On May 25, the Fiscal Analysis Initiative of Pew’s Economic Policy Group published an overview of what might happen to the federal government’s annual deficits should the tax relief of 2001 and 2003 be allowed to expire, be extended through 2012, or be made permanent. As readers may know, all of the tax relief currently in force will disappear by law at the end of this year.

Unfortunately, Pew’s report does little to inform policy makers on the awesome economic decisions they are about to make. Had it focused as much on the economic implications of the expiring tax relief (which is all gone on January 1, 2011), it easily could have moved this important tax debate forward. Instead, it is almost entirely derivative of an earlier analysis by the Congressional Budget Office (January 2010). It proves once again, as the CBO study did a few months ago, that introducing economics into the discussion of tax policy change is absolutely critical. By leaving out the economy, Pew may have actually moved this momentous tax debate back.

Why is economics important in the analysis of tax change? Taxes affect economic activity.

As the economy changes so does the pool of income from which tax revenues are drawn. An analysis that ignores the effects of tax policy on the formation of income is a woefully deficient analysis, indeed.

What the Pew analysts do tell policy makers is that extending the Bush era tax relief will worsen  our fiscal position: “Making the tax cuts permanent for all taxpayers, regardless of income, would cost $3.1 trillion over the next 10 years and inflate the national debt to 82 percent of GDP.” Allowing them to expire would “cost” nothing, and extending them for, say, two year would be relatively affordable, according to this report.

However, this clearly is only half of the equation. What’s lacking is the economy. If you’re a business owner, an investor, or a consumer (and who’s not one of these three), you may be thinking that allowing tax relief to expire means an increase in taxes. After all, tax rates on wages and salaries will go up, taxes on dividends and capital gains could increase, death taxes reappear after a year off; and, certain deductions, credits, and exemptions shrink in value.

If taxes go up, you, the taxpayer, may react by sheltering your income from taxation. Then again a tax increase might just slow the economy, as investors require higher returns on their money to pay for the higher taxes on capital and workers decide it just isn’t worth their time to work harder and pay higher taxes. Either way something is happening in the economy that affects the base of income from which the federal government gets its taxes.

So, it’s curious that Pew and CBO don’t provide an analysis of how this substantial increase in tax rates and revenues may affect the tax base. It’s not that Pew and CBO fail to see the importance of analyzing the economic effects of tax change Its just too hard to do in their opinion.  Both organizations argue that estimating these effects requires too many questionable assumptions in their economic models.  OK, let’s think about that.

Imagine two models of the economy that inform policy makers on how raising taxes will affect the economy. One model assumes that an increase in tax rates will leave taxpayers unfazed: they will work, save, and consume just as much after taxes rose as before. The other model assumes that tax rate increases will produce changes in the way taxpayers behave: higher taxes reduce labor effort, investment, and, thereby, overall economic activity.

Now, which of these two models makes the more questionable assumption? Which of these two models do you believe is based on economic theory?

It often surprises otherwise good analysts to learn that they are making bold and perhaps questionable assumptions about taxpayers when they avoid thinking about taxpayer reactions to tax policy change. It also surprises them to learn that they may be doing serious damage to the economy by presenting their analysis as based in economics.

Policy makers, most of whom are untrained in economics, assume that analysts from such groups as CBO and Pew are engaged in good economics. If the only “economic analysis” these policy makers get is the accounting exercise of multiplying tax rates by changes in the tax base, then tax policy can be enacted that temporarily fattens the Treasury at the expense of long-run economic prosperity.