Within 2 weeks of sharing the 2019 Nobel Prize in economics with Michael Kremer, MIT economists Esther Duflo and Abhijit Banerjee wrote a long piece for the Sunday New York Times in which they argued that financial incentives are not as important as many economists think. The op/ed is titled “Economic Incentives Don’t Always Do What We Want Them To,” New York Times, October 26, 2019. What I find striking is how badly thought out and how badly backed up their argument is. To be sure, they do back it up somewhat. But their argument overall is weak. Their conclusion about the weakness of incentives is ironic given that they got the prize for their experimental work using incentives in poor countries, work in which they found that incentives seemed to be pretty important. The incentives were not necessarily financial incentives, but they were closely related. More on that anon.
Almost every paragraph of their long piece is interesting and important. That’s why this is a 2-part series.
Start with the last sentence in the first paragraph. They write:
Over the last few decades, this faith [by economists] in the power of economic incentives led policymakers in the United States and elsewhere to focus, often with the best of intentions, on a narrow range of “incentive-compatible” policies.
Notice their word “faith.” They could have chosen the word “confidence.” But by using “faith,” they subtly undercut from the getgo the idea that there is much evidence for the importance of incentives and, instead, claim that the view is faith-based.
Their second paragraph gives their main message:
This is unfortunate, because economists have somehow managed to hide in plain sight an enormously consequential finding from their research: Financial incentives are nowhere near as powerful as they are usually assumed to be.
At least now, they are basing their case on consequential findings from research. Do they back it up? Somewhat yes but mostly no.
Notice their first example:
We see it among the rich. No one seriously believes that salary caps lead top athletes to work less hard in the United States than they do in Europe, where there is no cap.
The typical salary cap is on overall team payroll, not on the amount an individual athlete can be paid, which is what is relevant here. Moreover, even if the salary caps are sometimes on individual players what matters for athlete effort is the size of the caps. Imagine that the NBA caps an individual player’s annual salary at $40 million and a European soccer team has no cap but pays a maximum salary of $30 million. What matters is pay, not whether there’s a cap. So their first example is not evidence at all.
Research shows that when top tax rates go up, tax evasion increases (and people try to move), but the rich don’t work less. The famous Reagan tax cuts did raise taxable income briefly, but only because people changed what they reported to tax authorities; once this was over, the effect disappeared.
This paragraph contains a number of important claims. Whereas for some of their claims, they give links to back up their statements, they give no links in this paragraph. Notice also their subtle slur about people who try to avoid taxes: they mention evasion, which is illegal, rather than avoidance, the non-evasion part of which is legal. Moreover, I’m pretty sure they’re wrong. If they had said that the main effect of higher top marginal tax rates is not that people work less, they might have been on firmer ground. But they didn’t say that. Instead, they said categorically that the rich (by whom they main, in this context, higher-income people) “don’t work less.” The main evidence I know on the Reagan tax cuts was by former Harvard economics professor Lawrence B. Lindsey in some academic papers, a book, and a popular study for the Manhattan Institute. Here’s what I wrote in “Are We All Supply-Siders Now?” Contemporary Policy Issues, Vol. VII, No. 4, October 1989:
Lindsey (1988) shows that 1985 income for taxpayers with an AGI [adjusted gross income] of more than $200,000 was $86.8 billion higher than their baseline income. What were the sources of this added income? Lindsey breaks down the income into four categories: dividends and interests, wages, capital gains, and other income. Interestingly, dividends and interest virtually were identical to the baseline, wages were about 30 percent higher, capital gains were more than 100 percent higher, and other income was nearly 200 percent higher. Because “other income” is made up primarily of business and proprietary income, Lindsey concludes that the main supply-side effect was due not to people working harder but rather to people paying themselves more in cash and less in fringe benefits. In other words, a key to the Laffer Curve is not, as many previous critics and some proponents of the curve had assumed [this included me in 1980], a large elasticity of supply but rather a large elasticity of tax avoidance with respect to tax rates. [italics in original]
Duflo and Banerjee are wrong on two counts. First, a 30 percent increase in wages is strong evidence that they did work harder. Second, although they are right to emphasize the increase in the income that people reported, they are wrong to claim that the effect disappeared.
