Baseball Crank
Covering the Front and Back Pages of the Newspaper
May 12, 2003
POLITICS: CONSERVATIVE TRUTH #1

First in a series.

As you may have noticed, one of my running themes here of late has been the difficulty of finding intellectually honest people on the other side of political arguments. This is particularly infuriating because I know plenty of decent, honest people who are politically liberal. Yet, the combination of professional Democrats and leftist bloggers too often leaves me feeling like I'm dealing with people who are immune to both reason and reality.

Liberals and conservatives, or Democrats and Republicans, or Left and Right - however you define the two sides - disagree on a lot of basic assumptions about how the world works. Some of those gaps can't be bridged by even the most fair-minded commentators. But on others, one of the things that drives me berserk is when the other side just refuses to admit to something that is frankly impossible for a reasonable person to argue with.

So, in an effort to focus on the things I see as litmus tests for honest commentary, I'll be starting a periodic series on The Conservative Truths and The Conservative Beliefs. Both are things that many or most conservatives believe; the former are those that we feel any intellectually honest liberal or leftist should have to admit. (I would, of course, welcome a similar initiative by someone on the other side). I'm not putting them in any particular numerical order.

Today, we start with Conservative Truth #1: Incentives matter. Government initiatives that give rewards or punishment as a result of individual or corporate behavior will change people's incentives and therefore, applied to a large population, will change behavior. The result is that any estimate of the effects of a government program will be erroneous if it fails to take account of the incentive effect.

This seems astoundingly obvious, and yet discussions by politicians and the media of the effects of things like tax cuts, welfare plans and health care plans have far too often completely ignored the incentive issue. About the only time you hear the Democrats admit that taxing something will change it is when they tax smoking - the one good whose sales won't be much affected by taxes because the buyers are addicted. Congress has for many years institutionalized this resistance to reality by "scoring" the revenue effects of tax cuts or tax hikes on the assumption that nobody ever changes their behavior in response. And critics of tax-cutting Republicans invariably cite these transparently fraudulent estimates as Exhibit A on the "cost" of tax cuts. How can an honest person take such criticisms seriously?

Now, for Conservative Belief #1, and I'll classify this as a Belief because I recognize that it's more controversial: that the incentive effects following from most government initiatives are, in general, larger and more powerful than the dollar size of government intakes or outflows on the initiative. Here's an example:

Democrats often propose "temporary" tax cuts as a counter to long-term rate cuts. The problem with a "temporary" tax cut is that it ignores the fact that the incentive effect is the centerpiece of conservative thought on tax cuts. Yes, tax cuts are good because they push cash into the economy and stimulate demand, and for that purpose, the more cuts for the low end of the income spectrum, the better. And yes, tax cuts are good because they push cash into the hands of investors and stimulate supply, and for that purpose, the more cuts for the high end of the income spectrum, the better. And yes, there is (although quantifying it is intensely controversial) a wealth effect where cuts targeted at the stock market will make people feel richer and more optimistic about the economy.

But the #1 reason for tax cuts is to affect incentives, or more properly (from a conservative or libertarian perspective) to remove tax-driven distortions from incentives. An explicitly short-term tax cut is not only useless but counterproductive for that purpose: the now-you-see-it-now-you-don't cut will drive more people to arrange their affairs to get the short term cut rather than to get long-term growth.

Critics have charges that Bush's dividend tax cut plan (the big tax initiative of the day) is too tilted to wealthy shareholders. Even crediting this sort of study (I'm skeptical but I haven't looked under the hood myself), if you look at incentives, the obvious effect of a dividend tax cut is to encourage people to put more money in stocks, and specifically to encourage those eeeevil top however-many percent to invest their income (after it's been sliced the first time by high marginal rates) in stocks. (I'm leaving out the reason why dividend cuts got pushed onto the agenda in 2002, which is corporate-governance related). More investment in equities is precisely how to stimulate supply and job growth.

You may disagree with the idea that stimulating investment is better for the economy than passing out spending money. Fair enough. But you simply aren't making a serious argument if you ignore the difference between the improved incentives to invest under a dividend tax cut and the absence of any positive incentives from a temporary cut.

