Newton’s Third Law of Motion states that for every action there is an equal and opposite reaction. Isaac Newton was a physicist – when a pendulum swings to the left, it will swing back to the right with equal force, or when a rower places his oar in the water, and pulls back, it propels the boat forward. The same theory, though, applies to economics. When money is taken in taxes, there is a commensurate reduction in available funds to be spent on consumables.
A taxpayer who keeps more of what he or she earns is incentivized to produce more. Greater production raises economic output and, consequently, generates more revenues for the Treasury. It is the essence of the argument for comprehensive tax reform, with simplified rules that allow for lower nominal rates and fewer deductions and credits. It all seems commonsensical.
But not in Washington. Washington’s biggest failure (and there have been many) has been persistence in spending money we do not have. A second problem has been the inability to ignite the economy. (The two are, of course related.) The consequence has been a ballooning of debt and an unusually slow economic recovery. In fiscal 2011, the federal government borrowed 36% of the $3.6 trillion spent, while GDP expanded at about 1.6%. Last September, on David Letterman, the President raised eyebrows when he said that debt was not a problem in the “short term.” He added: “Right now interest rates are low because people still consider the United States the safest and greatest country on earth…” In truth, rates are low, not because the U.S. is the “safest and greatest,” but because the Federal Reserve is the elephant in the room, purchasing 60% or more of Treasury issuance. Were free markets at play in the world of Treasuries, interest rates would be higher, though by how much no one can say.
Into this ‘la la land’ was slipped an amendment onto the Senate budget resolution. It may offer a glimmer of light in an otherwise murky world. Senator Rob Portman’s (R-OH) amendment would have the Congressional Budget Office (CBO) offer dynamic scoring, in addition to their traditional static method, when determining the effects of tax legislation on spending and revenues. Dynamic scoring is supposed to provide a more complete picture of the macroeconomic budget effects from tax and spending proposals. The process comes with risk, as the scoring requires subjective judgments, but at least it is an acknowledgement that lower tax rates may produce higher revenues. The fate of this amendment is uncertain, as the Senate budget has little possibility of being adopted as written. Nevertheless, the fact it passed may be a sign that spring has brought a thaw to a frozen and recalcitrant Congress.
It may be a stretch to suggest dynamic scoring is a direct descendant of Isaac Newton. But it is certainly true that actions create reactions. A 10% reduction in personal income taxes will not result in a 10% decrease in revenues. As the Russian physiologist Ivan Pavlov demonstrated over 100 years ago, a dog’s (and a person’s) behavior can be influenced and conditioned by stimuli. And stimuli can take many forms, including the benefit for wage earners and investors of lower taxes. In an editorial supporting the amendment, yesterday’s Wall Street Journal cited the example of when Congress cut the capital gains rate in 2003 from 20% to 15%. The CBO estimated that the rate cut would reduce revenues to $65 billion in 2006, down from a previous estimate of $68 billion. In actuality, capital gains revenues rose that year to $109 billion.
Most Democrats opposed the amendment, though six supported it. Yesterday’s Journal quoted Senate Budget Chairwoman Patty Murray (D-WA) as saying that scoring is “very difficult” and “relies on judgment calls.” Both objections ring true; nevertheless, does it make better sense to suggest that any tax cut should assume lower revenues? Supporting the notion that predicting economic consequences is an arcane and hopeless task, people and businesses do not always act rationally. Any prophecy is but a guess; but an estimate based on precedent and which incorporates behavioral attitudes is likely to be at least directionally correct – certainly more so than the assumption that change will have no effect on behavior.
Economics combines elements of both science and art. Models are developed that seek to explain economic behavior in a way that can be theoretically proved. If economics were a perfect science there would only have been the need for the one-armed economist President Truman supposedly sought. There would have been no irrational exuberance that led to the housing bubble in 2007. An accurate efficient market thesis would never have led to the booms and busts so common to equity markets. We would have been forewarned. And, certainly, employment opportunities for economists would be limited, as a single economic model would work for all. But that is not the world.
The economy, which is the subject economists spend so much time interpreting and forecasting, has grown increasingly complex. It is global in nature and subject to feast, famine, pestilence and war. It is defined somewhat grandiloquently by Webster as the wealth and resources of a country, especially in terms of production and consumption. It is defined in more easily understood terms by Ambrose Bierce, in the Devil’s Dictionary, as the “purchasing of barrels of whiskey that you do not need for the price of a cow you cannot afford.” However, its complexity has provided the opportunity to build econometric models, which of course increases job security for economists, as they increase the level of confusion for all who study them.
A good Congress, conventional wisdom tells us, is one that is busy passing laws, protecting the innocent from those who would do them harm. That is how they spend their time, but I am not so sure that makes for a good Congress. For most of the past two hundred and twenty-five years, Congress has been making and passing such laws; and they keep insisting there is more to do. In my opinion, they should say ‘enough,’ and focus on reducing debt and helping the economy grow. Dynamic scoring seems to be a small step in that direction.
The AEC’s fundamental goal is to promote a free, responsible and prosperous society. Through education and improving public understanding of key economic questions, the AEC promotes the idea of a free market economy and the ideal of a free society.