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Tax Policy: A Behavioral Science

Tax Notes
April 3, 2006
By Ernest S. Christian and Gary A. Robbins

Taxes and tax policies affect behavior. Changes in behavior change economic performance and therefore affect broad measures of well-being such as job creation, national income, and growth in gross domestic product. Thousands of intricately drafted tax exemptions, deductions, credits, and exclusions, many tailor-made for only a few taxpayers, influence behavior and economic outcomes at the micro level as well. The tax code daily reallocates resources from one individual or business to another, punishing some choices (and those who make them) and rewarding others. It creates competitive advantages for some at the expense of others and influences the way businesses are operated, both domestically and internationally -- all for reasons and in ways that have little to do with the need to collect tax revenue. To suggest otherwise is pure sophistry.

Not only is the tax code the government's most effective device for modifying behavior, it has set the pattern for thousands of other governmental interventions: first, a broad general rule that inflicts the maximum amount of penalty or prohibition; and then a series of exceptions and special rules for those who fit a favored profile or conform their behavior.

In the tax code, Congress is constantly changing the mix of carrots and sticks. It has amended the tax code more than 10,000 times in recent years, and every time it gets ready to change the rules, hundreds of Washington's most powerful lobbyists swarm around the taxwriting committees. Those lobbyists know that the stakes are enormous. By the time legislation emerges from Congress, it is usually the case that another $200 billion of wealth and income has been reallocated and another 200 to 300 additional tax-based influences let loose on the economy.

Every owner of a successful mom and pop business, as well as every Harvard MBA and just about everybody else, knows that taxes are a cost just like any other expense. When something costs more there will be less demand for it, and when the profit from selling a product is reduced by higher costs, businesses will be less willing to supply it. All of us who work for a living know we work for an after-tax wage that we call "take-home pay."

Only an economic nihilist would deny the large-scale negative effects of high marginal tax rates that are -- under the current tax code -- applied more heavily to capital than to labor and more heavily to saving than to consumption. There is less saving, less investment, and, as a result, slower GDP growth and lower incomes. When we save and invest too little, we produce too little and consume too much; and because our consumption is too high relative to our production, our imports are too high and our exports too low; and because we import more than we export, we must borrow from foreigners; and if we borrow from foreigners and also continue to consume too much, we must repay them with part of our savings; and when we deplete our savings, it is harder to invest and produce.

Just as overtaxing saving and investment relative to other choices has negative economic effects, it is only common sense (as well as correct neoclassical economics) that relieving saving and investment from the extra-heavy burden of tax (and thereby moving toward neutral taxation) will have positive economic effects. (In the minds of some people, relief from a tax penalty is a "tax incentive.")

Yet there are those who have denied that either tax increases or tax decreases have any overall positive or negative economic effects. That conclusion is based on the dubious and generally counterfactual proposition that (a) the negative effect of higher taxes is offset by an equal or greater positive effect from higher levels of spending; and (b) any positive effects from reduced taxes are offset by the negative effects of increased government borrowing. No one really believes that anymore and most econometricians have long since departed from the pure Keynesian model, although, by building in false barriers, many still do not permit their models to show the full growth effects of removing extra layers of tax on capital.

To cut through that charade and to allow tax policy to be made based on reality rather than false theoretical speculation is what the new Dynamic Analysis Division at the Treasury Department is all about.

Ernest S. Christian and Gary A. Robbins are, respectively, the executive director and chief economist of the Center for Strategic Tax Reform, a Washington-based organization that has for more than a decade been doing research on tax reform options. Both now are also visiting fellows at the Heritage Foundation in a project focused on the relationship between tax reform, economic growth, and personal liberty.

This week's column is intended to be the first of a three-part series on the origins, purposes, and inner workings of dynamic analysis. Click here for part 2.