Duflo and Banerjee continue:
We see it among the poor. Notwithstanding talk about “welfare queens,” 40 years of evidence shows that the poor do not stop working when welfare becomes more generous.
Remember that they were trying to argue that financial incentives are weak. How do they do it? By arguing that welfare doesn’t cause poor people to stop working. The argument, at least the one made by economists–and remember that it’s economists that they’re taking on–is not that increasing welfare payments would cause people to stop working but that increasing welfare payments would cause people to work less.
In their next sentence, Duflo and Banerjee write:
In the famous negative income tax experiments of the 1970s, participants were guaranteed a minimum income that was taxed away as they earned more, effectively taxing extra earnings at rates ranging from 30 percent to 70 percent, and yet men’s labor hours went down by less than 10 percent.
In other words, high marginal tax rates did cause men to work less. To their credit, they could have made a stronger claim. The study they link to shows that husbands reduced their labor hours by only 5 percent. But wives reduced their labor hours by a whopping 21 percent.
Note their next sentence:
More recently, when members of the Cherokee tribe started getting dividends from the casino on their land, which made them 50 percent richer on average, there was no evidence that they worked less.
Notice what Duflo and Banerjee did. They switched from talking about the effects of higher marginal tax rates (explicit or implicit) to talking about the effects of people’s non-wage income increasing without their marginal tax rates increasing. Probably most economists reading this would notice the switch–at least I hope they would. But a large percent of non-economists would probably not notice. Why does it matter? Because basic economic theory says that when one’s dividend income increases, there is an “income effect” on labor hours worked, but the income effect could be quite small or even zero. Because marginal tax rates did not change, the study they cite, even if high-quality, is not a test of the effects of incentives. Recall that what the two MIT economists are trying to establish is that financial incentives aren’t particularly powerful.
In their next paragraph, they write:
And it is true of everyone else as well — tax incentives do very little. For example, in famously “money-minded” Switzerland, when people got a two-year tax holiday because the tax code changed, there was absolutely no change in the labor supply. In the United States, economists have studied many temporary changes in the tax rate or in retirement incentives, and for the most part the impact of labor hours was minimal. Nor do people slack off if they are guaranteed an income: The Alaska Permanent Fund, which, since 1982, has handed out a yearly dividend of about $5,000 per household, has had no adverse impact on employment.
I had been unaware of the Swiss experiment. Assuming the study was well done, score one for Duflo and Banerjee.
But the Alaska story is like the Cherokee story. We would not expect an incentive effect of a yearly dividend. So it’s not evidence at all for their claim about financial incentives.
Next time: Part II.
READER COMMENTS
Kevin Dick
Nov 8 2019 at 5:33pm
When Scott Alexander covered this article, I went and read it. Their claims did not jibe with my memory of the literature, but that memory is pretty stale. And they do have a Nobel.
I was hoping someone like you would address it and save me the time of digging in. Then here you obliged. Thanks!
Josh
Nov 8 2019 at 7:52pm
Their argument seems to be bouncing around but I think the point they’re trying to show is that it doesn’t seem to matter what you do to people’s income, they always work about the same amount. If you tax them more or less they work about the same. If you make them richer or poorer they work within about 20% of the number of hours.
That might be true but actually I think that misses the point of incentives. We want to reward things that are important but difficult. Reducing the incentive for doing difficult things doesn’t show up as reduced hours worked. It shows up as slower growth.
Eg if I’m already a doctor and you make random changes to my salary, I may not change the number of hours worked much. But if I’m a teenager considering whether to become a doctor, it might make a big difference.
As an example, take the $500m mega lotteries we see. A naive person might say “you only spent $1 on the ticket; financial incentives don’t matter much and surely getting a 10x return overnight for doing nothing is enough to make anyone happy. So there’s no reason to reward people with the full $500m – $10 is enough.”
