Garett Jones on Edward Prescott’s Model of the Universe

What happens when the government raises taxes? In a recent discussion of the work of Edward Prescott, Garett Jones reminds us that it depends on what the government does with the revenue. If the money is mostly wasted, the income effect will dominate, i.e., your disposable income will be lower and you will be more inclined to work. But if the money is not mostly wasted — say it is returned in the form of cash transfers — the tax increase doesn’t necessarily leave you any poorer. And that means the substitution effect will dominate:

Here’s the Wisdom of Prescott: If the government raises the tax rate on you and all of your friends, and then divides up all the tax revenue and dumps it from a helicopter, what do you get?  Well, none of the money gets wasted, so the tax hike doesn’t have a direct income effect (there’s a small indirect one I’ll ignore here). 

If the tax hike is used for pure redistribution from the “average person” back to the “average person,” then the tax hike doesn’t make the “average person” poorer: The government is taking money out of everyone’s right pocket and slipping it into their left.  

But if the income effect is gone, what’s left?  The disincentive to work: The pure substitution effect. 

This is obviously a very stylized model, yet it sheds light on a number of familiar patterns.

For a slightly tangential example, affluent suburban homeowners are often keen to support property tax increases designed to increase funding on local schools. One obvious motivation for this behavior is that any improvement in perceived school quality will be capitalized in local property values, so the tax increase won’t leave you worse off. If this connection is broken, however, we can expect resistance to property tax increases to build, as evidenced by California’s experience in the decades since Serrano. The point is that this tax increase could actually be a wash, or even a net positive, from the perspective of your pocketbook. 

Or let’s say substantial marginal tax increases are used to finance decent-sized demogrants. Even I choose to retire early or devote myself to household production, I will have at least some money coming in even if I drop out of the labor force — even more if I decide to work off-the-books. At the same time, I get to keep less for every additional hour I work in the formal sector. It is not unreasonable to assume that people will devote less time and effort to market production.

I should stress that this isn’t necessarily a bad thing. Some leftists support a more robust social safety net and full employment policies on the grounds that this approach allows workers to demand more from employers, as the alternatives to market production aren’t so unattractive. An increase in leisure could allow people to their true interests, etc. One rejoinder is that a decline in market work would lead to a decline in the kind of measured collective wealth that can be deployed by the state in wartime and other exigent circumstances. Another is that it will prove corrosive of self-reliance. Regardless, Garett has given us something to think about.

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute policy fellow.

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