In short, the cash-to-spend/cash-to-invest debate is two ways to look at how far the tax cut dollar will go. But changing incentives doesn't just affect the dollar that's been cut; it affects the calculus for every dollar in the economy. That is why conservatives argue for rate cuts rather than 'targeted' relief: changing incentives is the one and only way to get more bang than just the size of the cut multiplied by some X or Y effect that's linked to the number of dollars put back in the economy. In other words: Incentives matter.

Posted by Baseball Crank at 7:39 AM | Politics 2002-03 | Comments (16) | TrackBack (2)
Comments

I'm not aware that anyone is saying that incentives don't matter, or that the government's actions don't cause incentives which can distort the economy. The gist of my objection to the President's tax cutting proposals is that I'm not convinced that the problem right now is one of insufficient supply; I think the problem is more that there is an oversupply (especially in the IT sector), and stimulating demand would be more useful than stimulating investment. I might even go so far as to argue that encouraging further capital investment, in an era of oversupply, is the exact opposite of what should be done.

In any event, you are correct that no reasonable person could deny that government actions create incentives, and that incentives matter. But the debate over the budget is really about whether or not the incentive the budget creates - which may be a good incentive in the long-term - is the best medicine for the economy in the short-term.

Posted by: aphrael at May 12, 2003 2:33 PM

I think incentives matter. I don't have any idea how they measure up to intakes, outflows, mid-terms or OPS. I also think balanced budgets are generally good, and deficits generally bad, so I'm having a hard time understanding the need or even possibility for further tax cuts.

Posted by: Matt Welch at May 12, 2003 3:04 PM

Why do you say that "more investment in equities is precisely how to stimulate supply and job growth"? I haven't seen any support for that whatsoever. Why not make a tax cut that provides companies with incentives to hire more workers?

Posted by: Matthew Yglesias at May 12, 2003 3:44 PM

First, it's not true that liberals regard high-income earners as evil. That's just Limbaugh moonshine. If we did, we wouldn't be liberals, we'd be members of a loathsome organization called the RCP (an association of psycho wingnuts with "leftist" pretensions). But American social fabric, mutual trust, and economic health are threatened when income concentration rises above certain levels.

So the incentives to earn more and reward productive behavior are popular with nearly everyone. As for the economically invalid estimates of the impact of tax cuts on revenue--I've had to do reports on this and I can tell you that in some cases, as with the Congressional Budget Office (CB), they are statutorily required to include all sorts of "objective" assumptions which sometimes inflate and sometimes deflate the impacts of tax on revenue.

To argue that a liberal is a contemptible liar because he doesn't run a regression model to generate all possible indifference curves, then establish all possible production functions for all possible industries, and then solve for a general equilibrium analysis, before accepting these GAO/CBO/SBO estimates, is so silly I think you are getting a little carried away in your rant.

Here's a little piece of conservative legerdemain in your posting (I believe in polite Japanese conversation it is said "You speak magic!"): the US will never want for investment capital as long as capital markets are liquid and investment opportunities exist. We already suck in $2 billion every day. This is not replaced by household or coprporate savings, the very thing these proposed tax cuts will further discourage.

Posted by: James R MacLean at May 12, 2003 4:10 PM

Thanks for starting such an interesting topic. I think we'll really be able to get somewhere now that you've broken down frequently acerbic discussions into basic assumptions.

Now, of course incentives matter.

I'm a liberal Democrat, but I support a dividend tax cut, or at least a change in our current capital market taxation structure. To support the contention, though, that a dividend tax cut will raise investment, you'd need to show that it will also slow consumption by an equal or greater amount. Otherwise, the net savings rate goes down and there's less net investment. And the people who would benefit from a dividend tax cut are hardly those who must decrease their personal consumption to take advantage of the improved investing climate. But I digress.

