In all the back and forth about the numbers not adding up for Romney's tax plan you may have seen references to a study from John Diamond at Rice University. Diamond claims that Romney's policies would increase economic output by about 5% each year by the end of 5 years, and result in 7 million additional new jobs at the end of 12 years.
This paper is the primary support for both the jobs claims and the claims that Romney's tax cuts can be accomplished without increasing the deficit. Most writers have just accepted the analysis, or questioned its application to our current economic situation, probably because only a handful of people in the country are really equipped to understand what Diamond did. I am one of those people and I am here to tell you his work is complete crap.
Short version - he built a model that assumes there are no rich or poor people and that the economy is already at full employment to analyze the effects of Romney's tax plan. Unfortunately that model predicts NO gains in employment but does predict that already employed individuals will work longer hours. He then uses a result from another empirical (uses real data) study which finds that everything in Diamond's paper is wrong (in particular that individuals don't actually work longer in response to wage increases) to argue that the effect would actually be to increase jobs.
Crap
details beneath the Communist Croissant.
PS I am a PhD economist that teaches graduate level economics courses in a midwestern business school.
To explain why I need to explain a little about economic models.
Diamond's paper is an analytical model (computer simulation) that tries to capture the response of the economy to policy changes by building a simplified or abstracted mathematical model of the real dynamic economy. It is what is known as an "overlapping generations model" in which each period a cohort of identical individuals is born, they live 55 periods during which their productivity first increases (to simulate youth), then plateaus, and finally falls as they age. Because the wage they receive reflects their productivity, very young and old individuals may choose not to work because they don't earn very much, and so they borrow as youths and save during their prime working years and then spend their savings in old age. The saving in the middle years provides resources for capital investment which increases overall productivity.
In Diamond's model, Romney's tax rate changes effect the economy primarily in two ways. Most importantly the lower marginal tax rate leads individuals to work more hours each year, and both enter the work force earlier and work longer into old age. Diamond models the tax rate cut as a reduction in marginal wage tax rates from 26% to 20.8%, which results in an aggregate increase in labor supply of almost 6%. He then uses results from a different paper (Blundell Bozio Laroque 2011) to argue that 90% of this increase would be from additional workers joining the labor force. That gives him the 7 million new jobs number. Reading Blundell et al is key to understanding what is wrong in Diamond, and why this is nonsense.
Blundell tries to explain the labor supply response to changes in the effective wage rate (which is what is left after taxes). They find that these changes are extremely heterogeneous across different workers. In particular they find that women with children, very young workers and those on the verge of retirement are quite sensitive to wage rates, and tend to either work or not - this response is called elasticity of extensive labor supply. Almost all the change in labor supply in response to wage changes comes from these segments choosing to enter (or remain in) the labor market.
Diamond's paper has representative agents - everyone is identical in wealth and earning power except for differences that result from their age, so the women entering the workforce is not in his model (no women, no marriage, no children). He should be able to capture young and old workforce entry, but doesn't do that because the effect is negligible in his model. That is why he uses the Blundell result to estimate the number of jobs - his model has no jobs created.
But the Blundell model is not consistent with the base model of the paper. Diamond's model is about the labor supply response to the tax change. Blundell shows that the response is almost nothing for most workers, but very strong for a few subgroups. Diamond's result depends entirely on a response which Blundell finds is negligible.
To sum up. Diamond has a model that assumes that there are no rich or poor people, everyone is the same except for their age. He assumes that the economy is always at full employment, and that the amount that people choose to work is the primary determinant of how much they work and produce. He assumes that the typical worker is facing the maximum marginal tax rate. His model then predicts that people will on average work 6% more in response to a 20% cut in their marginal rate. Unfortunately, his model predicts that almost everyone is already working, and the ones that don't work don't actually earn high enough wages to pay income taxes so the effect doesn't lead to any actual increase in employment. So he uses the result of another paper that uses real data to show that everything in Diamond's model is wrong to convert his prediction into a prediction of job gains.
Crap.
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