(January 2006) Once upon a time many economists did not accept the idea that tax rates matter. Today, the opposite is true. Three sources of information widely recognized as credible among economists have devoted considerable attention to the idea. These sources are the Federal Reserve System; the National Bureau of Economic Research in Cambridge, Massachusetts; and research in leading peer-reviewed economic journals. Some economists still dispute the idea tax rates matter, but they no longer dominate the policy debate.

Policymakers at the federal and state levels face a number of related issues when examining the idea that tax rates matter. These include supply-side effects, dynamic scoring; broadening the tax base, while lowering marginal rates; cross-border adjustments; corporate tax rates; expensing versus depreciation; and the tax system's progressive structure. In this memo (Pt. 1), supply-side effects and dynamic scoring are briefly examined. Future memos will review the other issues.

Supply-Side Effects

Supply-side effects describe the impact tax rates have on economic behavior. Federal Reserve economists have examined the idea that tax rates matter in reviews published by member banks since the early 1980s. Their research shows the idea, rooted in neoclassical economics, has developed over several centuries.

In 1980, the St. Louis Fed co-sponsored a conference, "The Supply-Side Effects of Economic Policy." In 1981 the bank published a paper by John A. Tatom that "reviews the conceptual basis for supply-side economics and examines the fundamentals of supply performance in the United States."

In 1981, the Atlanta Fed published "Supply-Side Effects of Fiscal Policy: Some Historical Perspectives." In 1982 the bank organized a "Supply-Side Conference" that issued a 297-page report.

Other examples include the Richmond Fed in 1992 and the Atlanta Fed in 2000.


Dynamic Scoring

Dynamic scoring is an attempt to identify the true revenue effect of tax proposals. Government economists tend to rely on static scoring when analyzing proposals. Static scoring ignores feedback effects when tax rates are increased or decreased. One implication of static scoring is that reductions in tax rates are not seen as self-financing. Dynamic scoring attempts to identify the effect of rate changes on entrepreneurs, employment, income, government revenues and other variables.

Established n 1920, the Cambridge-based NBER is one of the nation's leading economic research organizations. NBER Working Paper 11000, "Dynamic Scoring: A Back-Of-The-Envelope Guide," examines these procedures. The paper was co-authored by Harvard Professor N. Gregory Mankiw and Harvard Ph.D student Matthew Weinzierl. The paper "uses the neoclassical growth model to examine the extent to which a tax cut pays for itself through higher economic growth," according to the abstract. They find "the feedback is surprisingly large: for standard parameter values, half of a capital tax cut is self-financing." Economists disagree about dynamic scoring variables but efforts are underway in Washington, D.C., and in several states to incorporate these feedback effects into revenue estimates.



It was relatively easy a generation ago for critics to dismiss the idea that tax rates matter. That is no longer true. This brief review demonstrates the Fed has examined supply-side effects, and the NBER has published on dynamic scoring. Both are widely recognized as credible mainstream sources among economists.

-- Greg Kaza

Next (Pt. 2): Corporate Tax Rates, Cross-Border Adjustments, and the Tax Base