Ex-Fiscal Conservatives

In the Times, David Leonhardt profiles McCain economics advisor Douglas Holtz-Eakin. Although the tone is sympathetic, Leonhardt cannot avoid asking the awkward question "are there any fiscal conservatives anymore?"

Holtz-Eakin headed the Congressional Budget Office when it took a stab at "dynamic scoring." Though that sounds like something Billy Dee Williams might do, it actually means trying to incorporate "supply side" effects into estimates ("scoring") of the revenue losses associated with tax cuts. Leonhardt writes:

When Douglas Holtz-Eakin took over in 2003 as the director of the Congressional Budget Office — the nation’s bean counter in chief — he walked right into a firestorm.

For years, Republicans had been pushing the budget office to change the way it estimated the cost of a tax cut. Rather than looking only at the revenue lost, they argued, the office should also consider how tax cuts would change behavior. With lower tax rates, businesses would invest more, workers would work more — and the government would thus get a tax windfall. This, in a nutshell, is supply-side economics.

A bearded academic, Mr. Holtz-Eakin had just finished a stint in the Bush administration and had spoken favorably about dynamic analysis. So his appointment excited Republicans almost as much as it scared Democrats. Senator Kent Conrad went so far as to call it “a mistake.”

But it turns out that both parties underestimated Mr. Holtz-Eakin. He did indeed begin using dynamic analysis, which makes a lot of sense, since tax rates really do alter people’s behavior. Yet he used it as it should be used.

What the budget office found, as study after study has shown, was that any new revenue that tax cuts brought in paled in comparison with their cost....

Now Holtz-Eakin is working for a candidate who opposed the 2001 and 2003 Bush tax cuts, but now wants to extend them, and go further. McCain's vague promises of spending cuts to keep the deficit under control are reminiscent of David Stockman's "magic asterisk." Leonhardt:

To deal with the deficit, Mr. McCain has said that he will get tough on year-to-year spending, both in military programs and domestic ones. Then he will try to remake Medicare and Medicaid so that, as Mr. Holtz-Eakin puts it, they no longer pay doctors “based on what they do to people, instead of what they do to make people well.” It’s a fine idea.

The problem is that the campaign has been far, far more detailed about its tax cuts, which would worsen the deficit, than its spending cuts, which would reduce it. Mr. McCain has proposed the elimination of the alternative minimum tax (at a cost of $60 billion a year), new child tax deductions ($65 billion), a corporate tax cut ($100 billion) and faster write-offs for corporate investments in new equipment ($50 billion to $75 billion).

Of course, there are some who are in denial about the budgetary consequences of a tax cut, still peddling the claim that somehow revenues will rise - and one of those cranks, Arthur Laffer, is also advising McCain (as is Kevin Hassett, co-author of "Dow 36,000;" see Jeff Frankel's comments). Given the varied quality of his advisors, and his flip-flops on the issues, what McCain really thinks - and really would do in office - is anyone's guess. Washington Post columnist Ruth Marcus believes we're not getting straight talk:

Call it McCainsian Economics. Its seminal treatise: "The General Theory of Getting Elected."

In the space of just a few years, McCain has morphed from someone who worried about the cost of the Bush tax cuts into a rabid tax-cutter. You don't need a fancy equation to explain this turnabout. McCain is running for president at the helm of a party that's deathly allergic to taxes and highly suspicious of him on this score. His campaign-trail buddy is Phil Gramm, the former Texas senator. When it comes to fiscal responsibility versus more tax cuts, Gramm is what your mother would call a bad influence.

McCain 2001 said he could not "in good conscience support a tax cut in which so many of the benefits go to the most fortunate among us, at the expense of middle-class Americans." McCain 2008 pushes a tax policy that makes Bush's plan look like a soak-the-rich scheme....

Although some respectable economists do believe that tax cuts can alter incentives and induce additional labor supply and capital accumulation, the notion that those effects would be large enough to increase revenues is well known to be fantasy. For example, this analysis by Greg Mankiw, a Republican and former Bush advisor, and Matthew Weinzerl used a neoclassical growth model to find that, in the long run, the supply side effects reduce the revenue impact of capital and labor taxes by 50% and 16.7%, respectively (that's after a transition to a new steady state; the effects are much smaller at, say, a 10-year horizon). What their analysis appears to leave out is the impact of deficit spending, which reduces capital accumulation through the "crowding out" effect (i.e. the government borrows some of the saving that otherwise would have financed investment).

This Jeff Madrick column from 2003 has more on the CBO study of the dynamic effects of tax cuts, and is also a nice example of the way in which macroeconomists use a grab-bag of different types of models.

Mark Thoma comments on Leonhardt's story, as does The Economist's Free Exchange.

Update (4/26): Krugman says "it’s really sad to see Holtz-Eakin lending his reputation to this sort of thing."