That’s clearly foolish. If you made the prize $10 for a lottery no one would buy a ticket. Clearly the financial reward matters a ton.
If you look at someone’s behavior conditioned on them having already won the lottery – or conditioned on them already having completed medical school – you get a very different sense than if you look at them unconditionally.
Henri Hein
Nov 9 2019 at 1:39pm
Josh,
I think that is right. I saw somewhere that when you look at life-time earnings, rather than the immediate response, then people do respond to changes in the marginal tax rate. With higher rates, they start work later, retire earlier, and, like you say, choose different professions.
Thaomas
Nov 8 2019 at 8:15pm
Agreed it was a pretty weak post, starting with the strange premise that over some time period policy has at the behest of economist, “focused on on a narrow range of ‘incentive-compatible’” policies. Could this refer to ACA being insurance policy focused instead of single payer? Economists generally opposed the “Tax Cuts for the Rich and Deficits Act of 2017.” Economists opposed the trade wars. Economist support lighter restrictions on urban density, occupational licensing, immigration, taxes on CO2 emissions,etc., but those polices have not been adopted. So which “incentive compatible” policies have been adopted in recent years to complain about?
The mindset behind the article is more understandable. In their research design of different aid interventions, it is clearly necessary consider more than a “narrow range of incentive compatible” variables.
Jim Rose
Nov 8 2019 at 10:20pm
An Icelandic study shows the opposite to the swiss study of tax holidays.
Mark Z
Nov 8 2019 at 10:31pm
A general issue with their conclusions here: they seem to cherry pick short term results and leave out the (more important) longer term effects. For example, in the Seattle-Denver negative income experiment, men (or, husbands) worked less by about 6% after 1 year, but the reduction increased to 13% 3 years out. For wives, it went from 15% to over 20%, averaging about 25% from 2-5 years. (https://aspe.hhs.gov/report/overview-final-report-seattle-denver-income-maintenance-experiment)
That people don’t quit their jobs or seriously reduce employment upon being assured a big check for one year isn’t evidence of the irrelevance of economic incentives. It’s evidence that they think in longer terms than one year. In terms of lifetime income, a one year UBI (or NIT) is pretty small, and shouldn’t have much of an effect. But even after just 2 or 3 years of getting the NIT, the effect on labor supply is already double what it was from the first year. The work disincentive appears to be primarily in the longer term, rather than in an immediate response to getting the check. So how people behave after getting a year off taxes, knowing that after a year, things will go back to normal, doesn’t tell you much about how they’ll behave when you guarantee them a lifetime income. Just given the difference between 3-5 years of NIT vs. 1 year, we should probably expect the disincentive caused by a permanent UBI or NIT to be greater still.
BC
Nov 9 2019 at 5:35am
“husbands reduced their labor hours by only 5 percent. But wives reduced their labor hours by a whopping 21 percent.”
Does that mean that higher marginal tax rates would worsen the “gender gap” in pay? This connection doesn’t seem to be mentioned very often. Most people that refer to a “gender gap” refer to the total gap, the gap due to both hourly wages and total hours worked. (In fact, the second factor seems to contribute more significantly than the first.) It doesn’t seem to be well known or publicized that higher marginal tax rates tend to disproportionately impact women’s participation in the labor force.
Rick T.
Nov 11 2019 at 8:58am
It makes sense that gender wage gaps and marginal tax rates are very closely connected for married couples. I don’t think it was a coincidence that it wasn’t until after the Reagan tax cuts in the 1980s that there was a big jump in women in the higher paid professions. Before that, the tax rate from their first dollar earned was so high if they were married to a higher income man, that it didn’t pay all that well to start a career versus stay home. Bring back a 73% marginal tax rate, and watch the lower paid partner of married couples leave the workforce.
Dillard Swope
Nov 9 2019 at 9:38am
In the Switzerland example, wouldn’t a temporary, two year change be expected to have a limited affect?
Jon Murphy
Nov 9 2019 at 10:43am
I have a problem with their opening sentence:
This is incorrect. Adam Smith explicitly says otherwise in Theory of Moral Sentiments and Wealth of Nations. Indeed, it’s not even a correct interpretation of Smith’s point, which is merely that we need to do something for them if we want them to do something for us.
