Memo to Paul Ryan: Let the Markets Do Dynamic Scoring
Immediately after the 114th Congress is sworn in, the Republicans will face a battle that will determine whether they will be able to deliver for the voters, who have just given them sizeable majorities in both the House and the Senate. The battle in question will be the fight over how the Congressional Budget Office (CBO) will "score" tax bills for budget purposes.
The CBO has long employed "static scoring," which assumes that tax changes have no impact upon economic growth. The liberals will fight to retain static scoring, because they know that static scoring is their first and best line of defense against "pro-growth" tax cuts, which they fear the way that vampires fear sunlight.
If the Republicans are to accomplish anything in the coming two years, and win the White House in 2016, they must fight for "dynamic scoring." And, they must win.
Dynamic scoring will pave the way for supply-side tax cuts, which are essential if America is to enjoy the rapid, sustained economic growth that the voters are looking to the Republicans to deliver. We need a long economic boom to make up for 14 years of sub-par economic performance under Bush 43 and Obama.
The irony is that progressives know in their hearts that supply-side tax cuts work. Liberals are well aware that reductions in marginal tax rates on savings and investment (e.g., the corporate income tax, the capital gains tax, and the death tax) would boost real GDP (RGDP) growth, incomes, job creation, and (with a lag) federal revenues.
Think about it. If progressives didn't believe that supply-side tax cuts would work, they would have no reason to oppose them. Instead, the liberals' best strategy in confronting the new Republican majorities in Congress would be to step aside, allow pro-growth tax cuts to become law, and then exploit the tax cuts' failure to deliver the promised benefits as a issue in the 2016 elections.
Sure, if big supply-side tax cuts were enacted and they didn't boost growth, the federal deficit would be larger for the next two years, but the liberals are Keynesians, and Keynesians like deficits. Also, the resulting higher national debt would give the progressives more reason to do what they truly want to do-raise taxes-after they regained power. Besides, to liberals, an extra few hundred billion dollars of public debt would be a small price to pay for burying supply-side economics once and for all.
Republican leaders, including incoming House Ways and Means Committee Chairman Paul Ryan, appear to be planning to push for dynamic scoring after the 114th Congress convenes in January. Let's hope they do, and let's further hope that they press the financial markets into service to perform the dynamic scoring, rather than assigning this task to analysts at the CBO. We'll discuss later how we would go about having the markets do dynamic scoring of tax proposals.
Make no mistake-there is a lot at stake in the fight over the methodology that the CBO will use to score tax bills going forward. This is why the New York Times fired an early shot in this battle in an editorial published on December 7.
The Times made a bid to persuade the victorious Republicans to stick with "static scoring," which ignores the impact of tax changes on economic growth. For the Republicans to go along with the Times on this issue, they would have to be "the Stupid Party" indeed. Caving in to the liberals on static scoring would be intellectually bankrupt and politically suicidal. The Republican Party is either the party of economic growth, or it is nothing, and it loses elections.
The Times' argument for static scoring is the equivalent of your realtor telling you that, because longitude and latitude cannot be measured with absolute precision, you should ignore location when buying a house.
Static scoring is insane. Just as the three most important things about a home are "location, location, and location," the three most important things about economic policy are "growth, growth, and growth."
This is not a matter of opinion. America's rate of real economic growth is what matters the most, whether your concern is jobs, family incomes, or even the fiscal health of the federal government. Economic growth quickly overwhelms all other economic and fiscal considerations.
Here are some facts that illustrate how just how important and impactful RGDP growth really is:
• From 1790 to 2000, U.S. RGDP growth averaged 3.86%. If it had simply continued at that rate for the 13 years that followed, 2013 GDP would have 30.6% larger, and (with the same spending) the federal government would have run a $0.5 trillion surplus, rather than a $0.6 trillion deficit.
• On the other hand, if, for the nation's first 223 years, the U.S. economy had grown at the anemic rate (1.74%) seen from 2001 to 2013, America would have had GDP per capita of only $717 in 2013-about that of Haiti.
• An RGDP growth rate of 3.5% would solve all of the financial problems of Social Security and Medicare, with no need for tax increases or benefit cuts.
• On a present value basis, raising our RGDP growth rate by 1.0 percentage point (over the CBO's 2.15% forecast) would produce 1,727 (yes, going on two thousand) times the improvement in federal finances that reducing spending by 1.0% of GDP (equivalent to cutting this year's outlays by about $180 billion), or raising taxes by 1.0% of GDP, would deliver.
• It would take only a 0.07 percentage point increase in RGDP growth to "pay for" (in the sense of maintaining a constant present value of federal revenues) eliminating the entire corporate income tax, which brings in about 2.0% of GDP.
One reason that the Republicans simply must push through dynamic scoring is that there is no path to prosperity at the 2% RGDP growth rates currently being forecasted by the CBO (aided and abetted by the OMB, the Social Security Trustees, etc.). America grew up as a "4% growth" country. At 2% growth, we turn into Europe-a bankrupt welfare state that is helpless to defend itself against its enemies.
"Secular stagnation," the notion that changes in the economy have made achieving historically normal rates of RGDP growth no longer possible for America, is all the rage among economists these days. The CBO implicitly buys into it, by forecasting that America's "potential GDP" will grow at only 2.1% per year. Because "actual" can never exceed "potential," the CBO's formulation tends to prevent the possibility of rapid economic growth from even being discussed.