The dividend tax cut is important because it will encourage corporate managers to eschew debt financing and hold less capital. Currently, managements are incentivized to retain too much capital rather than paying it out to shareholders; this is the systemic root cause of corporate fraud. But Bush's plan is the wrong way to reform the system. First of all, the tax modification should be revenue neutral or even accretive so as to prevent our deficit from increasing. This might involve higher marginal tax rates on the top brackets to offset their gains from a lower dividend tax rate. Second, the tax cut should be applied on the corporate level not the investor level, so as to maximize responsible behavior. Third, you'd need to aid local and state governments and low income housing so as to minimize the impact you'd see on their debt service levels. (Tax-free munis and low-income tax credits lose their allure when a dividend tax cut goes away).

There's a little more detail here.

But basically, dividend tax reform makes sense. The way that Bush is doing it does not.

And to suggest that somehow this is a stimulus is both disingenuous and wrong. If this plan is enacted, the capital market might become marginally more efficient (I say might because the specifics of the proposal aren't clear yet), but the net loss in terms of GDP due to larger deficits will be large enough to make that point irrelevant.

Posted by: MattS at May 12, 2003 6:04 PM

Via Calpundit, I'll jump in.

Incentives matter. Well, yes and no. Here's the no part: incentives make no difference when you have no alternatives. Single mothers with little education and whose children's father(s) are guests of the state will need a lot of help to get off welfare. Providing by federal law that welfare will run out forever after four years may provide her an incentive to find work. But when the economy is in recession so jobs are unavailable and the state is too broke to provide child care, all the "incentives" in the world won't get her employed.

but otherwise, yes, incentives do matter. I don't know of a person who disagrees, unless you mangle the definition beyond all recognition.

the difficult question is analyzing, in advance, the incentives that will be created by a certain gov't action. remember the law of unintended consequences?

now, Brad DeLong seems to me to be a pretty straight shooter, although i'll admit that i'm not enough of an economist to know for sure. but he argues pretty persuasively that the Bush administration is proposing a series of tax cuts which provide incentives which are unrelated to that which is currently ailing the economy.

so, if the world capital markets see a series of tax cuts which appear to create long-term deficits without generating short-term stimulus, what incentives do we create?

As to Conservative Belief #1, do you have any data to support this belief, or even a particular government program in mind? If not, then you have proven true my First Rule on Debating Conservatives About the Government: Expect gross overgeneralization. Of course, i have no data to support my First Rule, only anecdotes. but you get the idea.

Posted by: FDL at May 12, 2003 8:41 PM

Stick to baseball, jerk...

Posted by: dave at May 12, 2003 10:49 PM

Along with the other liberals who have responded here, I have no problem with the assertion that incentives matter. Of course they do. But I also agree with FDL that you need to pay more attention to the law of unintended consequences.

Let's say that removing the tax on dividends makes investing in the stock market more attractive. That money has to come from somewhere, presumably shifted to stocks from other investment alternatives. Those other investment alternatives, e.g., bonds, now have to raise their rates to become more attractive to investors.

So have you really helped the economy? It's entirely possible that all you've done is establish a new equilibrium and a world in which bonds (ultimately paid for through tax revenues from the general public) are more expensive. Hence, all you've really accomplished is a net transfer of wealth from the poor and middle class to the wealthy.

I freely admit that this analysis is oversimplified and does not take into account a hell of a lot other possibilities and factors. My point is, though, that neither does your analysis. It is just not as simple as saying that cutting taxes on dividends means economic and job growth. It never is.

Incentives matter, but so do a hell of a lot of other factors. All you can do is do the best you can to predict those other factors. If (in economic discussions) you find yourself saying, "If x, then y," then it's almost a sure thing that your analysis is oversimplified to the point of being worthless.

Posted by: PaulB at May 12, 2003 11:07 PM

First of all, Conservative Truth #1 certainly demonstrates the "Duh" level of thinking liberals have learned to expect from conservatives. Everything the government does affects peoples' behaviors to some extent or another. Well, duh! You guys are sure geniuses.

Second, Conservative Belief #1 might be more succinctly stated as:

Everyone assumes that incentives cause behaviours that supports their politics.

To wit, the nonsensical arguments the right is pushing in regards to tax cuts. You can fill in your own view about the left's nonsensical arguments on your issue du jour.

