How much economic growth will tax cuts create? The President’s outline of his tax proposals is based on the premise that tax cuts pay for themselves by stimulating the economy to create additional and offsetting tax revenues. There are varying ways to project the effect of tax policy on economic growth and tax revenue; the most popular method is called dynamic scoring. To bring dynamic scoring into focus, it is necessary to understand what it is, how it is calculated, and why it matters.
Please note that we will be looking at dynamic scoring through the lens of a tax cut, though dynamic scoring could also be used to measure the effects of a spending increase. Also, we will be using a series of simplified examples to illustrate the basic principles of dynamic scoring, which do not incorporate all of the factors that can affect dynamic scoring projections.
What Is Dynamic Scoring?
In its simplest form, dynamic scoring is a projection of future revenue derived from the economic effects of changes in fiscal policy. For instance, dynamic scoring assumes a behavioral response to tax policy that impacts labor, capital investment, savings, and other incentives. In the case of tax cuts, the macroeconomic effects of these responses adds projected revenue into the pool of money that the government taxes.
This can be shown in a simple example. Suppose the economy of a small hypothetical country is expected to generate $10 billion in gross domestic product. If the current effective tax rate is 15 percent, then the government of the country will collect $1.5 billion in tax revenue. Now assume the country’s leadership changes and proposes a 10 percent tax rate. Without dynamic scoring, the budgetary effect will be a loss of $0.5 billion in revenue. But if the new leadership argues that by using dynamic scoring, the rate cut will be wholly offset by economic growth, leadership is asserting that the economy will grow to $15 billion as a result of the tax cuts. This projected growth yields the same tax revenue as a result of this country’s use of dynamic scoring.
How is Dynamic Scoring Calculated?
This result begs the question of how the government calculated its projected growth in arriving at this very favorable result. Answering this question in full would require travelling through a morass of economic theory, analysis, and perhaps some philosophy as well. For our purposes, a more cursory explanation will do. Nearly everyone agrees that certain tax cuts have positive ripple effects throughout the economy. A dynamic scoring analysis assumes that tax cuts boost spending and investment in the economy by some amount, perhaps by an equal amount. However, spending and investment do not affect the economy in the same way, with spending generally having a greater short-term effect and investment leading to more long-term effects.
This can be shown by looking at two fictional recipients of the 5 percent tax rate cut in the previous example. Suppose each person received $100 as a result of the cut. Recipient A spends his $100 immediately at a shoe store that makes a $50 profit on the sale. Taxed at 10 percent, the shoe store pays $5 in taxes in the year of the sale. On the other hand, Recipient B invests his money in 5 shares of the shoe store’s stock. In 15 years, he sells the stock when it is worth $2,000. The government gets $200 in tax revenue from this sale, but it had to wait 15 years to collect. Because dynamic scoring generally looks at a 10-year window , only Recipient A’s purchase is actually reflected in the budget effect of the tax cut. Thus, estimates of how the projected tax cut affects spending versus investment is a critical assumption in dynamic scoring. The amount and timing of income generated by the investment is also relevant, but beyond the scope of this discussion.
Measuring the Long Term Effects of Tax Cuts
The previous example also demonstrates the short-term effects of dynamic scoring. The estimated spending must be further parlayed into a projected impact on demand for goods and services. In our simple example, if everyone spent his or her tax cut on shoes, shoe demand would increase and would lead to higher shoe prices. These higher prices would promote hiring and higher wages. Added together, the tax cut would effectuate more economic output from the shoe store and its employees as more money is generated.
The long term economic effects of tax policy are much more difficult to calculate and carry a greater degree of uncertainty. Projections of future growth depend on the quality of available labor, the availability of mechanisms to produce the goods (factories, shipping capacity, and technology), and how efficiently these items are incorporated into the production of goods and services. Essentially, long-term projections attempt to analyze how taxpayers will incorporate the tax cut into their decision making process, and how much economic activity will be generated as a result. Multiplier effects are estimated to capture compounding of economic growth.
All of this also depends on a positive outlook. If a tax cut results in higher deficits, then higher interest rates and uncertainty may inhibit investing. The stage of a cyclical economy may also produce an economic downturn, whereby growth offsets to tax cuts under dynamic scoring would diminish. Such downturns typically force increases in government spending, decreases in government revenues, and increasing deficits. This theoretically leads to less investment, and that compounds the problem. All of these factors must be estimated as part of dynamic scoring, making the process subject to speculation and debate.
How Dynamic Scoring Relates to Tax Reform
So why is dynamic scoring playing such a key role in the debate about tax reform? In our prior article on budget reconciliation, we discussed how tax reform must be deficit neutral over a 10-year window to get through the Senate on a simple majority vote. Since 2015, the Congressional Budget Office (CBO) has been directed to use dynamic scoring to determine the cost of proposed legislation and whether it will be deficit neutral. Additional tax revenues estimated under dynamic scoring lessen the need for measures that broaden the tax base or that cut spending in order to maintain deficit neutrality. This is a key premise used by President Trump to pay for his tax proposals.
Currently President Trump’s proposals are projected to increase the deficit by as much as $7 trillion. As a result, the Administration is relying heavily on the revenue projections provided by dynamic scoring to pay for the changes and meet the reconciliation requirements. There is widespread agreement among economists that tax cuts have a positive effect on the economy (and incremental tax revenues), but that tax cuts do not pay for themselves. Thus, there is consensus that President Trump’s proposals must incorporate additional tax revenue or spending cuts to be passed through reconciliation. The tax plan proposed by the House Ways and Means Committee (the “Blueprint”) is an alternative being debated currently in Congress. It also relies on dynamic scoring, albeit to a lesser extent.
Dynamic scoring will continue to be central to the tax reform debate, and will be hotly contested as it inherently includes many estimates that are difficult to project. Nevertheless, its application attempts to bring the budgetary impact of fiscal policy closer to economic reality. For more information on dynamic scoring and tax reform in general, please contact your local CBIZ tax professional.
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