Incentives Matter, Period
Long before Adam Smith, people learned that incentives matter. If a person cannot keep enough of the fruits of his efforts, he will not put forth the effort in the first place.
Kings, emperors, sharecropper landlords, treasury secretaries, slave owners, and many others over the ages understood that they maximize their tax collections by limiting their tax rate to something less than 100 percent. Even the so-called Communist Chinese government appreciates this. An economy with excessive tax rates will necessarily be an economy that produces far less than its potential, and ultimately produces little revenue for its tax collectors.
This impeccable logic, supported by centuries of experience around the world, includes nothing about “interest rates,” nothing about the “Federal Reserve,” and nothing about the “zero lower bound.” In the grand scope of human experience, the Federal Reserve (a U.S. institution that was absent for most of its history) is at most a minor footnote.
Yet now a few New Keynesian economists are telling us that hiking tax rates raises income and labor usage (sic). Their logic hinges critically on an esoteric theory of the Federal Reserve. Without evidence, they believe, and would have you believe, that the Federal Reserve’s situation can turn the impeccable logic of incentives on its head.
[Hereafter, for brevity I refer to those making this argument as “New Keynesians”, but please recognize that many New Keynesians such as Professor Mankiw are not so gullible as to conclude that incentives don’t matter. For now, I am not naming the gullible, in order to give them more time to pause and see the big picture].
Incentives from the (Usual) Macro Perspective
That incentives matter is not just a microeconomics point. If you have a large group of people (members of a kibbutz, citizens of the Soviet Union, etc.), each of whom has little incentive to work, the aggregate result for the group will be low output and low living standards.
The point that incentives matter in the aggregate seems so obvious, but the recent debate about them requires that we revisit each of the logical steps.
Suppose that something happens at the individual level to reduce the supply of labor. An increase in personal income tax rates, or an increase in unemployment benefits, are examples. New Keynesians agree with me that, say, an unemployed individual enjoying higher unemployment benefits will be less willing to accept a low paying job. Or that the substitution effect of a higher personal income tax rate is to cause people to put forth less of the effort that produces that income, unless the rate hike were offset by higher pre-tax pay.
As each individual supplies less labor, wages rise as employers compete for the smaller labor pool.
We usually say that the prices of the goods produced by those employers would rise with wages, or that employers would take other steps (suspending advertising, sales, discounts, reducing product quality, etc.) to reduce the volume of goods they deliver to customers (after all, the wage increase is reducing the profit they earn from delivering each unit). This process may not be exactly as in the undergrad textbook – that is, volume may react a bit less (or a bit more) than it would if prices increased one-for-one with wages – but the basic point is that higher costs ultimately and significantly reduce production and sales.
So the macro story, as most economists understand it, ends with less labor usage and output. And the basic conclusion that higher costs reduce production has been supported by decades of experience and economic measurement.
The New Keynesian Miracle
Nevertheless, the New Keynesians depart from me at this point. They say that, in response to higher wage costs, employers/producers will do essentially nothing in the short term to raise prices or otherwise reduce their production and sales. In the longer term, employers/producers will pass on their wage costs to costumers, and those costumers understand that they must buy now before the producers can adjust. This extra spending by the customers actually induces employers to produce more in the short run, and thereby employ more in the short run.
Thus we have quite a miracle. A greater tax on personal income increases aggregate income (even if the revenue from that tax is given back to taxpayers), because they have an individual incentive to earn less!
A tax rate cut would reduce income. The logic is the same: tax cut –> more labor supply –> lower costs and anticipation of lower prices –> less spending –> less production and labor usage.
Putting the Federal Reserve in the Picture
Like encounters with aliens, the New Keynesian miracle is said to occur in only specific situations when the skeptics happen to be looking elsewhere. Normally, they say, the Federal Reserve would respond to the labor supply shock by adjusting the nominal interest rate. When something reduced labor supply at the individual level, the Federal Reserve would normally raise the nominal interest rate to choke off the additional spending that would otherwise appear in the New Keynesian story.
When something increased labor supply at the individual level, the Federal Reserve would reduce the nominal interest rate to encourage the spending that (in the New Keynesian story) consumers would otherwise hold back until prices fell. That’s where the “zero lower bound” comes in – it supposedly prevents the Federal Reserve from reacting in this last step.
For this theory, it doesn’t matter whether the interest rate were stuck at zero, one, two, or ten. Nor is the “reason” for the interest rate’s being stuck relevant. The critical assumption is that nominal interest rates do not adjust in reaction to a shift in labor supply.
Tax Collectors’ Dream Come True
To recap, New Keynesians tell us that income and labor usage increase when something reduces labor supply at the individual level, as long as the nominal interest rate does not adjust upward.
This miracle is exactly what centuries of tax collectors have dreamed about. They could take a larger share of the economic pie and in doing so make the pie grow! All they have to do is make sure that the nominal interest rate cannot adjust upward.
That leaves us with the question. Is it a great misfortune of history that the New Keynesian miracle was not discovered until 2009?
Or have tax collectors over the years understood what New Keynesians do not: incentives matter, regardless of whether there’s a Federal Reserve, and regardless of the details of how nominal interest rates adjust?