Smith does do a brief thought experiment in TMS on a purely mercenary society (how Duflo and Banerjee describe the primary motivation of economics, purely financial) but he ultimately rejects it as unlike human society (See Part 2, Chapter 3, pages 85-91 of the Liberty Fund edition).
Jon Murphy
Nov 9 2019 at 10:59am
Something else in their article I am not understanding: why they use “economic incentives,” “financial incentives,” and “incentives” interchangeably. Their first paragraph discusses “economic incentives” but then the second paragraph switches to “financial incentives.” Finally, they conclude by summing a survey they did: “Everyone else responds to incentives, but I don’t.”
This is confusing because economic incentives and financial incentives are two different things. Indeed, they report in their op-ed and in their survey (and the other links they provide) that people do respond to incentives and in predictable ways.
People will respond to financial incentives and other incentives only if that is the only margin they can adjust along. It there are other margins (such as some of those identified in the article, like tax avoidance), then we should expect they will adjust along those margins, too. Yes, an increase in taxation does not necessarily mean that folks work less simply because there are other margins along which they adjust. If those margins are fully capitalized, which that working less is the only means they can use to reduce their costs (or, which comes to the same thing, maximize their net benefits), they will work less.
But also, just because there are these margins along which folks can adjust, it does not logically follow that the policies they propose are worthwhile. Public choice issues aside, they are deliberately hindering the market process by protecting against pecuniary externalities; in other words, they are discouraging healthy and innovative competition and encouraging unhealthy and destructive competition (ie, rent-seeking).
Thaomas
Nov 12 2019 at 1:22pm
But since there are no free lunches, there is really no other way than looking for the least costly (the little triangles along all the dimensions) forms of taxation to transfer consumption if that’s what you want to do.
Henri Hein
Nov 9 2019 at 1:53pm
I was curious about the Swiss tax change, so I looked at it a bit. Here is what the abstract says:
So there was an effect in behavior, just not in measurable hours worked. Switzerland generally has a high labor participation rate, but when I looked it up, I noticed it jumped 0.5% in 1998 and 1999, compared to the surrounding years. I would say their claim is at the very least highly selective.
OH Anarcho-Capitalist
Nov 11 2019 at 8:38am
Indeed, if we look at those whom logic says are more highly motivated to work than the societal average, those would be high income workers and the self-employed. We can assume they are more motivated (incentivized) based upon their current status as either high wage earners or those with a vested interest in making their own business succeed. If my job safety (and reliability) is more important to me than the risk associated with chasing higher wages or self-employment, that’s the choice I’ll make.
As another economist once said, just because something is possible, doesn’t mean it is plausible. I find it a shocking claim that “incentives” do not motivate changes in behavior; possible? perhaps. Plausible? nope.
Lastly, these types of studies are often used support claims that individual preferences do not matter. Are there selfless workers who claim that they’d perform their occupation “no matter the pay”? Absolutely. Are there others who seek out the highest compensation package possible for their skill set? The sports pages are full of them. That doesn’t mean that even if a majority of folks are claimed to fall into category 1 that those in category 2 lose the rights to their own property because “policy” is aimed at collective goals created by politicians…
Alex
Nov 9 2019 at 3:51pm
Scott Alexander recently had a post about this article:
https://slatestarcodex.com/2019/10/28/financial-incentives-are-weaker-than-social-incentives-but-very-important-anyway/
Jack QR
Nov 11 2019 at 10:58am
If financial incentives aren’t important, why do top US economics departments pay so much more than lower-ranked departments? If I’m a rising star at Big State U and Stanford swoops in to hire me, why should they increase my salary by 50%? This is just one example, but specifically in the context of the professors’ own work.
David Seltzer
Nov 13 2019 at 6:19pm
As per Henderson’s critique; “Faith” in, ostensibly rigorous scientific inquiry, seems a contradictory term as faith is belief without evidence.
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