Naked Economics: Undressing the Dismal Science pdfdrive com

participation in the work force jumped three times as much.
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On the corporate side, high taxes can have a similar effect. High taxes lower a
firm’s return on investment, thereby providing less incentive to invest in plants,
research, and other activities that lead to economic growth. Once again we are
faced with an unpleasant tradeoff: Raising taxes to provide generous benefits to
disadvantaged Americans can simultaneously discourage the kinds of productive
investments that might make them better off.
If tax rates get high enough, individuals and firms may slip into the
“underground economy” where they opt to break the law and avoid taxes
entirely. Scandinavian countries, which offer generous government programs
funded by high marginal tax rates, have seen large growth in the size of their
black market economies. Experts estimate that the underground economy in
Norway grew from 1.5 percent of gross national product in 1960 to 18 percent
by the mid-1990s. Cheating the tax man can be a vicious circle. As more
individuals and firms slip into the underground economy, tax rates must go up
for everyone else in order to provide the same level of government revenue.
Higher taxes in turn cause more flight to the underground economy—and so
on.
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The challenge of transferring money from rich to poor is not just on the
taxation side. Government benefits create perverse incentives, too. Generous
unemployment benefits diminish the incentive to find work. Welfare policy,
prior to reform in 1996, offered cash payments only to unemployed single
women with children, which implicitly punished poor women who were married

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or employed—two things that the government generally does not try to
discourage.
This is not to suggest that all government benefits go to poor people. They
don’t. The largest federal entitlement programs are Social Security and
Medicare, which go to all Americans, even the very rich. By providing
guaranteed benefits in old age, both programs may discourage personal savings.
Indeed, this is the subject of a longsimmering debate. Some economists argue
that government old-age benefits cause us to save less (thereby lowering the
national savings rate) because we need to set aside less money for retirement.
Others argue that Social Security and Medicare do not reduce our personal
savings; they merely allow us to pass along more money to our children and
grandchildren. Empirical studies have not found a clear answer one way or the
other. This is not merely an esoteric squabble among academics. As we shall
explore later in the book, a low savings rate can limit the pool of capital
available to make the kinds of investments that allow us to improve our standard
of living.
None of this should be interpreted as a blanket argument against taxes or
government programs. Rather, economists spend much more time than
politicians thinking about what kind of taxes we should collect and how we
should structure government benefits. For example, both a gasoline tax and an
income tax generate revenue. Yet they create profoundly different incentives.
The income tax will discourage some people from working, which is a bad thing.
The gasoline tax will discourage some people from driving, which can be a good
thing. Indeed, “green taxes” collect revenue by taxing activities that are
detrimental to the environment and “sin taxes” do the same thing for the likes of
cigarettes, alcohol, and gambling.
In general, economists tend to favor taxes that are broad, simple, and fair. A
simple tax is easily understood and collected; a fair tax implies only that two
similar individuals, such as two people with the same income, will pay similar
taxes; a broad tax means that revenue is raised by imposing a small tax on a very
large group rather than imposing a large tax on a very small group. A broad tax
is harder to evade because fewer activities are exempted, and, since the tax rate
is lower, there is less incentive to evade it anyway. We should not, for example,
impose a large tax on the sale of red sports cars. The tax could be avoided, easily
and legally, by buying another color—in which case everybody is made worse
off. The government collects no revenue and sports car enthusiasts do not get to
drive their favorite color car. This phenomenon, whereby taxes make individuals
worse off without making anyone else better off, is referred to as “deadweight
loss.”

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It would be preferable to tax all sports cars, or even all cars, because more
revenue could be raised with a much smaller tax. Then again, a gasoline tax
collects revenue from drivers, just as a tax on new cars does, but it also provides
an incentive to conserve fuel. Those who drive more pay more. So now we’re
raising a great deal of revenue with a tiny tax and doing a little something for the
environment, too. Many economists would go yet one step further: We should
tax the use of all kinds of carbon-based fuels, such as coal, oil, and gasoline.
Such a tax would raise revenue from a broad base while creating an incentive to
conserve nonrenewable resources and curtail the CO
2
emissions that cause
global warming.
Sadly, this thought process does not lead us to the optimal tax. We have
merely swapped one problem for another. A tax on red sports cars would be paid
only by the rich. A carbon tax would be paid by rich and poor alike, but it would
probably cost the poor a larger fraction of their income. Taxes that fall more
heavily on the poor than the rich, so-called regressive taxes, often offend our
sense of justice. (Progressive taxes, such as the income tax, fall more heavily on
the rich than the poor.) Here, as elsewhere, economics does not give us a “right
answer”—only an analytical framework for thinking about important questions.
Indeed the most efficient tax of all—one that is perfectly broad, simple, and fair
(in the narrow, tax-related sense of the word)—is a lump-sum tax, which is
imposed uniformly on every individual in a jurisdiction. Former British Prime
Minister Margaret Thatcher actually tried it in 1989 with the community charge,
or “poll tax.” What happened? Britons rioted in the streets at the prospect of
every adult paying the same tax for local community services regardless of
income or property wealth (though there were some reductions for students, the
poor, and the unemployed). Obviously good economics is not always good
politics.
Meanwhile, not all benefits are created equal either. One of the biggest
poverty-fighting tools in recent years has been the earned income tax credit
(EITC), an idea that economists have pushed for decades because it creates a far
better set of incentives than traditional social welfare programs. Most social
programs offer benefits to individuals who are not working. The EITC does just
the opposite; it uses the income tax system to subsidize low-wage workers so
that their total income is raised above the poverty line. A worker who earns
$11,000 and is supporting a family of four might get an additional $8,000
through the EITC and matching state programs. The idea was to “make work
pay.” Indeed, the system provides a powerful incentive for individuals to get into
the labor force, where it is hoped they can learn skills and advance to higher-

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paying jobs. Of course, the program has an obvious problem, too. Unlike
welfare, the EITC does not help individuals who cannot find work at all; in
reality, those are the folks who are likely to be most desperate.
When I applied to graduate school many years ago, I wrote an essay expressing
my puzzlement at how a country that could put a man on the moon could still
have people sleeping on the streets. Part of that problem is political will; we
could take a lot of people off the streets tomorrow if we made it a national
priority. But I have also come to realize that NASA had it easy. Rockets conform
to the unchanging laws of physics. We know where the moon will be at a given
time; we know precisely how fast a spacecraft will enter or exit the earth’s orbit.
If we get the equations right, the rocket will land where it is supposed to—
always. Human beings are more complex than that. A recovering drug addict
does not behave as predictably as a rocket in orbit. We don’t have a formula for
persuading a sixteen-year-old not to drop out of school. But we do have a
powerful tool: We know that people seek to make themselves better off,
however they may define that. Our best hope for improving the human condition
is to understand why we act the way we do and then plan accordingly. Programs,
organizations, and systems work better when they get the incentives right. It is
like rowing downstream.

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