Thursday, October 4, 2012

John Cochrane is being very misleading on tax scoring

I'm no tax policy expert by a long shot, but there seems to be a whole lot that's misleading about this post from John Cochrane. He praises the Tax Foundation's analysis of Romney's plan. I can't speak to how good the analysis is, but this is Cochrane's reaction:

"The Tax Foundation study, "Simulating the Effects of Romney's Tax Plan" is worth reading and thinking about, especially in contrast to the standard static, Keynesian analysis that I complained about at the CBO.

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.

Unlike a Keynesian plan, whose purpose is to transfer wealth to the hands of people (voters) likely to "consume" it, or a redistributionist plan, whose purpose is to transfer wealth from one category to another of people, 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.

What possible sense does it make, then, to evaluate such a plan by assuming off the bat that it has no effect at all on output, employment, investment and so forth? Yet that is precisely what the standard "static" scoring does! We build a rocket ship to go to the moon, and we evaluate its cost effectiveness by assuming that it never leaves the launch pad?

There are all sorts of things to appluad in this approach.

'we have simulated the effects using a model built on a standard neo-classical growth model'

Hooray! The "standard neoclassical growth model" is exactly the right building block for this sort of exercise, one that has pretty much taken over all academic tax analysis for the last 20 - 30 years, but has been virtually absent in Washington, still using Keynesian macro models from the 1960s. What does it mean? In general, we model households making decisions between work and leisure, consumption and savings; we model businesses making investment, hiring, and output decisions to maximize profits, and find the equilibrium."

First it's just weird how he calls "static" scoring "Keynesian" and dynamic scoring "neoclassical", since it's a pretty standard Keynesian point that cutting taxes is going to improve growth. Tax economists in Washington don't really line up with the macroeconomic camps that you see on the blogosphere. Len Burman, Rudy Penner, Bill Gale, Doug Holtz-Eakin, Doug Elmendorf, etc. all have different perspectives but they don't really line up in the freshwater/saltwater way a lot of blog readers have come to expect.

And they all think tax cuts are good for the economy, all else equal... just like a "static Keynesian model from the 60s" does (the trouble is low deficits are also good for the economy, all else equal).

Aside from that oddity, the impression that you get is that the Tax Foundation makes some kind of accounting for microfoundations that nobody else in Washington does. As far as I'm aware that's entirely untrue. CBO and JCT definitely model microeconomic responses to tax policy change, of the sort that Cochrane is talking about here. [UPDATE: someone that works on these models that I asked about this sugests that CBO and JCT and those sorts of people don't do exactly the same micro-adjustments that the think tanks listed below do. They only adjust for how people will file, etc. I have read elsewhere that they do include labor supply responses and things like that as well. Because of rules about how they can score, these analyses may be restricted to appendices or research reports. So there is some ambiguity here - if anyone knows more, please clarify in the comments].  So does the Treasury. I know the Tax Policy Center does with it's tax model, and the Heritage Foundation does this micro behavioral modeling as well. The Center for Tax Justice has a microfounded model. I've just assumed that most decent sized policy analysis organizations do this. Certainly the big ones you hear about do.

Dynamic scoring is somewhat different from just including microfoundations. Ironically, the "dynamic scoring" that Cochrane advocates would do the opposite. It would incorporate assumptions about the (aggregate) relationship between GDP, unemployment, and tax policy into the analysis. So in a lot of ways, dynamic scoring is more old school Keynesian than the standard Washington analysis that Cochrane is complaining about, not less.

So why doesn't everyone go all in for dynamic scoring? It's still a decent idea. The reason is the same reason why we didn't get a consensus behind stimulus: there's a lot of disagreement about the macroeconomic effects of fiscal policy, like tax policy, and the results are highly sensitive to the assumptions that you make.

Dynamic scoring is like the analytic treatment of the AMT, the baseline, or the SGR: it's a nuanced methodological point that people in Washington love to talk about with each other and are very concerned about confusing the public over. For that reason, the consensus (as far as I can tell) is that dynamic scoring is a good idea in theory but because of uncertainties around its application it's best left to an appendix as information on the variety of potential scenarios. Yes, in an ideal world we'd do dynamic scoring but there just isn't enough consensus on the macroeconomics involved to go too far with it.

Everyone agrees the sort of microfounded reactions to changes in tax policy that Cochrane presents here is important, and most policy analyst groups that are large enough to justify it have such a model Certainly the ones you hear about day in and day out do.

So read Cochrane with caution on this.


  1. The evidence is lower marginal tax rates increase consumption and this is what increases revenues. Higher marginal tax rates increase investment by making consumption more expensive and lower revenues by promoting tax deferral through investment. The dynamics go the wrong way, but taxes are a weak effect at best.

  2. Lower marginal rates on small businesses (who file through the individual tax code) and on individuals (who choose whether or not to work more - extra hours, another job, promotion, etc) can increase revenues through production. Studies indicate this has the greatest effect on top earners (whether this is business or non-business filers I'm not sure).

    To clarify here - CBO does do dynamic modeling, but mainly only for actual budgets, not for proposals. Apples to apples comparisons therefore may require some dynamic modeling...

  3. assuming you have customers to buy your product.


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