Adopting dynamic analysis would improve the budget process

In recent budget projections, the Congressional Budget Office (CBO) projects that under the extended baseline (based largely on current law), by 2040 revenues will increase to 19.4 percent of gross domestic product (GDP) — above the average of 17.4 percent from 1965 to 2014 — while spending will increase to 25.3 percent of GDP — above the average of 20.1 percent from 1965 to 2014. Financing a 26 percent increase in spending with a further increase in taxes — note that under the projections, taxes are already increasing by 2 percent of GDP — will be problematic. However, maintaining the status quo implies that in 2040, the deficit would equal 5.9 percent of GDP and the federal debt would equal 103 percent of GDP. Clearly, this is an unsustainable fiscal outcome.

{mosads}But this projection is far from certain. For example, under the CBO’s alternative fiscal scenario (arguably a more realistic path of future fiscal variables), the federal debt is projected to reach 175 percent of GDP by 2040. There are other sources of uncertainty as well, such as uncertainty regarding behavioral parameters used in the projections, the underlying economic variables used in the projections, and the economic effects of enacting new policies. For example, the CBO estimates that including the macroeconomic effects of higher marginal tax rates, larger deficits, larger transfer payments and increased federal investment would increase the projected deficit from 5.9 to 6.6 percent of GDP in 2040. There are no easy answers to these fiscal nightmares. However, examining the potential solutions and related uncertainties by officially adopting dynamic analysis and using it more widely would improve the budget process.

For example, consider two proposals. The first proposal raises $200 billion in revenue by taxing capital gains and dividends and increases tax expenditures by $200 billion by expanding child tax credits. The second proposal would raise $200 billion in revenue by reducing child tax credits and reduce revenues by $200 billion by lowering capital gains and dividend tax rates. The conventional estimates would view these two proposals as roughly equivalent from a budget perspective (with some small differences showing up to account for certain timing effects). However, analyses by the Joint Committee on Taxation, Office of Tax Analysis, the Organisation for Economic Co-operation and Development (OECD), and some of my own work, clearly show that the first proposal would decrease economic growth and cause an increase in deficits while the second would increase economic growth and lead to deficit reduction. If this type of information was more integrated in the policymaking process, it may lead policymakers to enact policies that would increase economic growth rather than reduce it.

However, there are several important issues regarding how to implement dynamic analysis to improve the budget process. Most importantly, while providing a dynamic score of policy changes is important, the primary goal of dynamic analysis should be to compare the macroeconomic effects of various provisions. However, it must not only look at proposals that are predicted to increase growth. Instead, it must analyze proposals with positive and negative economic effects. Identifying harmful proposals that reduce growth is as important as identifying proposals that promote growth.

Dynamic analysis should also examine the effects of related provisions separately for large policy reforms to the extent possible. For example, it would be informative to break the analysis of the Tax Reform Act of 2014 into three analyses examining the effects of corporate reform, a move to territorial and the effects of the individual income tax reforms. This would ensure that large-scale reforms of the tax system are more likely to promote growth.

Dynamic analysis should also be applied to spending proposals. However, the demand-side effects of spending and tax proposals should not be considered, especially for permanent proposals. In addition, debt service costs must be considered in the short and long run. This is important because budget gimmicks within the budget window can obscure the long-run effects of fiscal policies, especially policies that are debt-financed, temporary or phased-in late in the budget window. We should acknowledge the harmful effects of debt-financed spending and tax cuts whenever possible.

It is important to note that macroeconomic aggregates are not the only information that should be provided to policymakers. Some measure of welfare and distributional effects (both within income groups and across generations) are also often important. Also, the extent of the uncertainty contained in a dynamic analysis must be acknowledged.

Finally, public disclosure is imperative and as much information as possible should be released to the public. At a minimum, enough information should be released so that outside entities could replicate the work. In addition, it is important to note that preparing a dynamic analysis is no easy task and presenting and communicating the results to members, their staff and the general public is difficult.

While dynamic analysis will provide valuable information about the relative economic effects of alternative policies, it will not solve the fiscal crisis facing the United States. Policymakers will still face many tough decisions in the years ahead.

Diamond is the Edward A. and Hermena Hancock Kelly Fellow in Public Finance at the Baker Institute, an adjunct professor of economics at Rice University and CEO of Tax Policy Advisers, LLC.