In short, it's all about how incentives and behavior are related, not that they're related. Everyone on the left certainly knows that, even if it seems like a big "Truth" to the right.

Perhaps if you raised the intellectual content of your blog a bit above this sort of high-school reasoning you might engage the interest of some of "intellectually honest people" you crave, but you can hardly blame them for not wasting their time on this sort of drivel.

-- Scott

Posted by: Scott at May 13, 2003 12:26 PM

You said "But the #1 reason for tax cuts is to affect incentives". Whose number one reason? Certainly not mine. The way a tax policy affects incentives is certainly something which must be considered, but affecting incentives is not necessarily the motive of tax cuts.

For Bush, the motive seems to be one of fealty to tax cutting as an inherent good. He tlks about using tax cuts to stimulate the economy, but he's cuts certainly don't seem to crafted in that direction. Take the dividend tax cut boondoggle. No, that's not going to stimulate the economy. Why? Because its permanent. Business who have plenty of cash on hand for big investment projects are right now waiting for the economy to improve. Give them more cash, they keep waiting.

If you want to stimulate business investment, you don't cut the dividend tax, you provide corproate tax write-offs for any business investment which occurs in a two year window, starting now. The goal is economic stimulus through business investment. The mechanism is by providing a short-term incentive for businesses to do what you want them to do.

It's no different from a department store having a sale on socks. If you want to sell off your sock inventory now, you don't lower the price of socks forever. You have a temporary sale. We don't want more business investment in 2006, we want it in 2003.

Of course, even Bush admits that the dividend tax cut is really about "fairness", avoiding the "unfairness" of double taxation. Which is, of course, a total crock. Everything is multiply taxed. Boo frickin hoo.

You said: "An explicitly short-term tax cut is not only useless but counterproductive for that purpose: the now-you-see-it-now-you-don't cut will drive more people to arrange their affairs to get the short term cut rather than to get long-term growth." Uh, what?

That's the whole mother-loving point! What you do is create a situation where private actors have an incentive to behave in a way which will benefit the economy. The problem in the economy now is that businesses, though not hurting for cash, are not investing in themselves, not expanding production, not creating jobs. If they did do this stuff, now, it would create jobs, giving a lift to consumer spending, which would feed into the whole cycle.

When the temporary tax-cut expires, you hope that it has done its work such that we no longer need an immediate boost to new investment to stimulate a stagnant job-shedding economy. If not, you can always extend it.

It isn't useless, it's effecive specifically because it understands the incentive effects that you seem to think liberals don't believe it. It isn't counter-productive, either. Counter-productive is a broad-based tax cut passed without granting cash-payouts to the states, which will result in lower state tax revenues, which will force states to raise their own taxes or cut their spending. That's counter-productive.

It's also the Bush economic policy.

Posted by: Drew Vogel at May 13, 2003 1:49 PM

If it's a conservative truth that "Government initiatives that give rewards or punishment as a result of individual or corporate behavior will change people's incentives and therefore, applied to a large population, will change behavior", please explain to me how this applies to Enron? We haven't seen any prosecutions yet, seen any property seizures, and the only behavior we've seen change is that the overall population is more skeptic about investing in the stock market. It would be easy to say that the system worked in this case, and that Enron has been wiped out of existence, but the victims of this fraud are still around, and are still suffering. What is the conservative position on applying this obvious Truth in cases where the incentive is punishment, not reward?

Posted by: Caius Caligula at May 14, 2003 3:39 PM

I see I've been neglecting my own board here (and that a few people have ignored the warning on the Preview Comments page) . . . Matthew Yglesias asks:

Why not make a tax cut that provides companies with incentives to hire more workers?

The trend on the Democratic side has been to do precisely the opposite - loading up companies with payroll taxes, lost work time from the Family and Medical Leave Act, pushing more companies to provide health insurance, raising the minimum wage, etc. Although some of those burdens make sense individually, they collectively provide an escalating disincentive to hire more people.

Naturally, you don't want to give incentives just for hiring, either; if you incentivize hiring as against retention, companies will just replace current employees with new ones for the tax gravy.

