House Ways and Means Chair Dave Camp’s noble efforts to overhaul the U.S. tax system will reach a crescendo this week when he releases his tax reform plan. Unfortunately, over the last few years the merits of tax reform have been vastly oversold. So when Camp’s draft makes plain the harsh reality of tax reform, the high hopes of many will come tumbling down. His proposed reduction in tax rates will be too small and his scaling back of tax breaks will be too large for most lawmakers to support. Call 911 -- tax reform is flat-lining.
Die-hard tax reformers won’t give up easily. And some will be looking for an excuse for the failure to deliver. As a result, over the coming weeks you will repeatedly hear the argument that government scorekeepers should scrap their current estimating method and replace it with models that incorporate the growth effects of tax changes. If revenue estimates included growth effects from tax cuts, these "macroeconomic feedback effects" would offset the direct revenue costs of tax cuts. This would allow a revenue-neutral tax reform plan to have lower rates and less base broadening. And so tax reform would be much easier to get through Congress.
Well, here’s a prediction that’s one of the safest bets in town: Congress won’t revise the way it scores tax bills so that the estimates incorporate economic growth. That’s because what sounds good in theory—that is, that economists should do as thorough an analysis as possible—cannot be implemented in practice.
History is a useful guide here. When Newt Gingrich and conservative Republicans unexpectedly took control of the House of Representatives after the 1994 election, they were hellbent on cutting taxes and balancing the budget. Under congressional budget rules, official estimates of tax changes assumed that the overall economy was unaffected by taxes. This approach incensed and baffled conservatives, who took it as an article of faith that tax cuts increase economic growth. Because a growing economy increases tax receipts, when official estimators did not include this effect in their estimates, the new majority believed the bean counters were deliberately and consistently overestimating the cost of tax cuts.
To remedy this problem, they replaced the Democratic-appointed chiefs of the Joint Committee on Taxation and the Congressional Budget Office with tried-and-true Republican staffers. The first task of the replacements was to get to work on dynamic scoring. This would correct the errors of fixed-GDP estimation. And it would allow Republicans to fulfill one of the central tenets of the Contract With America.
But less than a week after the new Congress took office, a bit of the wind was taken out of the sails of the new majority. On January 9, 1995, Kenneth J. Kies, the JCT chief of staff, basically told his bosses that dynamic revenue estimation was not viable in practice.
Because of the complexity and lack of consensus as to the measurement of such macroeconomic effects, attempting to take macroeconomic consequences into account could undermine the credibility of the estimating process and render estimates less reliable.
Kies also pointed out that if tax proposals had to include macroeconomic effects, consistency would require that spending bills also get the same treatment.
Subsequently, the JCT spent years building macroeconomic models and developing the capability to measure the effect of taxes on the size of the economy. But this effort was solely for the purpose of conducting studies and providing background analyses that were not part of all-important official scorekeeping of tax legislation.
Over the years, the approach originally adopted by Kies, of reporting on macroeconomic effects but not incorporating them into estimates, has been endorsed by other Republican appointees. For example, in 2002 CBO Director Dan Crippen told the Ways and Means Committee, "Integrating dynamic scoring into the cost estimates would pose intractable problems." At the same hearing Glenn Hubbbard, chair of the Council of Economic Advisers, said, “It is straightforward to conduct a revenue estimate using existing methods and supplement these estimates with an impact statement that shows the macroeconomic consequences and the possible related revenue effects.”
It isn’t just the practical implementation problems that can disappoint Republican hopes for dynamic estimation. Although it is an article of faith that tax cuts and tax reform increase economic growth, that’s not always the case.
Consider the case of Rep. Bill Thomas, who in 2003 was the Ways and Means chair. Thomas had long supported the JCT’s extensive and expensive efforts to do dynamic analysis. And he and fellow Republicans got the House rules changed so that it became mandatory for the JCT to do a dynamic analysis of tax bills approved by the House. So when the House passed a $550 billion tax cut introduced by Thomas, the JCT estimated the macro effect. It found that the tax cut would have, at best, no effect on the economy's long-term health. Of the five estimates reported of the long-run effects on real growth in GDP, four were negative and one showed no change. Why didn't tax cuts increase growth? The JCT models showed that the negative effects of increases in the deficit more than offset the positive effects of tax cuts. Eight years of JCT work on dynamic analysis, and the JCT still was not giving any free lunch to tax cutting conservatives. Republicans couldn’t blame Democrats because they themselves were in charge.
Fast-forward to the present. Present-day Republicans need to understand, as Thomas did not, that it is by no means certain that economists will conclude that tax reform will increase economic growth. Many individual tax reforms, such as repealing the deduction for state and local income taxes and phasing out tax benefits for high-income households, increase implicit marginal tax rates. (It is this same type of increase in implicit tax rates in Obamacare that caused the CBO to conclude that the new healthcare law would reduce employment by more than 2 million.)
But it is on the corporate side that the inclusion of macroeconomic effects can backfire on tax reformers. Up until just a few years ago, the conventional wisdom among economists was that corporate tax reform would hurt growth. Why? Because rate cuts provided a windfall to existing (“old”) capital, and tax benefits for old capital provide no incentives for growth. At the same time, cuts in investment incentives (like accelerated depreciation) used to pay for the rate cuts concentrate a new tax burden on new capital expenditures and therefore significantly hurt growth. That is exactly the opposite result that policymakers would want to achieve.
More recently, some economists are revising their views and assigning more positive effects to rate cuts (because, for example, they provide good incentives for investment in intangible capital and they are important in international plant location decisions). But among economists, the issue is far from settled.
The bottom line: There will be a big to-do about dynamic scoring over the next few months. But it will change nothing. And even if conservatives were successful in their efforts to get dynamic scoring, they might not like the results.