Monday, January 12, 2009

Dynamic Scoring

Suppose that, at the beginning of the fiscal year, Congress appropriates $100 billion extra for infrastructure projects. At the end of the fiscal year, how much higher will the deficit turn out to be, compared to what it otherwise would have been?

The obvious answer, and the one that usually seems to be implicitly assumed by the media and the pundits, is $100 billion. But if you think about it carefully, it should become obvious that the obvious answer is the wrong answer.

The government is going to use most of that money to hire people and to buy things. Many of the people it will hire are people who were previously unemployed. Many are leaving other jobs which will subsequently be filled by people who were unemployed. These previously unemployed people, who may have been collecting benefits, will now be paying taxes. Those taxes will reduce the deficit, as will the reduced benefit payments. Moreover, for the businesses from which the government purchases, their profits will rise, and they will pay additional taxes on those additional profits. And they may expand and hire new people, or retain people that would otherwise have been laid off. And (if you believe in a multiplier effect), all the newly employed people, as well as the owners of the businesses, will spend more money, thus providing more profits and more employment for others, who will also pay taxes and stop collecting benefits. And so on. The ultimate effect of the original expenditure on the budget deficit will be considerably smaller than $100 billion.

This is called dynamic scoring. When contemplating a change in the budget – a change in government spending or a change in taxes – an accurate analysis of the effect on the budget has to take into account the effects that the change has on the economy and thereby on other revenues and expenditures – to the extent that we can get reasonable (conservative) estimates of such effects.

In the past, dynamic scoring has met with a lot of skepticism – and with good reason. Under normal economic conditions (by which I mean those that prevailed from 1953 through 2007), it's not clear that budget changes have any significant indirect effects on revenues and expenditures. Supply-siders claimed that the incentive effect of tax cuts would increase incentives for economic activity and thereby result in increased revenues. (I mean, "increased" relative to the static estimate of the revenue loss, not increased relative to what would happen without the tax cut. The latter idea had a lot of play in the popular press, but it was seldom taken very seriously by economists.) Keynesians (the old-fashioned kind) claimed that tax cuts and expenditure increases would increase demand and thereby result in increased revenues (again, relative to the static estimate). But...

Mainstream economic analysis said they were both wrong. Many economists think there are major supply-side benefits to more efficient taxation, but most such economists think those are primarily long-run benefits (faster growth over a span of time) rather than benefits that would significantly affect revenues in the short run. The Keynesian argument would make sense if monetary policy were passive, but in fact, the Fed has its own goals, and its goals don't necessarily change in response to fiscal policy. And of course the Fed takes fiscal policy into account when deciding how to accomplish those goals. So if a tax cut or an expenditure increase were expected to create, say, a million extra jobs, then, under normal economic conditions, the Fed would simply raise interest rates enough (according to its best estimate) to destroy a million jobs. (If the Fed didn't think the demand for those million jobs would be potentially inflationary, then it would already have tried to create them.)

But today's economic conditions are not normal. The Fed, like most everyone else, is expecting the recession to be a severe one, a potentially deflationary one, but the Fed is running out of options for how to deal with it. Contrary to what happens under normal conditions, the Fed will make no attempt to offset the effects of fiscal policy; indeed, it will enthusiastically welcome the help. The old-fashioned Keynesians, whose advice about dynamic scoring was (properly, in my opinion) considered wrong or irrelevant for so long, can now dust off their computers and start giving meaningful dynamic estimates of the effects of budget changes.

No doubt there have been times in the past when advocates of dynamic scoring turned out to be right. For example, with respect to the Reagan tax cut, the supply-siders were probably right that some revenue was made up by people who devoted less effort to avoiding taxes. But there has never been a consensus beforehand about how dynamic scoring should be done, or even about the direction of the effects. In the past, the only conservative approach was to use static scoring – to ignore any indirect effects that budget changes might have on the ultimate deficit.

There is still no consensus about the details. But today one can hardly doubt that the indirect effects of stimulus policies on the budget will partly (if not entirely) offset their direct effects, or that the indirect effects will be large enough to be important. In today’s environment, static scoring is not just conservative, it's fundamentally unreasonable.

The details have to be negotiated: we should choose conservative parameters from among those estimated by various experts, and to avoid bias, we should probably do the scoring (at least) twice with two different sets of parameters, one that takes a comparatively more optimistic view of tax cuts and another than takes a comparatively more optimistic view of spending. And we should keep in mind the full range of projected outcomes, from those based on the most optimistic overall assumptions to those based on the most pessimistic.

As I said, the details have to be negotiated. But next time you think that an $800 billion stimulus plan will add $800 billion to the national debt, think again.



DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

68 comments:

Anonymous said...

The obvious classical reason to disallow dynamic scoring was that supply-side 'economists' rate tax cuts in a manner similar to how ratings companies rated financial instruments.

-Barry

locust said...

Maybe this is a crazy question. I'm wondering about the inverse.

How much was lost through the Iraq supplementals of about $700 billion? One of the appeals for Americans who chose to work overseas was the first 80K was more or less free of taxation. What was the cost to the United States in tax revenue?

Michael said...

clearly the outcome of any economic actions like tax cuts or budget stimulus is very complex and more or less impossible to predict. Most opinions and expert advice is full of self-interest (e.g. cuts of ones own taxes) or ideology.
I hope that the pessimic views which e.g. the people on prudentbear.com (well obviously pessimisic by design) and most converatives have will prove wrong.
Despite all the blame, keynesian instruments have worked in the past (at least sometimes), why shouldn't they work today?
I can't imagine where the high interest should come from, when the jobless rates rise globally.

Alex said...

locust well said man.adter all this taxation how you can think of Savings Account Interes

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