Cash for Clunkers and Other Lemons

Wednesday, January 12, 2011

“Supply-side economics” is a memorable phrase from the Reagan administration. These catchy yet misleading words pertain not to supply versus demand but rather to incentives, good or ill. For income taxes, the key point is that cuts in marginal tax rates spur the economy partly through enhanced supply (greater work effort, higher productivity) and partly through expanded demand (increased investment in plant and equipment and in research and development).

President Reagan cut the average marginal income tax rate to 21.8 percent in 1988 from 29.4 percent in 1981. The GDP growth rate between 1982 and 1989 was a strong 4.3 percent per year, and I estimate that 0.6 percent per year of that seven-year growth came from the tax cuts. Similarly, George W. Bush cut the average marginal rate to 21.1 percent in 2003 from 24.7 percent in 2000. The GDP growth rate between 2001 and 2005 (including negative effects from the 2001 recession) was a respectable 2.7 percent per year, and I estimate that 0.5 percent per year of that four-year growth reflected the tax cuts.

As the Obama administration considered whether to maintain the Bush tax cuts or let them expire, little of the administration’s analysis referred to incentives. Rather, the discussion mainly centered on whether the poor or the rich spend a greater fraction of added disposable income, whether the rich can afford to pay more taxes, and so on.

From the standpoint of incentives, the important point is that higher marginal tax rates harm the economy. For example, I estimated that undoing all of the 2003 Bush tax cuts (which alone reduced the average marginal rate by 2 percentage points) for 2011 would reduce the GDP growth for 2011–12 by 1.1 percentage points.

Incentive-based arguments imply that it is best to cut marginal rates where they are the highest—usually at the top of the income distribution but sometimes for poor people who lose transfer-payment eligibility by earning more money. A common suggestion is to cut the Social Security payroll tax, but this change is less effective than a cut in the federal individual income tax. In contrast to the income tax, the payroll tax is nearly a flat tax and therefore generates a lot of revenue compared to the marginal tax rate.

Incentives certainly worked under “cash for clunkers,” but in an unhelpful manner.

Parts of President Obama’s economic agenda do rely on incentives, a notorious example being “cash for clunkers,” the now-expired program that encouraged Americans to scrap old cars and buy new ones. The two main responses to this program were destruction of functional old cars and accelerated purchases of new ones. Hence, used-car prices went up and automobile sales followed a boom-and-bust pattern. Here, incentives worked but in an unhelpful manner.

A more favorable case is the recent proposal for accelerated depreciation allowances for business investment. This change delivers good economic incentives and ought to be a permanent part of the tax system. Unfortunately, the stimulative effects are likely to be weak in an economy where nominal interest rates are close to zero. With low interest rates, businesses value near-term depreciation allowances only a little more than far-off allowances.

The extension of unemployment-insurance eligibility to ninety-nine weeks had incentive effects as well, though not in the way it was intended. According to recent Labor Department statistics, 57 percent of all people receiving unemployment benefits were on extended programs—those for workers unemployed more than twenty-six weeks—and the share of the unemployed getting benefits of some form was 67 percent.

In a weak economy, extended jobless benefits incentivize unemployment.

We know from the U.S. Bureau of Labor Statistics (BLS) that in early August 6.25 million, or 42 percent, of the unemployed had been jobless more than twenty-six weeks. If we subtract the 5.67 million getting extended unemployment-insurance benefits, we can estimate that 580,000 people were unemployed more than twenty-six weeks and not getting benefits. That is, around 11 percent of the 4.93 million unemployed without benefits were in the longer-than-twenty-six-weeks category.

If more data were available, we could do serious research on the determinants of unemployment duration for those eligible or ineligible for benefits (by taking into account differences across the two groups in work experience and other characteristics). Yet even with the available data, it is not a great stretch to infer that the main reason for the sharply higher unemployment duration among those receiving benefits is the eligibility up to ninety-nine weeks. In a weak economy, extended benefits incentivize unemployment even when the benefits offered by unemployment insurance replace only 40 percent of previous wages.

I hope the administration shifts away from programs based on Keynesian reasoning and toward policies that emphasize favorable economic incentives. Extending the full tax cuts of 2001–3 and reducing the eligibility period for unemployment insurance would be good starts.