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Incentives matter


Question: Mr. President announces that, starting in 2011, there will be a sharp increase in tax rates. What do you think individuals and businesses will do in 2010? Using basic economics, Arthur Laffer in a Wall Street Journal article dated June 6 gives us a very plausible scenario: Individuals and businesses will do their best to transform the wealth and income to be taxed in 2011 into wealth and income to be taxed in 2010.

One of the things they can do, for instance, is to inflate their 2010 profits at the expense of their 2011 profits so as to benefit from lower taxes. He argues that this is precisely what is going on in the US right now as people anticipate the end in 2011 of temporary tax reductions that were passed under George W. Bush’s presidency. He recalls also many instances where such mechanism was at work in the past. For instance, when Reagan announced his tax cuts the same phenomenon was observed: businesses were postponing the declaration of their profits for 1981 and 1982 until the lowering of taxes was to take place in 1983.

If Arthur Laffer is right, as we believe, it means that the present recovery of the US economy is over-estimated and will be soon followed by a second wave of recessions.

It might be too late for the US to change their fiscal policy. But surely the lesson comes right on time for European policymakers. Indeed, we read from various sources—I should say from almost all sources, including The Economist or the OECD–that a tax raise is necessary to get out of the recession that resulted from the housing market crisis which itself contributed to unveil the desperate situation of our public finances after years of welfare state.

Note that those calls for higher taxes should not come as a surprise. They are the expression of a too-well known and dangerous form of pragmatism that does not attempt to go to the roots of the problem. Such pragmatism typically makes things worse.

Good economics, as Arthur Laffer reminds us, teaches that people react to incentives. The root of our present troubles is that people are given the wrong incentives and therefore do exactly the opposite of what our politicians would like them to do. Our politicians and their advisers wish that in 2011 we all work more. Thanks to higher tax rates, higher tax revenues will be available that are necessary to put our public finance back on its feet.

This will not work. If we wish to get things straight we need to create the incentives that will bring back people to wealth creation. For this, we must lower the tax rates, and this needs to be done not just as part of a temporary Keynesian stimulus that do not fool people but as part of a new and long lasting fiscal policy. And for those who fear that the effect of that new policy will not be immediate, let’s cut on public spending since it is clear, anyway, that this crisis is the crisis of the welfare state.

What we need is that our governments, at last, get their economics right.

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