Tax Rates, Efficient Government, and Jobs: Prescott's Surprise
“Why do Americans work so much more than Europeans?” That’s the title of one of Nobelist Ed Prescott’s papers. His story has something to do with high taxes causing low employment, so you might be tempted to begin your yawning momentarily: Old news.
But don’t do that. Prescott rejects one of the main tenets of free-market thinking–that the welfare state is a big waste. That rejection is the key to his Big Idea.
David’s post on Governor Romney’s “lower-rates/broader base” tax reform is what reminded me of this idea, and you’ll realize there’s a lot of overlap. But Prescott takes the tax debate in quite an unusual direction.
Here’s the story: Whenever government raises the tax rate on a particular person, an economist’s first instinct is to think that the tax hike has two effects:
1. The higher tax rate makes it less appealing to work in the formal market economy (this is called the substitution effect). With higher taxes, early retirement, unpaid work at home, and under-the-table work all look like better options.
2. The higher tax rate makes you poorer (the income effect). And poorer people (other things equal) would prefer to work more. If your retirement gets wiped out in a market crash, you might delay retirement a few years; same thing if your tax rate goes way up.
So when you ask a typical labor economist what a tax hike does, they’ll have to think to themselves: Does the “I feel poorer” effect balance out the “Work pays less” effect?
Answer: It depends.
But Prescott’s not a labor economist: He’s a macroeconomist. That means he (implicitly!) asks a big question, oft-neglected by the labor folks: “What does the government do with the extra tax money?”
You know the conventional response of free-market economists: “Government wastes it! It gets burnt on endless boondoggles! The government just grabs potatoes and throws them in the river!”
If that’s a fairly accurate summary of government spending, then it’s hard to tell whether a tax hike raises or lowers labor supply. The government distorts work incentives (so you want to work less) and then destroys the output it grabs from you (so you want to work more). Total effect on work effort? We’ll need to bring in the econometricians to figure out if it’s a “+” or a “-“.
But Prescott rejects the free-market response: Instead, he takes the claims of welfare-state supporters at face value. He takes it for granted that government output–health care, retirement funds, job training, all the rest–is just as awesome as privately produced output. A foolish, foolish assumption, no? A grave concession to the opposition, no?
No and no.
Here’s the Wisdom of Prescott: If the government raises the tax rate on you and all of your friends, and then divides up all the tax revenue and dumps it from a helicopter, what do you get? Well, none of the money gets wasted, so the tax hike doesn’t have a direct income effect (there’s a small indirect one I’ll ignore here).
If the tax hike is used for pure redistribution from the “average person” back to the “average person,” then the tax hike doesn’t make the “average person” poorer: The government is taking money out of everyone’s right pocket and slipping it into their left.
But if the income effect is gone, what’s left? The disincentive to work: The pure substitution effect.
So here’s Prescott’s Big Idea:
If higher taxes are wasted, then a tax hike has a small, ambiguous effect on employment.
If higher taxes are spent wisely, then a tax hike causes a big fall in employment.
Not quite what you expected, was it?
Coda: I’ll save the data for another time.