If rapid economic growth is not possible, then all there is to talk about is tax increases, spending cuts, and "grand bargains." If this becomes the game, Republicans lose-and so do ordinary Americans, who need more jobs and higher incomes in order to realize their dreams for their lives.
The CBO bases its conclusion that America's economy can only grow at 2.1% upon the following equation:
RGDP growth = labor force growth + productivity growth
This equation is a simplification of this equation:
RGDP growth = growth in hours worked + productivity growth
This second equation is true by definition-it is simply the definition of productivity growth. However, it is profoundly misleading, because it implies that RGDP growth is limited by labor force growth. Both the CBO and much of the mainstream economics profession have gone down this intellectual rat hole, which leads to visions of secular stagnation, and despair.
In reality, RGDP growth is driven by capital investment. Here is the equation that describes the actual cause-and-effect relationship:
RGDP = 0.44 (real nonresidential assets) + 0.08 (real residential assets)
It can be estimated from the Bureau of Economic Analysis' "Fixed Assets" numbers that raising nonresidential gross capital investment by 1.0% of GDP would increase our RGDP growth rate by 0.43 percentage points. Because investors base their decisions regarding where and how much to invest upon after-tax returns, cutting marginal tax rates on savings and investment will spur investment and RGDP growth. And, faster RGDP growth will boost incomes, job creation, and the present value of federal revenues.
One caveat. Supply-side economics requires that the Federal Reserve deliver "good enough monetary policy. This is something that the Fed has not managed to do over the past 14 years. The Fed must be set straight, or even the best tax policies will not work as well as they should.
OK, so the voters expect the Republicans to deliver economic growth. Supply-side tax cuts are required to deliver the desired growth. And, a move to dynamic scoring is essential to pave the way for the needed tax cuts. How should the dynamic scoring be done?
One way would be to have the CBO try to estimate the impact of tax changes on nonresidential capital investment, and then to assume that every additional percentage point of GDP invested would yield an incremental 0.43 percentage points of RGDP growth. However, it would be far better to press the financial markets into service to score tax proposals.
The first step would be for the Treasury to issue two new kinds of securities. Let's call them "GDP Shares" and "Revenue Shares." These shares would be non-expiring, and non-callable. Both the dividends and any gains on the sale of the shares would be exempt from all federal, state, and local taxes.
Each quarter, the GDP Shares would receive dividend payments totaling some small percentage of GDP. The Revenue Shares would receive quarterly dividend payments equal to some small percentage of actual federal revenues.
It would be necessary to sell enough of these shares so that the markets for them would be adequately deep and liquid, so let's assume for the purposes of this analysis that the total dividends payable on the GDP Shares would be 0.058% of GDP, and the dividends payable on the Revenue Shares would be 0.333% of actual federal revenues. If these shares had been outstanding during FY2014, the dividends on each class of shares would have been $10 billion. The total dividends of $20 billion would have amounted to about 8.6% of the amount that the federal government spent on interest in FY2014.
The new securities would represent direct claims on future GDP and future federal revenues. Accordingly, the prices of the shares would fluctuate based upon the market's constantly changing projections regarding the present values of the aggregates in question. The movements in the prices of the GDP Shares and the Revenue Shares would provide invaluable feedback on economic policy actions and proposals.
Positive economic news would cause the price of the GDP Shares to rise. Developments that promised to increase federal revenues would cause the Revenue Shares to go up. The ratio between the market prices of the Revenue Shares and the GDP Shares would provide feedback on the outlook for the federal tax take (which was 17.39% for FY2014). Changes in the difference between the prices of the two shares would provide a proxy for the economic well being of the rest of the nation (America exclusive of the federal government).
Trading in the GDP Shares and the Revenue Shares would provide a powerful check on counterproductive proposals regarding taxes, trade, regulations, and monetary policy. The market prices of the shares would provide instant feedback on the economic policy ideas currently being discussed in Washington, including supply-side tax proposals.
Now, here is how we could get the markets to score specific tax proposals.
Once the Republicans had settled upon a specific supply-side tax proposal, the Treasury would auction off two new series of GDP Shares and Revenue Shares. Series A GDP Shares and Revenue Shares would be linked to the new tax proposal, while Series B shares would be linked to the existing tax regime.
If the Republican's tax proposal were signed into law within (say) six months, the owners of Series B shares would have their shares converted to three-month Treasury bills, with the principal amount equal to what was paid for the shares at auction, and paying the interest rate that three-month Treasury bills commanded as of the date that the Series B shares were sold. If it were not, the owners of the Series A shares would see their shares converted to Treasury bills.
The auction results for the Series A and Series B shares would provide dynamic scoring of the tax proposal under consideration. If the markets felt that the proposed tax cuts would boost economic growth (and therefore the present values of GDP and federal revenues), the Series A shares would command higher prices in the auction than would the Series B shares.
That's all there would be to it. The method described above would press the best minds, possessing the most information, into service to perform dynamic scoring, and it would make them "put their money where their mouth is."
It is essential that the Republicans fight and win the battle over dynamic scoring. They could greatly aid their cause by opening up federal government policy to market feedback, and by pressing the financial markets into service to score tax proposals.