Basic Tenets, Part 3 — Incentives Matter

After some of my blog database mishaps, Parts 1 and 2 can be found here.

I’m writing brief blog posts on these 8 guideposts for economic thinking.

1. The use of scarce resources is costly; trade-offs must always be made.
2. Individuals choose purposefully — they try to get the most from their limited resources.
3. Incentives matter — choice is influenced in a predictable way by changes in incentives.
4. Individuals make decisions at the margin.
5. Although information can help us make better choices, its acquisition is costly.
6. Beware of secondary effects: economic actions often generate indirect as well as direct effects.
7. The value of a good or service is subjective.
8. The test of a theory is its ability to predict.

Source: Economics: Private and Public Choice, | Gwartney, Stroup, Sobel, Macpherson

This third tenet is a simple one: Incentives matter — choice is influenced in a predictable way by changes in incentives.

However, this is also one of the tenets that also is one of the most bastardized economic principles, but we’ll get to that later. Suffice to say, there is a vast difference between intrinsic incentives and artificial incentives.

When I walked out of work last night, I made a conscious decision — do I walk up hill into the wind to a metro station that is closest or do I walk a little bit further to another metro station that is down hill with the wind at my back and near a tasty McDonald’s? (I chose the latter.)

I made a choice: walk a little longer with less wind in my face and McDonald’s goodness. For me the incentive was McDonald’s and less wind in my face. For others, the incentive might be that they like wind in their face and a more strenuous walk after a day of work. Incentives can vary based on an individual’s preferences. However, most times, these are somewhat predictable.

Whatever the issue, if a choice yields more and more benefits, one becomes more likely to pick that option. With very few exceptions, there are always substitutes.

Longer Walk:

Pros: Downhill, no wind in my face, delicious burgers

Cons: Longer

Shorter Walk:

Pros: Shorter

Cons: Uphill, wind in my face, no delicious burgers.

If you had to walk through an Occupy Wall Street encampment, WTO protest, or something you found objectionable to get there, the disincentives start mounting and things change. Similarly, the opposite of what we just examined is true: As costs associated with your decision yield less benefits, you will be less likely to make such a decision.

Now this is where politics comes in, and frankly ruins this. Incentives and disincentives exist naturally. They do not have to be created. The people who you vote for want to create incentives and disincentives to win votes and be re-elected.

Examples:

Artificial Incentives: Tax credits for having children, buying school supplies, production of certain types of energy, donating to charity, subsidizing certain companies, activities or industries.

Artificial Disincentives: Excise taxes on cigarettes, alcohol. Taxing individuals for using a tanning bed, not having health insurance, putting tariffs, duties or import limitations on foreign made goods.

This list could go on for a very long time. But, if you assume there are natural incentives and disincentives, it’s easy to see why politics bastardizes economics.

“The first lesson of economics is scarcity: There is never enough of anything to satisfy all those who want it. The first lesson of politics is to disregard the first lesson of economics.” -Thomas Sowell

Let’s just examine one artificial incentive and one artificial disincentive.

WRITING OFF CHARITABLE DONATIONS — Naturally, this has its own incentive — namely doing good. You could make the argument that another incentive is feeling good about doing good, or buying good feelings.

But why does our tax code allow individuals to write off something charitable? Isn’t charity its own intrinsic reward? Sure it is.  However, up to a certain point that varies from individual to individual, one cannot write off their charitable donations. Would people be charitable absent this write off? Sure. Do some people donate just to get tax benefits? Of course.

Politicians created this to please charities and people who like donating money. It’s a win win for that reason, and why this deduction is rarely ever brought up for suggested changes or elimination. Popular as it may be, it’s artificial.

SIN TAXES — Does consumption of alcohol or tobacco have incentives? Definitely — alcohol is delicious and can lead to fun times. Disincentives? Sure. Cirrhosis of the liver, cancer, premature death, ruined marriage/career/life. Without doing anything, these items have natural incentives and disincentives.

Insert politicians. Federal politicians increased taxes on tobacco products just a little over a week into President Obama’s term in office. There are state taxes, and even sometimes local taxes on these products. Mostly (in theory) these tax revenues go to fund health-care. They are regressive, in that they hurt poor people more than rich people, and higher taxes can lead to fewer purchases and less taxes for health-care.

Reasonable people will disagree on the role of tax expenditures and artificial incentives. Some argue they have merit, others argue they distort markets and are inefficient. I am in the latter group.

We cannot subsidize everything. The best way to subsidize everything is to subsidize nothing.

Take energy as a quick example. Coal gets special tax benefits, even though intrinsically it is cheaper and more efficient than many other forms of energy. Of course, that comes with the natural disincentive to it being a pollutant. Wind has a natural incentive of being cleaner than many forms of energy, but it has natural disincentives of being really expensive and inefficient. We subsidize that too. Why provide subsidies for either? Those who value cleanliness over cost can pick what they want, and those who want lower cost over cleanliness can pick what they want?

Few can argue that our labyrinth of federal incentives and disincentives is the best we can do in terms of an efficient, fair tax system that raises the funds necessary for funding government and nothing else.

Politicians of both parties are guilty of legislating through the tax code — whether it’s folks like Rick Santorum calling for more robust child tax credits or President Obama calling for countervailing duties on things like Chinese tires.

I plan to write more about fundamental tax reform and the challenges I think we’re facing in getting there. I’ve just gotta finish this 8-part series first.

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