Economic theory and reality – Econlib

Kevin Corcoran recently posted a post discussing the distinction between being wrong in theory and being wrong in fact. Here I am interested in a different situation, the case where theory fits quite closely with reality, but people hesitate to accept the implications of that fact. For example, basic economic theory suggests that higher tax rates should reduce the number of hours worked. Europe has higher tax rates than America and significantly fewer hours worked per year. But many people seem reluctant to accept the obvious implications of these facts.

The economist has a very good article on this topic:

Edward Prescott, an American economist, came to a provocative conclusion, stating that the key was taxation. Until the early 1970s, tax levels in America and Europe were comparable, as were the number of hours worked. By the early 1990s, European taxes had become heavier and, according to Prescott, workers were less motivated. There is still a significant gap: US tax revenues are 28% of GDP, compared to around 40% in Europe.

Note that Prescott relies on two types of evidence, both cross-sectional and time series. That makes his claim much more convincing than a simple comparison of two places at a given time. And yet many people remain reluctant to accept the obvious implications of these facts.

The article presents one empirical study that suggests that the disincentives to work resulting from high taxes may be quite modest:

A recent study by Jósef Sigurdsson of Stockholm University examined how Icelandic workers responded to a one-year tax holiday in 1987, when the country overhauled its tax system. Although people with more flexibility – especially young people in part-time jobs – did indeed put in more hours, the overall increase in work was modest compared to the increase shown in Prescott’s model.

Again, this result is not surprising at all. Because of the “collective action problem” aspect of the work structure, one would expect the short-run elasticity of labor supply to be much lower than the long-run elasticity. Work schedule decisions are generally made at the corporate level, and to some extent even at the societal level (as with things like school schedules, which need to be coordinated with work schedules). Note that the elasticity was higher for part-time younger workers, who face less of a coordination problem.

How can we explain the reluctance to accept the obvious implications of a theory? A few more examples will help clarify the sources of bias:

1. Theory suggests that higher CO2 levels should increase global temperatures due to the “greenhouse effect.”

2. The theory suggests that injecting a lot of money into the economy should cause price inflation (that is, reduce the purchasing power of a single dollar bill).

It would be quite surprising if more CO2 did not lead to global warming, or if large cash injections did not cause inflation. And yet I often meet people who disagree with these claims. They might argue that global warming is an unproven theory, or that inflation is caused by corporate greed. Why reject evidence that almost perfectly matches the standard theory? What is going on here?

I find that people who believe in the inflation theory of corporate greed also tend to have left-wing policy views, while people who are skeptical of global warming tend to have right-wing policy views. Perhaps this provides a clue as to why so many people are skeptical of the claim that high taxes discourage the work effect.

Suppose you are someone who, for a variety of reasons, favors a large welfare state. In that case, you might be resistant to accepting empirical data that points to negative effects of high taxes. From a purely logical perspective, this makes little sense. It is certainly possible for a welfare state to be beneficial despite leading to a reduction in GDP per capita. Maybe the extra free time is worth the blow to national income.

Unfortunately, when people had a strong policy vision, they became more like lawyers and less like scientists. They look for any evidence that appears to strengthen the arguments for their policy preferences and ignore evidence that weakens the arguments for their policy preferences.

Political bias is not the only factor that leads people to reject the implications of economic theory. It is also true that many economic theories are counterintuitive. For example, most elasticities tend to be higher than what you would expect if you relied on introspection, that is, on “common sense.” So even people with so-called “addictions,” such as smoking or illegal drug use, often respond surprisingly well to price signals.

Many people probably have trouble imagining how higher taxes would cause them to work fewer hours. They may think, “With higher taxes, I would have to work more hours to pay my bills.” Their mistake is not to recognize that tax revenues do not disappear, but are returned in the form of benefits to those who consume more leisure time. This is what economists mean by an “income-adjusted elasticity of labor supply.”

To summarize:

1. When the theory suggests that X is true.

2. And when empirical evidence seems to confirm the theory.

Be very careful before you reject the claim that X is true.

P.S. Suppose you go back in time and David Hume shows the following graph for the M2 money supply:

If Hume were asked what he thought happened to inflation in the early 1920s, how would he have responded? Then suppose you told Hume that many people now blame “corporate greed” for the high inflation of the early 1920s. How would that information affect Hume’s view of progress in economics in the 270 years after he developed the quantity theory of money?