The danger of new tax cuts


A new group of politicians has arrived in the nation's capital. Elected on a populist platform, they promise the average family an immediate improvement in its economic condition. Many economists are warning that they have promised too much. But these politicians have their own advisers, who believe that their programs will deliver so much incremental economic growth that conventional concerns about deficits and inflation are overblown.

Does this sound like some country you recognize? If you are familiar with Latin American history, it sounds like a lot of countries: Peru in 1985, Mexico in 1977, Chile in 1970, and Argentina or Brazil every five years or so.

In the current atmosphere in Washington, in which politicians of both parties are competing to offer tax cuts and in which there is an ever-growing array of "experts" prepared to explain why these cuts won't raise the deficit, there is a 1991 book that ought to be on everyone's reading list: The Macroeconomics of Populism in Latin America, edited by Rudiger Dornbusch and Sebastian Edwards. The book details more than a dozen episodes in which Latin American governments convinced themselves that the conventional rules no longer applied, that growth would cure deficits (or that in any case deficits did no harm), that inflation wasn't really a threat--then pursued policies based on these ideas with such vigor that they pushed their countries into deep economic crisis.

Is this comparison overdrawn? Bear in mind that the budget situation in America right now is far worse that it was when Ronald Reagan took office. Reagan started with a federal debt that was less than 40% of GDP; now it's 70%. Reagan's tax cuts took place near the bottom of a deep recession, so a there was a lot of room for rapid growth as the economy took up the slack; right now the economy is operating close to capacity, with GDP growth almost certain to slow rather than accelerate. Most important of all, we are steadily approaching the time when baby-boomers begin to retire, putting federal programs like Social Security and Medicare deep into the red.

But if you want to know whether we are really on the way to becoming a Latin American look-alike economy, the key issue to watch is a seemingly arcane one: the idea of "dynamic scoring" for tax cuts.

The basic idea of dynamic scoring is reasonable: People will alter their behavior when you change tax rates, so if you want to figure out how much revenue is gained or lost from these changes, you should take that altered behavior into account. For example, if you cut the federal gasoline tax, people might buy less-fuel-efficient cars, raising gas consumption, so the feds could conceivably end up with more rather than less revenue.

The problem is that economics is not (to say the least) an exact science, so that attempts to predict the effects of tax changes on behavior are both uncertain and controversial. Thus, the only kind of person you want to trust with dynamic scoring is someone who not only knows his stuff but will consistently bend over backwards to avoid reaching comfortable conclusions simply because they are politically convenient.

Do the Republican leaders and their economic advisers who are calling for dynamic scoring meet this test? Does the Republican majority believe that a cut in the capital gains tax will actually reduce the deficit because it has made an objective study of the statistical and economic issues involved, and has reached the conclusion in spite of a determination not to engage in wishful thinking?

In fact, some of the ideas that "experts" have been circulating among Republican Congressmen are downright terrifying. One proposal claims, for example, that a tax break on investment will raise the U.S. growth rate from 2.5% to 4.5% for the next five years- that is, that the U.S. economy will grow as rapidly from its current position of near-full employment as it did during the years from 1982 to 1987, when it started with almost 11% unemployment. (For a deeper look into the capital gains tax debate, see Politics & Policy.)

So how should you approach the idea of dynamic scoring? With great caution. If the Republicans show a lot of enthusiasm for the idea, or if they choose a director for the Congressional Budget Office who loves the notion, then you might want to think about investing your money someplace where bitter experience has taught politicians and the public the virtues of responsibility--someplace like, say, Argentina.

Originally published, 2.6.95