When econ models potentially mislead, econ profs should say so

October 23rd, 2017 at 6:42 pm

Last week saw an interesting and revealing dustup in the tax debate. President Trump’s economic council, headed by Kevin Hassett, released a piece claiming that the proposed corporate tax cut would immediately boost average household income by at least $4,000, a claim that was widely pilloried in the economics community. One of the authors of a paper CEA cited to defend their results claimed that the CEA misinterpreted their paper.

A particularly salient objection was the CEA’s claim that the incidence of the corporate tax cut fell not just wholly on workers, but that their aggregate wage gains from the cut would be multiples of the revenue lost. Their paychecks would grow more—a lot more, as much as 500% more!—than the revenues lost to the cut.

That sounds wrong, but as Greg Mankiw points out, the direction of Hassett’s result is consistent with a particular economic model (though even Greg’s model doesn’t get you the magnitudes Hassett claims). Mankiw was not per se defending Hassett, as much as teaching his students how to get a result like Hassett’s by imposing standard assumptions common to such models. Greg’s explanations, for the record, are lucid and instructive as always.

But, because the model he employs bears little resemblance to reality, his work does not provide information that would help someone answer the key question at hand. That is, Greg answers the question: is there an economic model that might defend Kevin’s findings, at least directionally if not their magnitudes? Answer: yes.

Yet, the much more pressing question for people trying to decide if $200 billion a year in corporate tax cuts will help workers is: what’s the real-world likelihood that corporate tax cuts will raise workers’ wages anywhere near the amount Hassett claims?

As many, including myself, have stressed, the answer to that question is “very low.” That’s based on both theory and evidence. The historical record is unconvincing regarding corporate cuts leading to wage gains, and in most of the models used by the Joint Tax Committee and CBO, corporate tax cuts that aren’t paid for lower GDP (relative to a baseline) and thus over time would reduce wages. Moreover, even if the wage effect is positive, it is highly unlikely to be large enough to offset the future cuts in benefits (or, less likely, increase in taxes) needed to pay for the plan either now or, more likely, later.

The interesting economics question is why the model predicts such an unrealistic result for the US economy? Which of the assumptions most fail to comport with reality? To the extent that we want to train students to be useful practitioners as opposed to proficient, yet unrealistic, modelers, answering those questions would also provide some real educational value-added.

In this case, the model assumes that the US is a small, open economy such that capital inflows instantaneously fund more investment, such investment immediately boosts productivity, and the benefits of faster productivity immediately accrue to paychecks. The simple model ignores the extent to which these inflows would raise the trade deficit as well as their impact on revenue losses and higher budget deficits.

The model assumes away imperfect competition, which is relevant today as a) monopolistic concentration is an increasing problem, and b) the one thing economists agree on in this space is that in these cases, the benefits of the corporate cut flows to profits and shareholders, not workers, other than maybe some “rent sharing” with high-end workers.

Larry Summers made a great point about this: The modelling of Mankiw and others “illustrate why well-resourced, team-based institutions with a strong culture of attention to detail like the Congressional Budget Office, the GAO, the Joint Tax Committee Staff or the Tax Policy Center are so important.” By “detail,” I take him to mean an unbiased use of literature (unlike Hassett, who totally cherry-picked), and more important, an historical perspective. As many critics of the White House analysis have shown, corporate tax cuts never come close to the wage impacts Hassett claims and Mankiw’s modelling supports. Real modelers analyzing real policy proposals must reference real empirical results, and not just the ones that go their way.

This all points to a bigger problem with contemporary economics, particularly as it is deployed in DC debates. A well-placed, highly-pedigreed economist (Hassett) makes an implausible claim, one that is likely to impose great costs on our fiscal outlook and on those who will ultimately pay the cost of the cuts (likely through spending cuts). Sure enough, his claims can be and are, if not defended, then apparently corroborated, by an economic model, in this case by other highly pedigreed economists.

This is lovely development from the perspective of the politicians and their donors who crave these high-end tax cuts. All they need is some “analysis,” regardless of how cherry-picked, and a little backup from other erudite economists saying “under certain conditions, yeah…this could happen.”

They—those other erudite economists—shouldn’t do that. That is, unless they too have a thumb on the scale, they should be explicit about how applicable the model is to the real world, and whether the assumptions it violates are germane to policy makers (Krugman does so here; Furman here). To do otherwise may seem neutral in the analytic community, but in the hurly-burly of political economy, it’s an egregious omission, one with the potential to mislead policy makers and, once the tax cuts fail to generate the result predicted by the model, reduce the trustworthiness of economic analysis.

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16 comments in reply to "When econ models potentially mislead, econ profs should say so"

  1. Gerald Scorse says:

    Will Mankiw read your column? I suspect it’ll get to him, one way or another. Will he take heed? Not likely. The point you make is an obvious one, and it’s hard to believe it didn’t occur to him before he defended Hassett; ergo, he’d do it again tomorrow.

    • Osman Rahman says:

      Mankiw has once defended Hassett’s outlandish DOW 36000 claim on the basis of a finance model! So it’s nothing surprising! He is an economics teacher selling toy model textbooks to students. He has a particular proclivity towards the effectiveness of taxes and their role in the economy. So it’s ok….

