Kevin Corcoran recently did a post discussing the distinction between being wrong in theory and wrong in fact.  Here I am interested in another situation, the case where theory matches reality quite closely, but people are reluctant to accept the implications of that fact. For instance, basic economic theory suggests that higher tax rates ought to reduce hours worked. Europe has higher tax rates than America and considerably lower hours worked each year. But many people seem reluctant to accept the straightforward implications of those facts.

The Economist has a very good article on this topic:

Edward Prescott, an American economist, came to a provocative conclusion, arguing that the key was taxation. Until the early 1970s tax levels were similar in America and Europe, and so were hours worked. By the early 1990s Europe’s taxes had become more burdensome and, in Prescott’s view, its employees less motivated. A substantial gap persists today: American tax revenue is 28% of GDP, compared with 40% or so in Europe.

Notice that Prescott relies on two types of evidence, both cross sectional and time series.  That makes his claim much more persuasive than a simple comparison of two places at a point in time.  And yet many people remain reluctant to accept the obvious implications of these facts.  

The article does present one empirical study that suggests that work disincentives from high taxes might be rather modest:

A recent study by Jósef Sigurdsson of Stockholm University examined how Icelandic workers responded to a one-year income-tax holiday in 1987, when the country overhauled its tax system. Although people with more flexibility—especially younger ones in part-time jobs—did indeed put in more hours, the overall increase in work was modest relative to that implied by Prescott’s model.

Again, this result is not at all surprising.  Because of the “collective-action problem” aspect of work structure, one would expect the short run elasticity of labor supply to be much lower than the long run elasticity.  Decisions on work schedule are generally made at the company level, and to some extent even at the societal level (as with things like school schedules, which must be coordinated with work schedules.) Notice that the elasticity was higher for part-time younger workers, who face less of a coordination problem.

How can we explain the reluctance to accept the obvious implications of a theory?  A few more examples will help to illuminate the sources of bias:

1. Theory suggests that higher levels of CO2 should raise global temperatures due to the “greenhouse effect”.

2. Theory suggests that injecting lots of money into the economy should cause price inflation (i.e., reduce the purchasing power of a single dollar bill.)

It would be quite surprising if more CO2 did not cause global warming, or if large money injections did not cause inflation.  And yet, I often meet people who disagree with these claims.  They might argue that global warming is an unproven theory, or that inflation is caused by corporate greed.  Why reject evidence that almost perfectly matches standard theory?  What’s going on here?

I notice that people who believe in the corporate greed theory of inflation also tend to have left wing policy views, whereas people who are skeptical of global warming tend to have right wing policy views.  Perhaps this provides a clue as to why so many people are skeptical of the claim that high taxes discourage work effect.

Suppose you are someone who favored a large welfare state, for a wide variety of reasons.  In that case, you might be resistant to accepting empirical data that suggests negative effects from high taxes.  From a purely logical perspective, this doesn’t make much sense.  It is certainly possible that a welfare state is beneficial despite leading to a reduction in per capita GDP.  Perhaps the extra leisure is worth the hit to national income.

Unfortunately, when people have strongly held policy views, they became more like lawyers and less like scientists.  They seek out any evidence that seems to strengthen the case for their policy preferences and discount evidence that weakens the case for their policy preferences.

Political bias is not the only factor that leads people to reject the implications of economic theory.  It is also the case that many economic theories are counterintuitive.  For instance, most elasticities tend to be higher than what one would expect if one relied on introspection, i.e., on “common sense”.  Thus even people with so-called “addictions” such as smoking or illegal drug use are often surprisingly responsive to price signals. 

Many people probably have trouble visualizing how higher taxes would lead them to work fewer hours.  They might think, “With higher taxes, I’d need to work longer hours to pay my bills.”  Their mistake is in not recognizing that tax revenues don’t disappear, they are recycled back in the form of benefits to those who consume more leisure.  This is what economists mean by an “income-adjusted elasticity of labor supply”.

To summarize:

1. When theory suggests that X is true.

2. And when empirical evidence tends to confirm theory.

Be very careful before rejecting the claim that X is true.  

PS.  Suppose you went back in time and showed David Hume the following graph for the M2 money supply:

If Hume were asked what he thought happened to inflation during the early 2020s, how would he have responded?  Then suppose you told Hume that many people now blame “corporate greed” for the high inflation of the early 2020s.  How would that information impact Hume’s view of progress in the field of economics in the 270 years after he developed the Quantity Theory of Money?