With Congress in the midst of an intense debate over a big new tax and spending bill, policymakers are battling over the costs and economic benefits of many proposals. One way to measure those is dynamic scoring—a tool that makes it possible to better understand how policy changes affect the overall economy, and how those economic effects in turn impact the budget. But dynamic scoring is complicated—and controversial. To explain what it is all about, TPC Senior Communications Manager John Buhl talked with Senior Fellow Ben Page.
Q: Can you explain in general terms how tax models like TPC’s function?
A: Put most simply, our model estimates the effects of tax law changes on government revenues and after-tax incomes. We do this by applying those changes to the income data in a large sample of tax returns. The model also captures some behavioral responses of taxpayers to those changes. For example, people will be less likely to sell stocks if the tax rate on capital gains rises. This way of estimating the effects of tax policy on revenues generally is called conventional scoring.
Q: What does dynamic scoring add to this?
A: Dynamic analysis shows how changes in overall behavior impact the broader economy, such as output, unemployment, or inflation—effects which are not included in conventional scoring.
To think through how this works, consider President Biden’s proposal to raise the tax rate for high-income households. This would reduce the incentive to work, because the higher tax lowers the benefit someone gets from the next additional dollar of income they can earn. If you add that up for all taxpayers, total economic output would fall. That, in turn, would lower the amount of revenue the bill raises compared to a conventional score, because you’d be taxing a smaller amount of economic activity.
Q: Now to current events: The White House and congressional Democrats argue that dynamic scoring will reduce the estimated cost of the infrastructure and budget reconciliation bills. TPC’s model is obviously tax-focused, but what are some of the challenges with estimating how such a large tax and spending plan impacts the economy?
A: Much like the supply-side advocates of tax cuts, the administration is likely to be disappointed by dynamic analysis of the reconciliation bill. The history of such analyses strongly suggests that estimated effects on the economy, and feedback effects on revenues, would be modest. The main basis for judging the bill will likely be the direct effects of the new policies—an enhanced child tax credit lifting children out of poverty, for example—rather than the indirect effect on the economy.
A particularly tricky aspect of the President’s plans, in terms of estimating dynamic effects, is infrastructure spending. In theory, investment in public projects like roads and bridges can raise output and wages in much the same way as private investment. However, estimates of the size of the effect vary widely. And a lot of the benefits of the investment may not show up fully in output. For example, reduced commute times from better roads would make people better off, but won’t directly add to output.
Q: How can we tell whether the assumptions a model uses to gauge the potential economic response are reasonable?
A: As an example, consider corporate taxes. The theory is that reduced business taxes will encourage firms to invest more in capital goods like factories, machines, and computers. That capital, in turn, will make workers more productive—and raise their wages.
The Trump Administration’s estimates of the effects of the 2017 Tax Cuts and Jobs Act on wages implied that workers would receive over 100 percent of the benefits of its corporate tax cuts. While theoretically possible, that’s an extreme assumption that likely wouldn’t come close to bearing out. Based on historical evidence and economic models, TPC estimates that workers end up bearing 20 percent of the burden of an increase in the corporate tax rate.
Q: Another area of disagreement is how the federal debt impacts the economy. If you ignore the debt, tax cuts look like they provide a larger boost to growth. If you assume that more debt will inhibit growth, a tax cut that isn’t fully paid for could look like it drags down long-term growth. What does TPC assume about the debt when it dynamically scores a tax proposal?
A: In the short run, we assume tax cuts that raise the deficit will boost economic output, because they increase people’s after-tax incomes and allow them to spend more. However, that effect is only temporary. Over time, economic output returns to its long-term trend, as market forces and the actions of the Federal Reserve to manage interest rates kick in.
In the longer run, higher deficits soak up saving that would otherwise go to business investment. That reduces the capital stock—all the resources available for private-sector production. This effect is slow-acting, like rust, gradually shaving more and more off of output over time but without any dramatic change.
Q: Given that interest rates have stayed low in recent years even with more borrowing, more people are questioning when the debt will actually become a problem for the economy. What should someone new to this debate think about the way debt and deficits impact the economy?
A: At very high levels, debt might lead to more drastic effects, such as a financial crisis that causes a spike in interest rates or a sudden drop in foreign investment. Those effects have occurred many times in smaller economies. However, they are less likely in an economy such as the US that issues debt denominated in its own currency.
We don’t know how much debt would cause a crisis in the US. On the one hand, countries such as Japan have built up far more debt relative to their output than the US, without triggering a crisis. On the other hand, an unexpected crisis never happens—until it does. And the impact could be serious. Limiting the growth of debt relative to output is probably the most prudent policy in the long run.
Q: In recent years, dynamic scoring has become more common. Why do you think there was some hesitation to use this method?
A: There are political and practical reasons.
If you support tax cuts, you might favor dynamic scoring because it generally makes those cuts appear less expensive since the positive economic effects tend to reduce the potential revenue loss. If you support more government spending, you might oppose dynamic analysis because it lowers the perceived cost of tax cuts, perhaps making them more politically viable and reducing the funds available for spending programs.
A more practical reason to question dynamic analysis is that the effects of tax policy on the economy are much less well understood, making them more susceptible to bias.
But so far, dynamic analysis hasn’t really changed the politics of tax legislation. There also has been more of a consensus on the dynamic effects of taxes than many anticipated, and the estimated effects tend to be relatively modest.