      • Procopius says:

        Besides, it makes him more attractive to people looking to appoint an economist to a position of great power which will later lead to great wealth.

  2. JF says:

    So who on the Fed board and senior staff will publicly oppose this lunacy of wealth and income-control redistribution upwards (with flow or GDP concentrating and slowing too)?

    How about some bank Presidents across the US?

    Self government should not be used for these purposes.

    Please, economists, do something.

  3. Gerald Scorse says:

    Brad Delong on Mankiw (echoed by Krugman):

    “I think that the Greg we have here is not primarily (1) Greg-teaching-students-about-public-finance-issues Greg but rather (2) Greg-going-as-far-as-he-believes-he-can-to-be-helpful-to-the-Republican-Party Greg. And I wish we had (1) Greg instead.”

  4. Voter says:

    This is why I believe the CEA should be eliminated. If there is large-scale disagreement over economic issues, then the president and congresspeople should be required to listen to the chaos.

    Do we have to push for using referendums to approve major tax changes? It sounds silly, but it might produce better results. If it works for setting public employee’s wages, why can’t it work just as well for setting corporate tax rates?

    If it isn’t obvious, these are rhetorical questions.

  5. Smith says:

    I’m not understanding why Krugman models more capital as producing investment. Corporate American is swimming in cash, and uses extra money for stock buybacks or to buy competitors and trim payroll with economies of scale to boost profit margins, or closing the least profitable business lines of combined operations. Since stock is owned primarily by wealthy people, the stock isn’t sold, the money isn’t spent, or if it’s spent it bids up the price of assets or goods, pricing the middle class out of some market while adding nothing to the economy, or it boosts businesses and services catering to the rich, without actual expansion of production or investment in capital, especially since markets respond to signals the rich have money to burn. Charge more for hand crafted artisanal organic gluten free shirt or handbag and no new investment needed, it’s not inflation because it’s still labeled a different product. The profits are spent on equally investment free products or services. Except some capital finds it’s way into somewhat frothy tech bubble, or real estate. Liberal economists (like Galbraith) use to complain that corporations seek growth for growth’s sake instead of sound economic reasons. Those days are long gone, and who knew those were the good ole days. Corporations sit on cash, rich people sit on cash. Or cash is traded for assets with out investment occurring or sits in the bank and the banks sit on the cash and don’t loan it (despite the incentive to make more money) and not even the remote possibility exists for anything to trickle down.
    Why isn’t this the case when they sit on cash and banks are not short of funds to lend? Why must more capital lead to more investment? There’s not enough demand, this is Krugman’s pushing on a string? It’s why monetary policy failed to produce a robust recovery even with Quantitative Easing. Why does Krugman ignore his own commentary? Why this blog too?

  6. Richard says:

    I find it hard to believe that models that do not reflect reality and truth actually get used at all by anyone in a profession that claims to be a ‘science’.
    If they do not give results that are verified to be accurate in the real world, they should have been tossed long ago. Ever hear of the scientific method?

    • Jared Bernstein says:

      I do not consider economics to be much of a science, ftr. We use math and statistics, sure, but the discipline as practiced lacks the empirical rigor that links or rejects theory and real-world outcomes, as you note.

    • Procopius says:

      Milton Friedman defended the practice as simply abstracting the most salient features from less significant factors. I don’t remember the exact words, but basically he said that all models diverge from reality anyway, so it doesn’t matter how contrary to reality your assumptions are as long as the model produces correct results. He ignored the fact that the models being criticized did not produce correct results.

  7. JF says:

    Perhaps Senator Flake’s remarks will embolden others.

    Leadership in your area of competence dies take a bit of courage and the ability to stand for what you believe in.

  8. William Miller says:

    The fundamental limitations to economic growth and fair sharing of new profits as increased wages to workers (which is a part of income inequity) are not just bad economic models but two things – first: (1) the plutocratic rules described in “Rewriting the Rules of the American Economy” and second; (2) the failed and obsolete practices of the current generation of innovation management taught in business schools and by business consultants and practiced by corporations that would rather invest in stock buybacks and acquisitions than the radical innovation needed to restart productivity and cut costs in almost all industries including healthcare, education, and construction. The new generation of innovation management needed for growth and increased wage sharing is the fourth (4G) to emerge since 1900. 4G is changing entrepreneurship (Lean Startup – a subset of 4G) and financial accounting (Integrated Reporting – a subset of 4G). Policy needs to be revised with (1) but (2) is needed to correct teaching obsolete innovation theory and practice in university education (MBA …) and in business management. The NSF iCorps is teaching Lean Startup but that’s inadequate to yield real growth and wage sharing.

  9. Richard says:

    If the Administration believes wages will rise by $4 to $9 thousand dollars from their proposed corporate tax cut, then any corporation that would like to utilize the proposed tax rates should be required to submit to the Treasury in formation verifying that they have i deed raised wages by $4 to $9 thousand dollars.

  10. byomtov says:

    The interesting economics question is why the model predicts such an unrealistic result for the US economy?

    I’d say a more interesting question is why Hassett is not violating whatever ethical standards, if any, that the economics profession has.

  11. dilbert dogbert says:

    Read that Great Britain has run the experiment and the results are not good.