There is an old joke about some people who fell down a well. When they were unable to climb out, the economist among them said, “Assume a ladder.” The joke is funny because it’s true.
Economists make a lot of assumptions in their work. They have to because the enormity and complexity of the economy defy comprehension.
This is perfectly fine for college professors, who write only in obscure academic journals that no one reads, that exist only so people can get tenure at universities by publishing in them. But making too many assumptions can be very, very dangerous when it comes to public policy. Too often, economically unsophisticated politicians are led to adopt policies that sound good in theory, but in practice never work.
A recent example of this can be found in a new paper by the Congressional Budget Office, “Economic Stimulus: Evaluating Proposed Changes in Tax Policy.” It is the sort of thing that would probably get an “A” if written by a graduate student at Harvard, but can cause great mischief when put in the hands of politicians. (Keep in mind that getting an “A” at Harvard is not much of an accomplishment these days half of all grades given out there are A’s.)
The purpose of the CBO paper is to grade various tax proposals that have been put forward to increase economic growth in the short run. Since it deals only with tax initiatives, monetary policy is ignored, as are proposals for increased government spending. Moreover, the initiatives examined are not necessarily real proposals, in the sense that there is actual legislation that is being seriously pushed by the White House or members of the leadership in Congress.
The CBO report goes on to assert that certain proposals are being offered as measures to increase short-term growth, when in fact this is not the case at all. For example, it cites “industry representatives” as advocating changes in taxes on multinational corporations in order to stimulate short-run growth. Well of course that is what lobbyists are going to say.
They have said the same thing about every single tax and spending proposal they support ever since September 11. By treating such measures as serious stimulus proposals, all the CBO is doing is setting up straw men that are easily knocked down.
A more serious criticism of the CBO analysis is that it just assumes away all of the implementation problems of the proposals that it analyzes. Tax policy is treated like a water hose that can be turned on and off at a moment’s notice, with the flow directed precisely where needed and no where else. This is the equivalent of assuming a ladder.
Consider the proposal for a payroll tax holiday, which the CBO rates highest in terms of its “bang for the buck.” Although it acknowledges that changing payroll tax withholding would take time for employers to prepare, the CBO seems unaware of a report by the National Payroll Consortium that it would take up to six months for payroll systems to be adjusted to accommodate it. For this reason, the Democratic staff of the Joint Economic Committee give the payroll tax holiday low grades for stimulus.
The CBO also says that the proposal for a sales tax holiday has merit. The problem here is that there is no national sales tax to suspend in order to encourage consumers to spend. To have a sales tax holiday, therefore, would require states and localities to suspend their sales taxes. Not only would this require legislative action in hundreds of different jurisdictions, but would force the federal government to estimate the revenue loss in each case in order to reimburse state and local governments properly.
Again, the CBO acknowledges in passing the difficulty of actually implementing a sales tax holiday. Indeed, it even notes that the plan could be counterproductive, because people will put off buying in expectation of a tax holiday. So unless someone can figure out a way to wave a magic wand and make this proposal take effect almost instantaneously, it could easily do more harm than good. Nevertheless, the CBO says a sales tax holiday has a lot of bang for the buck, which will surely make it attractive to many politicians.
What the CBO report really represents is fine-tuning at its worst. By focusing only on the short-term and grading proposals mainly on their static budgetary effect, the CBO implicitly endorses proposals it knows will be bad for growth in the long term.
At this point in the business cycle, it makes more sense for the federal government to forget about short-term stimulus altogether, and just focus on sustaining the economic recovery that is already visible on the horizon.