Nell Henderson of the Washington Post reported today on the Treasury report released yesterday about financing the Bush Administration's tax cuts. Tax Cuts May Come At a Price, Study Says, Wash. Post, July 26, 2006, at D01. The report, A Dynamic Analysis of Permanent Extension of the President's Tax Relief, purports to apply a "dynamic" analysis that takes into account the effect of the tax change on the parameters being measured. Proponents of tax cuts have long pushed for such an approach, with some arguing that tax cuts can pay for themselves by pushing economic growth so high that tax revenues increase in spite of the cuts. The report itself begins with a rosy description of the economy, attributing what growth there is to the tax cuts with unequivocal language and describing what many consider relatively weak job growth over the past 5 year-period as "strong".
As evidenced by key economic indicators such as increased capital investment and Gross Domestic Product (GDP), and strong job growth, the President’s tax relief played an important role in strengthening the U.S. economy as it was coming out of the recent recession, and in the longer-term by increasing the after-tax rewards to work and saving. Lower tax rates enable workers to keep more of their earnings, which increases work effort and labor force participation. The lower tax rates also enable innovative and risk-taking entrepreneurs to keep more of what they earn, which further encourages their entrepreneurial activity. The lower tax rates on dividends and capital gains lower the cost of equity capital and reduce the tax biases against dividend payment, equity finance, and investment in the corporate sector. All of these policies increase incentives to work, save, and invest by reducing the distorting effects of taxes. Capital investment and labor productivity will thus be higher, which means higher output and living standards in the long run.
It certaintly is true that people who have to pay less in taxes will have more of their income to keep. But does this really mean brisk economic growth will result? The facts don't live up to the theory. Even this report, obviously intended to provide ammunition to support the Bush tax cuts that predominantly provide tax relief to the wealthy, suggests a best-case scenario--in which tax cuts are made permanent and are matched by comparable spending cuts--providing only a 0.7 percent rate of growth in economic activity. That would be nowhere near what is needed to fund the tax cuts.
And the assumptions about what produces that economic growth are not very heartening for ordinary Americans. For example, one possibility is that the reduction in income tax rates might act as an incentive for people to work more, putting in longer hours to add to productivity and thus paying higher taxes in spite of the lower rates. For ordinary Americans who make up the majority of the workforce and many of whom are already putting in long hours sometimes at two different jobs, working even longer hours likely has little allure. Much of American productivity has in fact been gained by longer hours worked, not more productive work per hour. That results in lesser quality of life for ordinary working Americans and does not bring the kinds of long-term sustainable broad-based economic growth that benefits everyone across the board.
The problem with dynamic analysis is that each component of fiscal policy is like a single item on a mobile--move one, and you likely move the others. But predicting in which direction the pieces will move is like solving the problem of the impact on an Illinois rose petal of a butterfly's flight in China. There is at least as much guesswork as there is science. See this 2002 Urban Institute discussion of Dynamic Scoring and Budget Estimation by Deborah Kobes and Jeff Rohaly. Where educated but subjective guesswork plays a major role, the result may be influenced by partisan pressure from higher ups. And, of course, dynamic scoring may well mask the true costs of tax cuts by making it look like they will pay for themselves. See this discussion of dynamic scoring.
Bush, of course, is convinced that dynamic analysis is the way to go. His budget proposal for 2007 proposed establishing a Treasury Division on Dynamic Analysis. I wonder if the 147 or so people laid off from the estate tax audit team will move over to Dynamic Analysis to figure out how to paint rosy scenarios for the way eliminating the estate tax on multimillionaires will cause the economy to take off in a new spurt of growth?