Economic illiteracy

Here’s why those forecasts you hear of weak growth from the tax cut are probably way off

By —— Bio and Archives--December 4, 2017

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Tax Cuts, Forecasts, economics
The left was pretty excited, and some tepid Republicans were pretty nervous, when the Joint Committee on Taxation came out last week with a supposedly “dynamic” forecast that showed even with likely economic growth factored in, the tax cut proposal would still add more than $1 trillion to the deficit over the course of a decade.

The reason? Joint Tax estimated the likely economic growth effect of the tax cut at only about $400 billion in new revenues to the Treasury.

Now: How would they know to that level of precision? They don’t. But they base their expectation of growth on some very limited models, which completely fail to account for the impact of tax policy on the movement of capital in international markets.

Writing for the Heritage Foundation’s Daily Signal, Adam Michel and Parker Sheppard explain exactly why Joint Tax is likely so far off the actualy growth impact of the tax cut:

Economic models have three options for how to describe international trade. The first is to assume that the economy is closed. This simplifies the task of producing estimates by ignoring the rest of the world.

The second is to assume that the economy is small relative to the rest of the world, so that changes in policy have no effect on the world interest rate. This allows the model to capture the effects of international trade without complicating the model too much.

The third is to include a complete market for international capital. This is the most realistic, but also the most computationally difficult.

The models used by the joint committee and Tax Policy Center use a blend of the first two options, building in assumptions that the U.S. economy is relatively closed to international investment.

For example, the Tax Policy Center follows the government assumptions that only 24 cents of each new dollar of government debt will be financed by foreign investors.

These assumptions come from the Congressional Budget Office’s Solow model, which fixes savings rates based on assumptions made by the modeler. Thus, it is little surprise that the Tax Policy Center model often finds the static and dynamic scores are “nearly the s


By modeling the U.S. as a partially closed economy, the models predict tax reform will only modestly increase the foreign investment that will flow into U.S. markets.

The effects of these assumptions have not gone unnoticed by other economists. In The Wall Street Journal, economists Laurence Kotlikoff and Jack Mintz explain that the Tax Policy Center and government scorekeepers depend on “closed-economy models that do not simulate the current, let alone the future, global capital market.”

Closed economy models ignore salient facts about the world economy. “For all the talk about the Republicans not being an ‘evidence-based’ party, in this particular debate they seem to have the science on their side,” concludes economist Tyler Cowen.

Joint Tax thinks the tax cut will only increase GDP by 0.8 percent, whereas Heritage’s economists think the increase will be close to 3.0 percent.

This kind of analysis coming from Joint Tax is like me raising the price of my books from the current $15.99 per copy to $159.90 per copy, and simply assuming my revenues will increase 1000 percent. You see the problem with that, right? When you raise the price, fewer people will buy the book, because incentives change when the economic dynamics of a transaction change.

The same thing happens when you adjust tax rates because the capital that isn’t collected in taxes has to go somewhere, and in all likelihood it will be used for a more productive pursuit than if it had been confiscated by politicians.

Continued below...

Now the truth is that no one knows for sure what’s going to happen. Not every movement in GDP is necessarily determined by tax policy, which is why neither side can really claim to be telling us for sure how the numbers will come in over the course of a decade. But if you want to know who’s more likely to be on the right track, it pays to look at the assumptions they make in putting together their forecasts, and as Michel and Sheppard point out, Joint Tax’s assumptions fail to take into account the most influential economic dynamics.

What we know for sure is that we’ve had piss poor growth for the past decade and that’s coincided with anti-business, anti-growth tax and regulatory policies. Washington’s swamp culture always talks a lot about the deficit, but these same people have run up $20 trillion in debt while claiming to care about not doing so. Why should their concerns be top of our list in formulating what tax policy should be?

They shouldn’t. And as Heritage clearly demonstrates here, they don’t even know how to correctly analyze the effects of their own policies.

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