HICKS: Economic activity stalls when taxes rise

April 16, 2011

Anyone with even a scintilla of parenting experience recognizes the role of incentives in modifying behavior. So it has always struck me as odd that so many forget the matter entirely when thinking about economic policy. The failure to realize the power of incentives in public policy is due to mistakenly assuming that everyone has to act in the same way for incentives to work. Let me explain with an example.

My wife and I have long thought it necessary to expose our children to a variety of experiences in sports, academics and social activities. Among these is an activity known as Cotillion, in which youngsters from fifth grade through high school learn rudimentary social behavior: how to dance, engage in polite but harmless conversation, and otherwise comport themselves appropriately at the more formal events at which all of us inevitably find ourselves.

My 12-year-old daughter greatly enjoys the experience (minus dancing with one or two particular boys), and looks forward to the evening sessions. My first grade son also sees the utility in it and views it as a harmless party practice. In contrast, my 10-year-old son looks at the coming experience as something akin to flogging. He so dreads the prospect of Cotillion that my wife uses his fear to compel appropriate behavior elsewhere, sentencing him to additional weeks of Cotillion for each infraction of table manners (for the record, his sentence currently runs through 2037). 

All the kids respond to incentives, but differ in subtle ways. The same is largely true with public policy efforts. The difference is that, for most matters, we care about the aggregate, not individual, effect. That is an important distinction. Here are some examples:

Suppose we subsidize food consumption through food stamps. The result will be that some recipients will eat more healthfully with the lower-cost food and others will simply become fat. Suppose we extend unemployment benefits for two years. Some recipients will go to school and prepare for the future; others will watch Jerry Springer all day. To properly judge these policies, we would want to know how many folks fall into each category, and how much the net cost on society would be. That, of course, is not a trivial exercise.

In pure economic policy, things are a bit simpler. We know from long experience that, if you raise taxes, you get less economic activity, even if higher tax rates make some people work harder. Likewise, if you lower taxes, you get more economic activity. Here, we know the net effect— the only real question is, “How much is the effect?”

Of course, we need tax revenue to fund the government, so the question has long been how to intelligently balance the trade-off between more taxes and a smaller economy. The problem the United States now finds itself in is that we need a larger economy, yet we are burdened with an enormous debt. Raising taxes is alluring in its simplicity, but the trade-off is a smaller economy.•

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Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.
 

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