Good Economic Analysis Requires More Than Static Vision

The Providence Business News
March 2012

If there’s one thing Rhode Island isn’t very good at, it’s due diligence. Not because we are incapable of undertaking it and producing a more-than-satisfactory analyses of various policy proposals. Instead, and ironically, the reason is that due diligence is so seldom undertaken by Rhode Island’s leaders. Some years back, I found it necessary to create a term to describe how our state’s leaders deal with needed economic analysis: Due Presumption. Apparently, they continually choose to presume that whatever they think will occur will actually occur. This is further compounded by the fact that these leaders also tend to think linearly. By this, I mean that in their minds the impact of anything is presumed to be independent of anything else. The inevitable result is use of the word “should” far too often, and following policy changes, being surprised by the fact that things didn’t work out as had presumed.

Worse yet, on the rare occasions when due diligence is actually undertaken here, it is almost exclusively based on static analysis, which is also a very linear way of viewing how an economy works. Using this framework, the only effects identified are those that can be expected to occur if existing patterns and market participants remain essentially unchanged. Based on this type of analysis, increases in any type of tax always generate higher tax revenue, while tax cuts always reduce revenue. There is no consideration of the fact that our state’s reputation as “Tax Hell Rhode Island” precedes us, or a host of other “compounding” factors, such as how changes relative to other states might mitigate possible gains, or most importantly, how market participants might change their behavior based on now-altered incentives. But that, of course, takes time to occur.
The analysis of the effects of time on economic activity is called dynamic analysis. It is this type of analysis that actually attempts to account for changing behavior based on interactions with other states, altered incentives, or a host of other possible factors that can reasonably be expected to occur through time.

So, in static analysis, raising the state’s highest tax rate, as was recently proposed, it expected to generate potentially large increases in tax revenue, since it is presumed that nobody will change their behavior, nor will anyone ever leave our great state. Dynamic analysis looks at both the initial and subsequent effects of this change, incorporating the possibility that some people might actually leave our state, as hard as that might be to comprehend, and with their exit, tax revenue might peak then possibly decline in the future. To quote Margaret Thatcher, the former Prime Minister of Great Britain: “the problem with Socialism is that eventually you run out of other people’s money.” In static analysis, that could never happen.

So, in the first significant use of dynamic analysis here in as long as I can remember, the Rhode Island Center for Freedom & Prosperity study concluded that the proposed changes to the sales tax made by Governor Chafee will produce a host of what they refer to as “severe unintended consequences,” leading to their expectation that the state’s static revenue projections substantially overstate what can be expected to occur. It is important to keep in mind, though, that as good as dynamic analysis is, it is not perfect. It too, must make a number of assumptions dealing with magnitudes (elasticities). And some of these might have changed as the result of “The Great Recession.” In spite of this caveat, which might at times be substantial, I always prefer to base my economic assessments on dynamic analysis over static analysis.

If Rhode Island truly wants to move beyond its largely structurally based economic malaise, it needs to not only institutionalize due diligence, but base it on dynamic analysis as well. Only then will we be able to put an end to Due Presumption and investigate the actual magnitudes and interactions of the factors impacted by proposed policy changes far more accurately than has been done to date, on the rare occasions when due diligence is even attempted. The benefits of this will accumulate very quickly – we will gain a far better understanding of key economic variables and their sensitivity to various changes. This will ultimately become part of the “economic toolkit” for our state’s leaders. If we fail to do this, expect many more economic “surprises” and ongoing humiliations whenever fifty-state comparisons are published.

 
by Leonard Lardaro