The Economist: Static or Dynamic Matters
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We live in a dynamic world. Actions cause reactions. One change can set off a series of other shifts. Consequences ripple out. The economy is certainly no exception (which is why my forecasting model requires millions of equations).
The importance of a dynamic viewpoint also applies to the realm of public policy. Government spending and taxation lead to economic reactions. These reactions, in turn, affect taxes. This is true for government at all levels (federal, state, or local), and interactions among these layers of the public sector can sometimes work at cross purposes.
If the State of Texas spends taxpayer dollars to build a highway, for example, a number of companies will benefit from the related contracts. These companies then have to buy things (and pay sales tax on some of them) to complete the job. They also pay franchise taxes, fees, permits, and so on. The workers who get paid also go out and spend their wages (generating sales tax). Over time, some portion of the initial outlay is recovered through incremental taxes. Going even further, the presence of the road will make transportation more efficient and, thus, spur greater productivity and an ongoing dividend to government coffers.
If tax laws change, individuals and businesses also react. If federal income taxes are cut, for example, more money is left in the hands of families to spend as they please. This spending then leads to gains in business activity and therefore additional tax collections. The type of tax imposed or reduced is relevant, because responses naturally vary.
Dynamic tax revenue analysis is a complex task, but one which is certainly necessary to get a better understanding of the fallout from tax code changes. Although it is somewhat subject to political gaming (such as tweaking assumptions to minimize/maximize the consequences of a potential change and, thus, better support a partisan position), it is nonetheless an important tool for policy analysis.
The same dynamic process applies to government spending and cuts, but budget analysis often leaves little room for incorporating ripple effects. The issue is, to some extent, a very static and myopic view of the budget that does not reflect reality. If $1 million is cut from a program, it counts as $1 million toward balancing the budget. In reality, however, the consequences of that cut may cost taxpayers more than $1 million.
For example, cutting State funds for education or health care can cause higher local taxes, lost matching federal funds, higher insurance rates, lost productivity from a less qualified pool of workers, and/or foregone revenues from economic growth. Social costs can be even higher. It must be remembered that the taxpayers of Texas are the same people and firms who pay local taxes, purchase insurance and health care, and benefit from better schools at all levels.
Many cost-saving efforts involve substantial negative fallout and should be evaluated within a framework that reflects overall consequences. Such dynamic costs are not always measured in policy debates, but are nonetheless very real and can greatly affect future prosperity.
It is also important to consider how one level of government’s action affects the others. A federal cost-saving measure can increase the burden on states or municipalities. A decision by the State of Texas likely affects cities and counties. In a perfect world, we could examine all of these relationships in order to get the highest benefit at the lowest cost; at a minimum, some thought must be given to the ripples.
At the federal level, we face upcoming elections and budget challenges. The fiscal situation the Texas Legislature will be dealing with in a few months will also not be easy. As we work through the difficult process of either raising revenue or cutting spending, the dynamic framework should always be kept in mind. Otherwise, short-sighted policy can lead to long-term problems.
Dr. M. Ray Perryman is President and Chief Executive Officer of The Perryman Group (www.perrymangroup.com). He also serves as Institute Distinguished Professor of Economic Theory and Method at the International Institute for Advanced Studies.