TCS Daily

News Flash: Nobel Laureate Criticizes Bush Tax Cuts!

By Arnold Kling - October 22, 2004 12:00 AM

"What Bush has done has been not very big, it's pretty small," Prescott told CNBC financial news television.

"Tax rates were not cut enough," he said.
-- AFP news agency

Winners of the Nobel Prize in economics usually are asked their opinion of policy issues, and this year was no exception. Edward Prescott, the American who shared the 2004 award with Norway's Finn Kydland, defied the conventional wisdom on the Bush tax cuts. Contrary to the widespread characterization of "massive" tax cuts, Prescott describes them as too small! Is he crazy?

Prescott did not win his Nobel by spouting conventional wisdom. On the contrary, he was part of a revolution within the economics profession. Over a period of roughly two decades, starting around 1967, the field of economics that deals with fluctuations in unemployment and inflation, called macroeconomics, underwent a dramatic transformation. Ideas that originally were considered crazy gradually came to be understood and accepted within the mainstream.

To do justice to Kydland and Prescott's work, I feel that I would have to delve into the full history of these macroeconomic controversies, which are alluded to in my book in the chapter on Sweetwater vs. Saltwater economics. Instead, let it suffice to say that Kydland and Prescott were two of the tugboats who helped turn around the ship of professional opinion. Other tugboats included Nobel Laureates Robert Lucas and Milton Friedman, as well as Edmund Phelps, who might have shared a Nobel prize had he been Scandinavian or had Friedman not been so clearly deserving of a solo award.

In contrast, it is easier to explain Prescott's research on tax rates and economic activity, which is the basis for his provocative views on the Bush tax cuts. The tax issue, rather than the macroeconomic theory that was the focus of the Nobel citation for Kydland and Prescott, will be the topic of the rest of this article.

Couch Potato or Home Improvement?

Prescott has subtly shifted the way that economists think about the way that people respond to a change in the rate of take-home pay. He argues that this response, which economists call the elasticity of labor supply, will be large. Traditionally, it has been assumed to be small.

The traditional view looks at the elasticity of labor supply in terms of the choice between labor vs. leisure. That is, you either work longer, or you lie around watching TV and eating Bon-Bons. In that framework, if you get a higher wage, that makes working more profitable, but it also gives you more income, making leisure more attractive. These two effects more or less cancel one another out, it was thought, so that you do not increase labor supply very much in response to a higher wage.

Prescott re-casts the trade-off as between "market time" and "non-market time." In addition to TV and Bon-Bons, you spend some of your non-market time producing goods and services, such as home-improvement projects, meals cooked at home, housework, and child care. Thinking of the choice in those terms, an increase in your wage rate could have a significant effect on your labor supply. The higher your wage rate, the more it makes sense for you to "outsource" household chores. If I can earn enough in six hours of work to pay for someone else to do eight hours of household chores, then I can get more hours for TV and Bon-Bons by increasing my "market time." Working six more hours but spending eight fewer hours on household chores gives me a net saving of two hours.

This use of market time to increase leisure time is an application of one of the most basic concepts in economics -- comparative advantage. An accountant could put together the bookshelves that she just bought from Ikea, but her comparative advantage is using spreadsheets, not screwdrivers. She and the economy are better off if she does more work as an accountant and pays a professional to assemble her bookshelves.

The Tax Wedge

Prescott emphasizes that taxes and regulations serve to limit the extent to which people can utilize comparative advantage and outsourcing. For example, if you are limited to a 35-hour work week, as is the case in France, then you necessarily cannot increase your market time in order to earn income that you might use to outsource household chores.

Taxes tend to penalize market time. If I use goods and services bought in the market to save on household chores, then I have to pay sales taxes. When I work additional hours to earn income to buy those goods and services, I have to pay payroll taxes and income taxes. Those taxes constitute a tax wedge.

The bigger the tax wedge, the more you will tend to do household chores yourself rather than outsource them. Suppose that you earn $40 an hour and it would take you 80 hours to build a deck, although a contractor could build the deck for $2400. On a pre-tax basis, it takes you only 60 hours to earn enough money to pay the contractor, so it makes sense to work more hours and pay the contractor. However, if your income and payroll tax rate together is 40 percent, then you have to work 100 hours in order to be able to take home $2400. Taking into account taxes, you are better off building the deck yourself, because your deck-building labor is tax-free.

The lower the tax wedge, the more likely it is that you will choose to use goods and services to replace household chores, increasing your market time in exchange for more true leisure time. Since many of the goods and services that we buy -- from microwavable food to lawnmowing services to wash-and-wear clothing -- are designed to save on household labor, the tax wedge is a significant economic factor.

Prescott has backed up this theoretical argument with studies of differences in labor supply across countries. In a paper entitled, Why Do Americans Work So Much More Than Europeans, Prescott pointed out that in the 1970's labor time was comparable between the United States and most European countries. His research suggests that an increase in the tax wedge in Europe relative to the United States is what accounts for much of the decline in the rate of market activity in Europe since then.

A friend who recently visited Germany reports that highly-educated workers there engage in do-it-yourself projects. Europeans assemble their own Ikea furniture, rather than paying others to assemble it. Because of taxes and regulations, Europeans engage in less market time than Americans. However, the extent to which Europeans actually have more leisure time is less clear.

Taxes and Entitlements

Whether Bush has cut taxes too little or too much depends in part on the outlook for entitlement reform. Economists all agree that the current structure of entitlements (Social Security and Medicare) will require an ever-increasing amount of tax revenues, as longevity increases and new medical treatments are developed.

Paul Krugman and other economists on the left are optimistic about the ability to raise tax revenues by increasing tax rates. They are pessimistic about the political feasibility of reforming Social Security and Medicare in a way that reduces the government's future liabilities.

Prescott, on the other hand, is very pessimistic about the ability to raise tax revenues by increasing tax rates. If an increase in the tax wedge leads to a large reduction in market time, then tax revenues will go up little, if at all, as rates increase. In that case, there is no way to sustain our current entitlement system. Some reform is imperative.

It seems to me that Prescott's views have gotten relatively little attention in the media. My recollection is that in past years, the Nobel Laureate was interviewed on the PBS news hour and other programs. I do not know whether Prescott's absence from the news reflects his own reticence or a lack of interest on the part of the media. However, I believe that his research on labor supply and taxes deserves a wider audience.

(Editor's note: see also this interview with Prescott and this op-ed by Prescott.)


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