June 1, 2008
This paper surveys the empirical and theoretical literature on macroeconomic production functions and assesses whether the constant elasticity of substitution (CES) or the Cobb-Douglas specification is more appropriate for use in the CBO’s macroeconomic forecasts. The Cobb-Douglas’s major strengths are its ease of use and its seemingly good empirical fit across many data sets. Unfortunately, the Cobb-Douglas still fits the data well in cases where some of its fundamental assumptions are violated. This suggests that many empirical tests of the Cobb-Douglas are picking up a statistical artifact rather than an underlying production function. The CES has less restrictive assumptions about the interaction of capital and labor in production. However, econometric estimates of its elasticity parameter have produced inconsistent results. For the purpose of forecasting under current policies, there may not be a strong reason to prefer one form over the other; but for analysis of policies affecting factor returns, such as taxes on capital and labor income, the Cobb-Douglas specification may be too restrictive.