Arthur Laffer in the Wall Street Journal

Arthur Laffer, of Laffer Curve fame, gives some recommendations on how to improve the economy in today’s Wall Street Journal.  First, Laffer provides some reasoning for why the economy isn’t working to its fullest potential:

Employment is low because the incentives for workers to work are too small, and the incentives not to work too high. Workers’ net wages are down, so the supply of labor is limited. Meanwhile, demand for labor is also down since employers consider the costs of employing new workers—wages, health care and more—to be greater today than the benefits.Firms choose whether to hire based on the total cost of employing workers, including all federal, state and local income taxes; all payroll, sales and property taxes; regulatory costs; record-keeping costs; the costs of maintaining health and safety standards; and the costs of insurance for health care, class action lawsuits, and workers compensation. In addition, gross wages are often inflated by the power of unions and legislative restrictions such as “buy American” provisions and the minimum wage. Gross wages also include all future benefits to workers in the form of retirement plans.

For a worker to be attractive, that worker must be productive enough to cover all those costs plus leave room for some profit and the costs of running an enterprise. Being in business isn’t easy, and today not enough workers qualify to be hired.

But workers don’t focus on how much it costs a firm to employ them. Workers care about how much they receive and can spend after taxes. For them, the question is how the wages they’d receive for working compare to what they’d receive (from the government) if they didn’t work, plus the value of their leisure from not working.

The problem is that the government has driven a massive wedge between the wages paid by firms and the wages received by workers. To make work and employment attractive again, this government wedge has to shrink.

He then goes on to make several recommendations to shrink the government wedge.  I particularly like this one:

The cancellation of all spending that punishes those who produce and rewards those who don’t. This is really the distinction between demand-side economics and supply-side economics. Stimulus spending and quantitative easing don’t make it more rewarding to work an extra hour. If the government pays people not to work and taxes people who do work, is it really so difficult to see why employment is so low?

Incentives matter.  Fact.

I’ve seen firsthand the incentives Laffer writes about in play in two separate conversations over the past month with out-of-work colleagues.  These are smart, productive people who have been continuously employed for most of their careers and currently find themselves without work. I heard them say things like:

I have offers on the table, but I’m not interested in working until after the beginning of the year, otherwise I’ll be paying too much in taxes.

And:

I’m in no hurry to find work.  With unemployment and severance I’m making more than I was when I was doing something.  I’m taking a little break.

Of course.  I think most of us would feel the same way.  We make the same trade-offs each day without realizing it.

I’m reminded of a conversation I had long ago with a fellow who couldn’t fathom that incentives matter.  We were discussing tax cuts for the rich.   He thought tax rates for high income earners should be much higher. Since he wasn’t wealthy, he couldn’t personalize how raising rates on marginal income could change behavior. I also believe he didn’t understand the concept of opportunity cost very well.

He’d say things, “it won’t matter if they bring home 60% or 40% after tax, their goal is to maximize their wealth.”

I’d ask him if he works for pay during every waking hour of every day.

No.

Why not?

My job only pays me for 8 hours a day.

Why don’t you find a second job?  You can deliver pizzas.

I wouldn’t make enough doing that to make it worth my while to give up my leisure time.

Hmmm…..

I still don’t think he could transfer that personal trade-off he just made to that vision he had of the fat cat, wealthy person.

3 thoughts on “Arthur Laffer in the Wall Street Journal

  1. i like your example about opportunity cost, but you imply that the wealthy person became wealthy by delivering pizza (working harder) and i just dont think that to be the case. i think we like to imagine that the universe has some merit based system of reward, but it seems to be much more akin to pure randomness.
    for example: i create a piece of art. what determines how i am rewarded? van gogh would be a fat cat if he were alive today, no? or no, he would still be an underappreciated hack destined to kill himself.
    what if i have an invention, but lack the capital to produce/market/distribute my product?
    i also found that idea for shrinking the wedge to be patently clear (i hope mr. laffer gets rewarded for it)

    • I agree that randomness is a major, under appreciated factor to success.

      The point was meant to show that even the incentives that we don’t think should be enough to change someone else’s behavior, would change our own behavior. So why begrudge a rich person for reducing his output when the reward is reduced when we do exactly the same thing?

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