How CBO is Implementing Dynamic Scoring

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Congressional Budget Office September 17, 2015 How CBO Is Implementing Dynamic Scoring Presentation to the Society of Government Economists Keith Hall, Director For additional information, see Congressional Budget Office, “Dynamic Analysis,” www.cbo.gov/topics/dynamic-analysis.

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The Congressional Budget Process ■ The Congressional Budget Act specifies that budget authority and outlay amounts are to be allocated to committees by a budget resolution. ■ The budget committees use a scorekeeping system to assess whether the estimated costs of legislation exceed the amounts in the budget resolution. ■ Cost estimates prepared by CBO, sometimes called scores, are used in that system. CONGRESSIONAL BUDGET OFFICE 1

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Scoring Legislation at CBO In 2014, CBO completed ■ More than 600 formal cost estimates, all of which were posted on www.cbo.gov ■ Between 5,000 and 6,000 informal cost estimates CONGRESSIONAL BUDGET OFFICE 2

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Behavioral Responses in Conventional Cost Estimates ■ Estimates incorporate some effects of changes in policy on people’s behavior that would generate budgetary effects. ■ By long-standing convention, estimates generally have not reflected changes in behavior that would affect total output in the economy (for example, changes affecting the labor supply or private investment). CONGRESSIONAL BUDGET OFFICE 3

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Requirements Under the 2016 Budget Resolution To the greatest extent practicable, CBO and JCT shall incorporate the budgetary effects of changes in macroeconomic variables resulting from ■ Major legislation reported by most committees that has a gross budgetary effect of 0.25% of GDP (excluding macroeconomic feedback) in any year over the next 10 years (an amount equal to about $45 billion in 2015) or ■ Legislation that is designated by one of the Chairmen of the Budget Committees CONGRESSIONAL BUDGET OFFICE 4

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Other Provisions Regarding Estimates ■ Not required for appropriation acts ■ Shall include a qualitative assessment for the subsequent 20-year period of the budgetary effects (including macroeconomic effects) CONGRESSIONAL BUDGET OFFICE 5

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Previous Dynamic Analysis by CBO ■ Included in selected recurring reports – Analysis of the President’s budget – Annual long-term budget outlook ■ Recently included in analyses of specific legislation – Proposal to repeal the Affordable Care Act – Tax Relief Extension Act of 2015 (estimate by the staff of the Joint Committee on Taxation) CONGRESSIONAL BUDGET OFFICE 6

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Estimated Effects on Deficits of Repealing the Affordable Care Act Billions of Dollars, by Fiscal Year 150 Without Macroeconomic Feedback 125 With Macroeconomic Feedback 100 75 50 25 0 -25 -50 2016 2017 2018 2019 2020 2021 2022 2023 CONGRESSIONAL BUDGET OFFICE 2024 2025 7

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Short-Term Effects of Fiscal Policies on Output ■ Reflect effects on the supply of labor, depending on the amount of slack in the labor market ■ Reflect direct contributions to aggregate demand from changes in purchases by federal agencies and those who receive federal payments and pay taxes ■ Incorporate the change in output for each dollar of direct contribution to demand (the “demand multiplier”), which varies with the response of monetary policy CONGRESSIONAL BUDGET OFFICE 8

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The Magnitude of the Demand Multiplier Demand Multiplier Likely Monetary Policy Response Time Period of Effect Range Central Estimate Limited Four quarters 0.5 to 2.5 1.5 Stronger Four quarters 0.4 to 1.9 1.2 Eight quarters 0.2 to 0.8 0.5 CONGRESSIONAL BUDGET OFFICE 9

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Long-Term Effects of Fiscal Policies on Output ■ Estimated using two models of potential output – Solow-type growth model – Life-cycle growth model ■ Determined by various factors – Amount and quality of labor and capital (depends on work, saving, and investment) – Productivity of the labor and capital inputs (depends in part on federal investment) – Amount of national saving (depends in part on federal borrowing) CONGRESSIONAL BUDGET OFFICE 10

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The Role of Expectations About Fiscal Policy: Solow-Type Growth Model ■ People base their decisions about working and saving primarily on current economic conditions, including government policies. ■ Decisions reflect people’s anticipation of future policies in a general way but not their responses to specific future developments. CONGRESSIONAL BUDGET OFFICE 11

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The Role of Expectations About Fiscal Policy: Life-Cycle Growth Model ■ People make choices about working and saving in response to both current economic conditions and their explicit expectations of future economic conditions. ■ The model requires specification of future fiscal policies that put federal debt on a sustainable path over the long run. ■ Forward-looking households would not hold government bonds if they expected that debt as share of GDP would rise without limit. CONGRESSIONAL BUDGET OFFICE 12

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Response of the Labor Supply to Changes in Fiscal Policy in the Solow-Type Growth Model ■ The overall effect of a policy change on the labor supply can be expressed as an elasticity, which is the percentage change in the labor supply from a 1 percent change in after-tax income. ■ CBO’s estimates correspond to a total wage elasticity for all earners of 0.19, comprising two effects. Type of Effect Substitution effect Income effect How Increased After-Tax Income Affects People Elasticity For an additional hour of work, it makes work more valuable relative to other uses of a person’s time 0.24 From a given amount of work, it allows people to maintain the same standard of living while working fewer hours -0.05 CONGRESSIONAL BUDGET OFFICE 13

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Other Key Aspects of the Solow-Type Growth Model ■ When the deficit goes up by one dollar, private saving is estimated to rise by 43 cents (national saving falls by 57 cents), and net capital inflows rise by 24 cents, ultimately leaving a decline of 33 cents in investment. ■ Additional federal investment is estimated to yield half of the typical return on investment completed by the private sector. CONGRESSIONAL BUDGET OFFICE 14

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Other Key Aspects of the Life-Cycle Growth Model ■ Labor supply and private saving are influenced by the current values and future anticipated values of the after-tax rate of return on saving, after-tax wages, and disposable income, among other factors. ■ The elasticity with respect to a onetime temporary change in wages (the so-called Frisch elasticity, which is calibrated to be consistent with CBO’s estimate of the total wage elasticity) is 0.40, according to CBO’s central estimates. ■ Because of uncertainty, households hold additional savings as a buffer against potential future drops in income. CONGRESSIONAL BUDGET OFFICE 15

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Presentation of Dynamic Analysis in Cost Estimates ■ Cost estimates that include dynamic analysis have these traits: – Show all of the information that traditionally would be included if macroeconomic effects were not incorporated – Identify the macroeconomic effects separately – Provide information on the uncertainty of the macroeconomic effects ■ Presentations will evolve over time as CBO learns what is most useful. CONGRESSIONAL BUDGET OFFICE 16

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