ObamaCare make work less financially valuable for lower-income Americans. Because the insurance subsidies are tied to income and phase out as cash wages rise, some people will have the incentive to remain poorer in order to continue capturing higher benefits.

The good news, from a forward-looking perspective, is that CBO's new method of dynamic scoring will make tax cuts easier. Before, CBO assumed that tax cuts were automatic losers no matter what; now they will assume that tax cuts can help pay for themselves by increasing economic activity. The economy is crying out for tax reform—particularly a reduction in the grievously high corporate income tax rate. So with the relatively low level of the federal deficit these days and CBO's new dynamic scoring methodology, we could see some very positive changes (e.g., lower marginal tax rates for businesses) in the future. And that, in turn, could revitalize the outlook for economic growth.

More great budget news points to a supply side revival

Arguably, the most under-appreciated statistic today is the unprecedented and ongoing decline in federal government spending. In the 12 months ended January 2014, spending was 4.4% below the level of January 2013. Annual spending has not increased at all since mid-2009. We've lived through over four and a half years of zero net change in spending, and almost three years of steadily declining spending (spending peaked in Q1/11), and the sky has not fallen. Not only is this excellent news, but it is news that has proven to be the exact opposite of what was expected to happen. Spending was supposed to continue to rise for as far as the eye can see, by at least 4-5% per year. 

The still-prevailing Keynesian wisdom (will it ever be vanquished?) holds that a decline in spending relative to budgeted baselines of such magnitude would prove devastating to economic growth. But our new (new in the sense that classical economic thinking is making a dramatic comeback) understanding of how the economy works tells us that less government spending—especially when it comes from a very high level—is very good for the health of the economy. The chart above makes that point: the unemployment rate invariably declines as the level of government spending falls relative to GDP. Regardless of how the money is spent (most of it goes not for infrastructure but rather for transfer payments), the federal government cannot spend money as efficiently or as productively as the private sector. And regardless of how federal spending is financed (by borrowing or taxing), spending always requires taking money from the private sector. At current levels, the bulk of government spending is still a deadweight loss to the economy.

The chart above shows that spending has not increased since mid-2009, whereas revenues have increased a lot. The vast bulk of the increase in revenues has been organic: the result of an expanding tax base (more people working, higher incomes, higher corporate profits), and not the result of higher tax rates. 

Today Congress decided to suspend the debt ceiling until March 2015. Is that a big deal? No, because we no longer have a budget crisis. The federal budget deficit has fallen to a mere 3.3% of GDP, and that's not scary at all. If recent trends continue, the budget deficit could be less than $400 billion by the end of this year, and that would probably be only 2.5% of GDP.

The challenge going forward, at least for the next year or two, will NOT be to rein in spending in order to keep the deficit and the debt from exploding. It will be to reform our tax code, which has become Byzantine in its complexity and suffocating in its progressivity. We have applied so-called "austerity" to spending, and we have succeeded. Now we need to apply policies that represent genuine stimulus, and that means lower and flatter marginal tax rates with fewer deductions and subsidies. Reduced regulatory burdens would also be a huge help (hint: repeal or redesign Obamacare so that market forces are brought to bear on the problem instead of trying to solve things by government fiat).

The biggest problem we face today is that the economy is operating at only 90% of its capacity (see above chart). We need policies that grow the economy, and the best way to do that is to create incentives for the private sector to work harder and invest more. What better way than to slash corporate tax rates and marginal tax rates on incomes (which in many cases are approaching 50-60%)? It's almost a no-brainer, but hardly anyone gives tax reform a chance these days.

As I pointed out the other day, the prospects for tax reform have improved greatly with the CBO's new-found respect for the dynamic effects of changes in marginal tax rates. Tax reform that flattens the tax code by eliminating subsidies and deductions and lowers top marginal rates shouldn't be difficult at all to justify, since it could dramatically boost future economic growth.

Thanks to a huge decline in the burden of government spending and the CBO's introduction of dynamic scoring, supply-side economics is about to experience a long-overdue comeback. We'll probably have to wait for the November elections to see exactly how powerful and imminent this new dynamic is, but a new and healthier direction for policy should be evident even before then, and markets are excellent at discounting that sort of thing.

More on Romney's tax plan

In the heat of last Wednesday's debate, there was little opportunity for Romney to explain the key features of his tax plan. It was clear that Obama was totally unfamiliar with the details of Romney's plan, which is why he kept repeating that it equated to a $5 trillion tax cut for the rich. Since this is such a key issue—on which Obama's and Romney's plans differ tremendously—I want to point readers to John Cochrane's excellent discussion of "Dynamic Tax Scoring." In it he offers critical insights that are not too difficult for the layman to follow (unlike some economists' discussions):

Gov. Romney has proposed, at heart, a reduction in marginal rates, together with tightening of deductions. He hopes to make the latter large enough so that the program is revenue neutral, or at least deficit neutral when some spending cuts are included, and as close to neutral across the income distribution as possible.

... the point of a revenue-neutral, income-neutral tax reform is to permanently and predictably lower marginal rates, giving rise to incentives to work, save, invest, and increase economic growth over the long run.

[According to the Tax Foundation study] ... The Romney plan would raise actual and potential GDP by about 7.4 percent over a five to ten year adjustment period.

The Romney tax plan would recover nearly 60 percent of the static projected revenue cost due to economic growth, higher wages and employment, and higher tax collections on the higher incomes. To keep the reform revenue neutral, the government would only need base-broadeners equal to about 40 percent of the static cost.

... the original Tax Policy analysis of Romney's plan [the one Obama referred to] concluded that, since in their static analysis there weren't enough base broadeners, that Romney must have a secret plan to raise middle-income taxes. OK, but Obama's budget numbers don't even pretend to reduce deficits. So what sense does it make to say, Romney has a secret plan to raise taxes because we forecast a deficit, but Obama's plan has... a deficit? If we're going to hold plans to a deficit path and make up taxes to do it, shouldn't we see how both plans stack up on the same deficit path?

UPDATE: Here is a good article in the WSJ which discusses why Romney's proposal to cap deductions could be a brilliant idea.

By limiting the amount of deductions that any individual tax filer can take, Mr. Romney is avoiding this lobby-by-lobby warfare. He'd let individual taxpayers decide which deductions they want to take up to the limit. In effect, the deductions would compete with one another as taxpayers decided which one was most important to them.