Today I was listening to the EconTalk podcast with Garett Jones, which was excellent. If you don’t follow Mr. Jones on Twitter, you’re definitely missing out, as he has an informal project where he is attempting to distill macro concepts into tweets…which seems like a very hard thing to do. He also “likes” my Facebook links from time to time, which is pretty awesome.

Anyway, in the course of the conversation Jones makes a very provocative statement to the effect of:

“If businesses claim that they don’t need a tax cut, you should cut their taxes.”

The logic behind this statement is fairly simple, but very counterintuitive. When a business makes decisions, they think much closer to the margin than the median person does, as they are able to spend a lot of time thinking through different decisions. However, surrounding the margin are a lot of inframarginal decisions that businesses have to make. These are decisions that are generally inconsequential to the person (or company) making them, for which others might have a much greater stake. These types of decisions are generally characterized by a highly elastic supply curve, such that a small change in the price will cause a very large change in behavior.

They discuss the example of locating a gas station on the east or west side of a street — which can be largely inconsequential to the business itself, however the townspeople may have a larger stake in wanting the gas station on either side. In this case, a very easy (Coasian) solution can be found. Offering the business a relatively minuscule amount of money can change their behavior dramatically — and everyone can get what they want for a very low transaction cost.

However, these are not the type of tax cuts that businesses typically agitate for. Businesses tend to like the government to cut taxes on things that they’re already doing very successfully, such that the tax cut will be relatively useless. Why? Because the supply curve is relatively inelastic, and thus a large change in incentives generally produces a much smaller change in behavior. This brings me to one of the core underlying statements in complexity economics:

Firms don’t innovate, markets innovate.

This statement is similarly counterintuitive. We have a sort of caricature of entrepreneurs and firms as lone innovators, toiling away in pursuit of the next big idea. This is epitomized by a fascination with “small business” and “mom and pop stores”. But the fact is, entrepreneurs fail constantly. There are entire shelves in the dens of collectors that are filled with failed products. In fact, if there is anything that characterizes entrepreneurship it would probably be the ability to “fail fast and efficiently“. What is happening is that, in an evolutionary context, entrepreneurs play the role of differentiation, whereas markets play the role of selection and amplification.

The preference for tax cuts on what a business already does well is a manifestation of the lack of innovation that characterizes monopolistically competitive firms. If you surveyed a lot of high-level businesspeople, you would probably find that they support some abstract concept of “the free market”, but revealed preference is that most of them quite enjoy protectionism. They like it when the government tips the scales in a way that helps them do what they’re already doing — and they almost never agitate for the government to give them breaks at the inframarginal level — the level in which shaping incentives produces the greatest resulting change in behavior.

This is a very powerful tool in the arsenal of public policy, and I think that a lot more time should be spent analyzing (and instituting) ways in which we can use taxes to get the most “bang for our buck”. As they say: work smart, not hard. It would likely lead to much better outcomes than using the tax code to buy off constituencies and play budgetary games.


Update: Andrew Sullivan provides a choice example of exactly what I was saying:

They [print magazine publishers] keep trying to replicate the magazine model online – like trying to make counter-insurgency work in Afghanistan. It’s all they know how to do. So they do it.

I guess it’s understandable because, like the record companies and the publishing houses, they don’t want to admit that their gig is up and their concept of a magazine is essentially defunct. You can’t really blame them for that, can you?

I seem to recall hearing about how the government now needs to subsidize media outlets…hmm…

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