Kevin Corcoran recently did a post discussing the difference between wrong in theory and wrong in reality. Here I am interested in another case, the case where theory matches reality closely, but people are reluctant to accept what that reality says. For example, basic economic theory suggests that higher tax rates should reduce hours worked. Europe has higher tax rates than America and much lower hours worked each year. But many people seem reluctant to accept the correct views of those facts.
The Economist has an excellent article on this topic:
Edward Prescott, an American economist, came to a disturbing conclusion, saying that the key was taxation. Until the early 1970s, tax rates were similar in America and Europe, as were working hours. By the early 1990s Europe’s taxes had become too heavy and, in Prescott’s view, its workers were no longer motivated. A huge gap persists today: America’s tax revenue is 28% of GDP, compared to 40% or more in Europe.
Note that Prescott relies on two types of evidence, both cross-sectional and time series. That makes his claim much stronger than a simple comparison of two places at the same time. Yet many people remain reluctant to accept the obvious implications of these facts.
The article presents one empirical study that suggests that a retrenchment from higher taxes may be modest:
A recent study by Jósef Sigurdsson of Stockholm University examined how Icelandic workers reacted to a one-year tax holiday in 1987, when the country overhauled its tax system. Although more flexible people—especially young people in part-time jobs—did put in more hours, the overall increase in work was small compared to Prescott’s model.
Again, this result is not at all surprising. Because of the “accumulating action problem” aspect of the labor structure, one would expect the short-run elasticity of labor supply to be much lower than the long-run elasticity. Decisions about work schedules are often made at the company level, and to some extent even at the community level (such as things like school programs, which must be coordinated with work schedules.) Note that elasticity was higher for younger part-time workers. , who face a small communication problem.
How can we explain the reluctance to accept the obvious results of the theory? A few more examples will help illuminate sources of bias:
1. The theory suggests that higher levels of CO2 should increase global temperatures due to the “greenhouse effect”.
2. The theory suggests that injecting more money into the economy should cause inflation (ie, a decrease in the purchasing power of the one dollar bill.)
It would be really surprising if more CO2 didn’t cause global warming, or if massive capital injections didn’t cause inflation. However, I often meet people who disagree with these claims. They may argue that global warming is an unproven theory, or that inflation is caused by corporate greed. Why reject evidence that almost perfectly matches the general theory? What’s going on here?
I notice that people who believe in the corporate selfish view of inflation tend to have left-wing policy views, while global warming skeptics tend to have right-wing policy views. Perhaps this gives an indication of why many people question the claim that high taxes discourage work.
Let’s say you are a big socialist, for many different reasons. In that case, you may be reluctant to accept empirical data that suggest negative effects from higher taxes. From a logical point of view, this doesn’t make much sense. It is certainly possible that the welfare state is profitable despite leading to a reduction in GDP per capita. Maybe the extra fun is worth the effort for the country’s money.
Unfortunately, when people hold strong policy views, they become more like lawyers and less like scientists. They look for any evidence that appears to strengthen the case for their policy preference and discount evidence that weakens the case for their policy preference.
Political bias is not the only thing that leads people to reject what economic theory says. It is also the case that many economic theories do not contradict each other. For example, multiple elasticities tend to be higher than one would expect if one relies on self-assessment, that is, on “common sense”. So even people with so-called “addictions” like smoking or using illegal drugs often respond surprisingly well to price signals.
Most people probably have trouble seeing how higher taxes will lead to them working fewer hours. They may think, “With higher taxes, I’ll have to work more hours to pay my bills.” Their mistake is not realizing that tax money does not disappear, it is recycled in the form of benefits for those who use more leisure time. This is what economists call “the adjusted wage elasticity of labor supply”.
To summarize:
1. When the theory suggests that X is true.
2. And where empirical evidence tends to prove theory.
Be very careful before rejecting the claim that X is true.
PS. Suppose you went back in time and showed David Hume the following graph of the M2 money supply:
If Hume were asked what he thought would happen to the devaluation of money in the early 2020s, how would he have responded? Then suppose you told Hume that many people now blame “corporate greed” for the high inflation of the early 2020s. How would that knowledge affect Hume’s view of progress in the field of economics 270 years after he developed the Quantity Theory of Money?
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