I'll admit that a dividend cut isn't my ideal; I'd rather see dividends and capital gains treated equally, and the corporate income tax abolished entirely (I'll probably post on that in more detail another day). It's not hard to see why that's such a political non-starter, though.

Posted by: The Crank at May 14, 2003 3:57 PM

Caius -- There have been prosecutions arising from the collapse of Enron, including the conviction of Arthur Andersen and the recent battery of indictments against Andrew Fastow and others. For reasons related to my law practice I can't address Enron in too much detail here, but the company's finances were quite complicated, and the prosecutors may have needed a lot of time to make sense of it all.

There's a related point that people never seemed to understand during the Clinton years, which is that big white-collar criminal investigations almost invariably take forever and cost a ton of money.

Posted by: The Crank at May 14, 2003 4:08 PM

Drew says:

If you want to stimulate business investment, you don't cut the dividend tax, you provide corproate tax write-offs for any business investment which occurs in a two year window, starting now. The goal is economic stimulus through business investment. The mechanism is by providing a short-term incentive for businesses to do what you want them to do.

See, the problem here is that what you want is sustainable and genuine growth. The problem with putting emphasis on the when rather than the how much is that you create an incentive to make bookkeeping shifts of pre-existing investment plans, rather than actually enlarging how much investment gets made.

We don't want more business investment in 2006, we want it in 2003.

I'd prefer both. And if you want the immediate boost, you have to support what I regard as the more important part of the Bush package, which is accelerating the rate cut package passed in 2001.

When the temporary tax-cut expires, you hope that it has done its work such that we no longer need an immediate boost to new investment to stimulate a stagnant job-shedding economy. If not, you can always extend it.

Um, how exactly does that provide businesses with some certainty for their long-term investment plans?

Counter-productive is a broad-based tax cut passed without granting cash-payouts to the states, which will result in lower state tax revenues, which will force states to raise their own taxes or cut their spending. That's counter-productive.

How is forcing states to cut spending counter-productive?

Posted by: The Crank at May 14, 2003 4:28 PM

Crank said:

"The problem with putting emphasis on the when rather than the how much is that you create an incentive to make bookkeeping shifts of pre-existing investment plans, rather than actually enlarging how much investment gets made."

But Crank, that's precisely the point! Loads of busineses have pre-existing investment plans that are on hold because they are waiting until the economy rebounds, but as long as they are on hold, the economy won't rebound as quickly. The market gives them no incentive to invest now rather than later. So, the government has to.

So, they pass a short-term, targetted tax-cut to give them the short-term incentive to invest. This raises business expansion now, which creates jobs, and helps resuscitate the economy. That's exactly what we want to do, isn't it?

On the other hand, if you pass a permanent tax exemption on business investment, it makes business investment permanently cheaper. This means a) businesses will continue to wait until the economy improves (useless), and b) when that happens, there will be more business investment than there would have been otherwise (positive). It won't create one job until after the economy improves, and it doesn't even try to get the economy to improve. It just waits for the upswing.

The dividend tax cut is even worse. It doesn't make investment cheaper, it increases the pool of funds available for investment. So business which have pre-existing investment plans will not be affected in the least, and any business who wanted to invest, but didn't have the funds, will now be in that position too. Got the plans, got the funds, wait for the upturn.

Whether you call it a recession or not, we're definitely in a tough time, economically, and the government should be focused on short-term stimulus to bring us out of it. Once that happens, we can look at the long-term. Passing huge long-term tax-cuts which are not stimulative but do add enormously to the deficit and the debt is precisely backwards. And it's precisely the Bush economic policy.

Posted by: Drew Vogel at May 14, 2003 5:58 PM

When Johnny Carson (remember him?) would tell a lame joke, he would often say, "Buy the premise, buy the bit." Here we have a simular situation. Sure, incentives matter, but how much and in what way? Incentives, whether economic or otherwise, are always filtered through individual life experiences and expectations. On the micro level, anyone who has raised kids knows that its just not as simple as a mechanistic incentives equal results calculation. To me this is akin to saying genetics matter -- yes, but exactly how and to what extent?

Posted by: Dan at May 15, 2003 8:09 AM
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