People change their behavior in response to incentives. This is a central tenet of economics and one that policy makers ignore at their — or society’s — peril.
But not all the incentives that people respond to are monetary, financial or even material in nature. This is also an important lesson from human experience and one that economists ignore at their — or their discipline’s — peril.
The first lesson applies to many situations, but is especially true in government programs initially intended to help only those “in need.”
Federal financial aid to college students is a good example. When federal grants and loan programs began in the 1950s, the idea was simple. Students from families with money would continue to pay tuition as they always had. Those who could demonstrate a “need” would get grants or subsidized loans.
The government wrote rules and formulas to determine the level of need from financial information supplied by the applicant’s parents and the costs established by colleges.
Neither students nor colleges, however, continued to act as they did before federal student aid existed. Households quickly learned how to arrange their finances to increase aid amounts or to at least increase the standard of living for their student children.
They learned, for example, that a student with $500 in savings and no car would get less financial aid than one with no savings and a $500 car. The message was clear. If you are going to need a car while in college, put some of your savings into a good used car before filling out the financial aid application.
Colleges also realized that if they increased tuition, the total amount of grants and loans received by their students would increase because their “need” would grow with tuition increases.
As long as the federal government picked up part of any increase, there was less student, or parent, opposition to tuition increases than there would have been without federal aid.
Similarly, when Medicaid began to pay nursing home fees for elderly people who had few resources, the intent was that people who had assets and income would continue to pay their own way. Medicaid would pay only for those whose income and net worth fell below a certain threshold.
But again, people caught on to the incentive. They realized that if they passed assets onto their children well before applying for Medicaid, their heirs would have a better life. If they did not give away most of their estate before entering a nursing home, a few years of paying the fees soon would chew up any net worth they had, and little or nothing would pass to their heirs.
Planning the timely transfer of assets between generations to avoid Medicaid liens is now a bread-and-butter part of estate planning for many households. Such early asset transfers would not occur if Medicaid had not created an incentive.
We face an analogous situation in pending Medicare drug benefit legislation. Retirees with high out-of-pocket drug expenses make good news stories, and their plight is real. But some 70 percent of all retirees have some level of drug benefit.
Congress was astute enough to recognize that if Medicare picked up drug costs for seniors who did not have other coverage, such “other coverage” would melt away.
Both the House and Senate versions incorporate “incentives” so that employers who provide drug benefits to their retirees do not drop this benefit. By “incentives,” they mean subsidies from the U.S. Treasury packaged in the form of tax reductions so that no visible appropriation of public funds need occur. No matter how these measures are camouflaged, the federal government will effectively pick up some of the drug expenses currently borne by employers.
None of this is intended to say that we should not subsidize college educations or provide good nursing home care or medications for the elderly. These are measures that I, for one, want government to take.
But we need to be realistic about the fact that when we create such programs, we inherently create incentives for people to alter their previous behavior so as to maximize their well being within the new program. Humans respond to incentives.
Virtually all economists know that. Most also know that humans are motivated by a wide range of incentives, of which money or goods or services form only a part. People want the things money can buy and many things that money cannot buy such as respect, status, love, friendship, self-actualization and so forth.
That is a self-evident aspect of human nature and you don’t need to study psychology to understand this. Thoughtful economists always have recognized the complexity of human needs and wants. Many of us abstract from that complexity when we are building theories, and we assume that getting goods and services dominates all other forms of self-satisfaction.
That simplifies theories and allows us to see economic forces at play. But economists should never lapse into assuming that the rational, well-informed income “maximizers” in our theory texts actually live in the real world. If we do, we will give bad advice on whatever issue is in question.
The general public needs to remember that people respond to economic incentives. Economists need to remember that such incentives are far from all that motivate us.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.