For many, many years, Congress’ Joint Committee on Taxation (JCT) insisted it could not produce credible analysis showing how the economy’s trajectory would alter under a material change in tax policy such as the Tax Cuts and Jobs Act now working its way through Congress. With the recent release of its dynamic analysis of the bill, the JCT has demonstrated it was right all along. The JCT still cannot produce credible dynamic analysis.
Credible analysis of the House and Senate bills, whether based on educated judgment or economic modeling, put the expected additional growth from tax reform in the range of 3% to 5% of GDP. The JCT concludes the tax reform based on such powerful pro-growth elements such as reducing the corporate tax rate from 35% to 20%, expensing of business capital purchases, and territoriality can, at best, muster about 0.8 percentage points of additional GDP after 10 years. Where did JCT go wrong? As the Tax Foundation also observes, the problems lie not so much in the models themselves but in a handful of ill-chosen assumptions.
In the past, JCT showed little economic benefit from pro-growth policies because it assumed the United States operated a closed economy and so additional inflows of saving from abroad were unavailable to finance additional domestic investment. This meant increases in domestic investment had to be financed entirely by increases in domestic saving. As domestic saving tends to change but slowly over time, this assumption guaranteed a dynamic analysis of even the most pro-growth tax policies imaginable would have little effect. However, the blossoming of global financial markets rendered this closed economy assumption fairly absurd by the 1970s.
When the closed economy assumption became untenable, the JCT turned to “crowding out,” the belief that budget deficits tend to crowd out private investment. Note that crowding out is actually a derivative of the closed economy assumption since foreign savings inflows tend to prevent any crowding effect. Even so, let’s check the evidence, because for crowding out to affect domestic investment levels the crowding out must raise nominal interest rates.
The national debt doubled, and then doubled again, under President’s George W. Bush and Barack Obama, respectively, while real interest rates remain astounding low. The Congressional Budget Office (CBO) projects the debt to rise by another $9 trillion over the next decade under current policies, and yet CBO projects interest rates rising only modestly to more normal levels from today’s abnormally low levels. If crowding out proponents believed their theory, they would be shouting from the rooftops about the coming economic collapse. If CBO believed crowding out to be relevant, its interest rate forecast would have to show significantly higher interest rates very soon. In short, the crowding out proponents’ silence confirms CBO’s interest rate forecast in refuting the theory.
Having seen both their closed economy and crowding out assumptions refuted, the JCT turned to predicting Federal Reserve policy responses to changes in economic growth rates. As their report indicates in discussing the use of the “Macroeconomic Equilibrium Growth” model more suited to policies altering conventionally estimated deficits, “monetary policy conducted by the Federal Reserve Board is explicitly modeled.” After brief reflection it is easy to see this approach fails the first blush laugh test.
Consider, with all we know today of the state of the economy, expert opinion varies widely as to how Fed policy is likely to unfold over the next year. Yet somehow the tax economists at JCT have the economic perspicacity to predict confidently Fed policy in response to a change in tax policy not one quarter or one year from now, but for the next 10 years. Suggestion to JCT: If you were really that good, you’d probably all be Wall Street millionaires by now.
As the late night commercials challenge us, “But wait, there’s more!” The essence of pro-growth tax reform is expanding the capacity of the economy and therefore total output and incomes. In short, pro-growth tax policy reflects an economy growing more rapidly because supply is growing more rapidly. Econ 101 folks: Increasing supply tends to put downward, not upward, pressure on prices. What this means is that were the Fed to respond, or were the JCT to attempt to model a Fed response to pro-growth tax reform, the response would if anything be to lower target interest rates to resist deflationary pressures. Not only was JCT foolish enough to plod into Fed forecasting, but they got the sign wrong.
Finally, JCT reports the estimate of the feedback effects were produced using all three available models, but in what way? A simple arithmetic average? One model, but for the Federal Reserve response folly, is clearly more appropriate as JCT acknowledges, but JCT doesn’t indicate the role of the other two models in its dynamic analysis.
To be clear, the JCT has done a creditable job in its traditional work in supporting the Congress as the tax reform bill has evolved. No criticism is intended to those so involved. However, the JCT has also proven it still cannot do credible dynamic analysis. The JCT’s work in this area should be quickly consigned to the circular file and serious questions raised as to the JCT’s future in dynamic analysis.