Monday, November 19, 2007

Here Comes Your Kicker - Thank the Dismal Scientist

The kicker is a strange piece of public policy in a number of ways, but I want to talk about one way in particular: counting on people like me (economists) to determine future economic conditions in the state and thus the amount of the kicker. Can this possibly be a good idea? I don't think so. Economic forecasts are educated guesses that are generally pretty good in the short-run but are pretty unreliable in the long-run. Why? Well in the short-run, risk is low, much is known and economic conditions are slow to change. But trying to predict the state of the Oregon economy two years out is a fool's errand. Consider the US economy and the subprime mess. The US economy is intensely studied, but until recently there were not many economists who thought 'softness' in the housing sector was that big a deal, now suddenly there is a crisis that could lead to recession soon (yet, again, no one is quite sure). Markets in general are not that wise either, had they been so smart, the price of citigroup stock, for example, would have fallen long ago. So the point is, relying on long range economic forecasts is simply silly.

But I have another concern, one that my be a bit far fetched (but I am not so sure how far fetched). In relying on forecasts instead of outcomes we are relying on something that can itself change economic conditions. What we would call an endogenous process. Here is what I mean: suppose the economic forecast is very pessimistic, this means a lower likely tax burden through a kicker return. This should spur investment in the Oregon economy as people act on expectations of the future and thus this should create even better economic performance and even bigger kicker refunds. Now consider an optimistic economic forecast, this will depress investment and may cause poor economic performance of the Oregon economy. Perhaps this counter-cyclical effect of the kicker is desirable, but I don't think it is understood and I don't think it is a first-best policy. If you want to restrain state spending, why not just limit state spending using some index based on economic outcomes? Or, if you want the state to act counter-cyclically, why not save part of the money collected in good years for lean years and then have the government spend these reserves in bad times as a counter-cyclical influence? (OK, I am speaking like a Keynesian here, but in the short-run, guess what? The Keynes model works incredibly well)

If you don't think my endogeneity story is very plausible then you must believe that people and businesses don't form opinions about the relative pessimism of the forecast. That means we are basically introducing uncertainty into the eventual tax burden of Oregon taxpayers. Uncertainty is not a good thing. Most people and many businesses are risk averse, which means that adding uncertainty will depress investment. If the goal of the kicker is to spur investment in Oregon, than this is counter productive.


Jeff Alworth said...

If you don't think my endogeneity story is very plausible then you must believe that people and businesses don't form opinions about the relative pessimism of the forecast.

It's interesting. If I owned a company that did a lot of business in Oregon, I would probably discount modest or rosy scenarios, knowing that the estimation couldn't be accurate out past a couple three quarters. Yet if it were very pessimistic, I might worry.

But of course, if I owned a company, it would likely involve the production of beer, in which case I might greet a pessimistic forecast with glee--people drink more beer when times is tough.

(That joke actually makes me wonder about a serious question: you suggest an endogenous process, but wouldn't activity based on forecasts differ by industry and company? How could you predict their reactions?)

Patrick Emerson said...
This comment has been removed by the author.
Patrick Emerson said...

I plead guilty for making essentially what is an academic argument. I don't really that in the aggregate this matters that much. Though I do think it does matter at least marginally. But what I wanted to highlight is that policy, poorly conceived, often suffers from unintended consequences.

BTW, not to get too wonky, but large corporations with facilities in more than one state practice transfer pricing to minimize their tax exposure - something that would also lead to curious feedbacks.