Students of mine frequently ask: “What is the most important idea in economics?” I respond: “Resources are scarce compared to people’s wants, and therefore they have to make choices.” “But what else?” a few persist in asking. I reply: “People respond to incentives,”
There are plenty of good examples.
Four decades ago, the United States instituted aid to college students. Drafters of the legislation intended this to help students whose families lacked the means to send them to college and not to subsidize those who did.
This ushered in the dreaded financial aid forms that most parents of college students must fill out. And it gave rise to a small industry of experts who write books and conduct seminars telling students and parents how to order their finances to maximize the amount of federal aid. Such ordering includes changes in behavior.
For instance, if a student saves up to $5,000 from summer jobs during high school and has it in cash at the time of filling out the aid forms, the financial-aid rules count it as available cash to pay tuition. But if the student buys a serviceable used car with that money two weeks before sending in the aid forms, her “need” will be that much greater.
Congress established Medicaid to meet the health care needs of poor people. It now extends to nursing home care for those whose net worth is below a specified amount. This net worth does not include the value of property given to heirs more than a specified number of years prior to applying for the benefit. Nor does it include the value of a pre-paid funeral.
Millions of households and thousands of attorneys now devote considerable time to making sure that farms, businesses and even homes are given to the kids or grandkids far enough in advance so that Medicaid pays the bill when Mom and Dad have to go to the nursing home. Funeral directors have sold hundreds of thousands more prepaid plans than they would have without that small clause in the Medicaid rules.
From the 1960s into the 1990s, the federal government offered price supports to farmers. As part of the deal, farmers agreed not to plant any crop on a specified percentage of their acreage. But it soon became clear that a 10 percent or 15 percent reduction in corn or wheat acreage did not reduce production by the same amount.
Why? Because farmers knew their land and chose to put the least productive acres into the set-aside program. I was involved in farming during much of that period and, with other farmers, played a cat-and-mouse game with the Department of Agriculture. Each year the USDA would make the regulations more detailed to force farmers to set aside truly representative acres. Yet, each year smart farmers, farm magazines and farm extension educators would find new loopholes.
Three or four centuries ago, the government of Scotland placed a tax on whiskey distillers, based on the liquid volume of the stills then in use – so many shillings per gallon. Historians have documented how this gave rise to a remarkable increase in productivity in still design as whiskey producers looked for ways to increase the daily throughput of smaller stills that accrued less in taxes. The process was similar to that of the designers of Formula 1 racing cars or 12-meter yachts. Smart people look for every possible way to improve performance subject to some measurement rule.
Or take a 1997 change in U.S. tax law. It used to permit deferring paying tax on any capital gains realized when selling a home, as long as the proceeds from the sale were used to buy another home. And there was a once-in-a-lifetime exclusion of any capital gains from any house sale, even if the proceeds were not reinvested in another residence.
The new law permits an unlimited number of untaxed gains of up to $500,000 for a couple on the sale of a home lived in two of the previous five years. But it eliminated the one-time unlimited exclusion. Now accountants are advising wealthy people whose homes have appreciated to nearly the $500,000 limit to sell and buy something else for the sole purpose of avoiding taxation. And lawyers push selling your house to a friend or relative and then renting back with an option to buy, all only to avoid the tax.
What is the lesson here? Should we abolish student aid, Medicaid, farm programs or taxes on distilleries? Not necessarily. Such measures should be evaluated on the overall costs and benefits they bring to society. But when designing such programs, one has to keep in mind that people respond to incentives, both intended and unintended.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.