The Tax Bill, Floodplains, and Time Inconstistencies

Depending on whom you ask, the tax bill recently passed by Congress will either be the driver of amazing prosperity or the worst bill the country has never seen. No matter the philosophical merits or faults of lower tax rates, history suggests that the correlation between tax cuts and economic growth is a bit muddied.

Nobel laureates Finn Kydland and Edward Prescott provide a valuable insight into why the recent tax bill will likely be neither as successful nor destructive as promised. Kydland and Prescott determined that government suffers from a “time consistency problem”. Government often makes a decision in the present that violates a declaration from the past. (Can you relate?)

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Edward Prescott (left) and Finn Kydland (right) during Nobel Prize interview.

To understand government’s time consistency problem, in regards to tax changes, consider Kydland and Prescott’s analysis of flood subsidies. It’s in the best interest of all citizens for the government to announce it will not subsidize losses due to floods in areas particularly susceptible to flooding. This urges individuals to purchase beach homes, only if they can personally fork up the cash to replace their water-damaged wood floors.

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Those wood floors are expensive… taken from Insurance Journal News

However, what happens when a flood actually hits? National news crews will soon descend on the area to provide helicopter views and Monday morning quarterback the actions of government officials. The internet will be filled with impassioned pleas from local citizens asking for monetary aid and rebuilding assistance. Quickly, the optimal action for government becomes to subsidize citizens’ losses. It’s not often you hear a politician on TV say, “Look, I made a policy decision and it’s important for my credibility that I stand by it!” That’s hardly the correct response when people are suffering. That politician would be the scourge of the nation.

Kydland and Prescott explain that because the government makes differentiated decisions as time progresses—changes its mind on the dime—we adjust our behavior to anticipate these decisions. We know that regardless of government policy today, our home in the flood-prone area will likely be subsidized should disaster strike. This encourages more people to live in the flood area than otherwise would. When the government fails to follow through on its previous declaration by ultimately subsidizing losses, it incentivizes more people to move to the floodplain, even if they can’t afford to replace the wood floors. This time inconsistency creates an endless loop of sub-optimality.

How does this relate to the tax cut? Well, people are smart. We understand that tax cuts today do not mean tax cuts in perpetuity. Turning on CNN will provide you with a barrage of outraged politicians and pundits declaring that it is their life’s mission to destroy this bill. We see demand for changes before we even get our first tax return!

Further, budgets will continue to be passed with deficits. The national debt continues to grow each day. Someone, sometime, will have to pick up the tab for this. We understand that while it may not be picked up by us today, it will likely be picked up by us (or our kids) in the future.

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(Photo: Michael Reynolds, epa. USA Today.)

Our anticipation of future changes alters our behavior to be more short-term focused as opposed to long-term. Sure, we may splurge on an iPhone upgrade. But we will likely think twice about making long-term financial decisions. Why take on the long-term financial responsibility of a new house or car if we think our take-home pay will be lower in the future, possibly as soon as 2020? Even more impactful, why take on the risk of starting a business?

Do Kydland and Prescott’s insights hold for those that don’t follow politics and economics? After all, reading about legislation and following the federal budget process can be dry enough to make an accountant bored (that’s an accountant joke). However, our past experiences of government policy changes affecting our lives guide us to act as if we understand the nuances of tax policy and government time consistency problems even if we don’t set out to do so.

Maybe the tax bill will provide the engine for prolonged economic growth Donald Trump and Republicans promise. Or, maybe Democrats will be correct and it will turn out to be the “worst bill ever”. But if these claims turn out to sound quite silly, it may be in part due to the enduring insights of Finn Kydland and Edward Prescott.

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