Should governments be more pessimistic about growth?
Why do so many wealthy countries keep running into deficit trouble? Consider the last decade: The United States, Britain, and a good many euro zone nations all failed to take advantage of the 2002-2007 boom to build up budget surpluses. So when they ran smack into a major financial crisis and severe downturn, these countries all found themselves saddled with high levels of debt and widespread pressure to tighten their belts — precisely the opposite of what they should have been doing.
One explanation is that politicians are too short-sighted to save up for rainy days. No doubt there’s something to that. But another theory is that politicians are constantly relying on faulty economic forecasts. A recent paper by Harvard economist Jeffrey Frankel examined the long-range growth predictions made by government agencies across 33 countries and found that the projections were consistently over-optimistic. (Note that these are different from the retrospective GDP numbers being released today.)
Official forecasters, Frankel found, tend to assume the good times will last far longer than they actually do, which puts less pressure on politicians to prepare for the bad times. We saw this in the United States circa 2001, when both the CBO and OMB were predicting we’d pay down our debt within a decade, giving the Bush administration cover for big budget-busting tax cuts.
This optimism bias was especially pronounced in countries with strict budget-balanced rules. In a way, that makes sense. If there are hard constraints on spending, but the government wants to spend more, then the thing to do is to make giddy predictions about growth and tax revenue. Problem solved — at least until the economy does worse than expected.
Interestingly, the one country Frankel studied that didn’t run into this problem was Chile, which has structural budget constraints (here’s a brief explanation) and which relies on independent forecasters outside of the government for its growth projections. The data Chile uses when crafting its budgets actually tends to err slightly on the pessimistic side. Partly because of that, the country socked away surpluses between 2002 and 2007 and was relatively well-positioned for the recession.
In any case, Frankel’s work came to mind while reading James Pethokoukis’ recent post on Rick Perry’s tax plan. Judged against the CBO baseline, Perry’s flat tax plan is expected to increase deficits $4.7 trillion from 2014 to 2020. But if you assume, as the Perry campaign wants us to, that the flat tax will supercharge the U.S. economy, then it turns out the tax plan only increases the national debt by a mere $1.7 trillion through 2020. Voila. Just assume the official projections are too dour, and the numbers look better. But anyone who thinks the main trouble with the CBO’s growth and revenue forecasts is that they’re not sunny enough should take a peek at Frankel’s work.