Good and Bad Incentives

by Ashley Muchow Robert Barro, in his most recent WSJ article, takes note of various logical shortcomings in the Obama administration’s economic agenda.  Rather than focus on the supply-side rationale of creating incentives that stimulate both supply and demand—thus yielding sustained economic growth—the Obama administration has ignored the breadth of supply-side manifestations in the policy measures it...

by Ashley Muchow

Robert Barro, in his most recent WSJ article, takes note of various logical shortcomings in the Obama administration’s economic agenda.  Rather than focus on the supply-side rationale of creating incentives that stimulate both supply and demand—thus yielding sustained economic growth—the Obama administration has ignored the breadth of supply-side manifestations in the policy measures it has supported or ignored.

Supply-side rationale holds that a decrease in the marginal tax rate leads to an increase in productivity, incentivized by structures that ensure reward for achievement, and causes an increase in demand through the subsequent increase in disposable income and flexibility of consumption.

Barro provides a few examples of good and bad incentive-based economic policies acted on or pending action by the Obama administration.

Unhelpful Incentives:

• The Car Allowance Rebate System (CARS) program—a $3 billion federal scrapping program intended to increase new car sales and prop up the failing American auto industry.  The program offered $3,500 to $4,500 to people who traded in old vehicles to purchase new vehicles.  Barro summarizes the program’s fallacy as follows:
  

  The two main responses to this program were destruction of functional old cars and acceleration of purchases of new cars.  Hence, used-car prices went up and automobile sales followed a boom-and-bust pattern.

• Unemployment-insurance eligibility extension to 99 weeks.  While shielded in altruism, this move creates incentives that keep individuals out of work—thus stimulating unemployment.  Barro refutes the administration’s logic.
  

  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 99 weeks.  In a weak economy, extended benefits incentivize unemployment even when the benefits offered by unemployment insurance replace only around 40% of previous wages.

Good Incentives:

• Extending the Bush-era tax cuts.
  

  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 & equipment and in R&D)…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.

Time will tell whether the current administration can get their economic incentive logic right.