The Role of Dynamic Scoring in the Federal Budget Process: Closing the Gap Between Theory and Practice

This paper discusses several issues that arise in the process of analyzing the macroeconomic effects of tax policy proposals in a way that is of practical use to legislators. In the current federal legislative process, much of the economic analysis of tax legislation boils down to a single set of numbers: an estimate of the effects of the proposal on projected federal revenues over the ten-year period following the current fiscal year. We discuss some of the practical aspects of developing a methodology for “dynamic scoring,” or accounting for potential macroeconomic effects in the estimate of the revenue effects of a specific tax proposal. While there are many areas of theoretical debate and uncertainty in modeling the macroeconomic effects of tax policy, we discuss three often-overlooked practical issues in incorporating those effects in a revenue estimate: (1) translation of the tax proposal into inputs to a macroeconomic model that capture all the features of the proposal that are likely to have an impact on the economy; (2) adjustment of the tax and revenue related equations in the macroeconomic model to account for the difference between the actual present-law Internal Revenue Code and the specifics of the tax proposal being analyzed; and (3) reconciliation of differences in definitions of income between National Income and Product Account (“NIPA”) data that macroeconomic models are typically calibrated to replicate, and the cash-basis income flows on which the present-law tax code is based. We show how the effects of proposed tax changes on GDP and revenues can vary depending on the methodologies chosen to address each of these issues.