Economic Incentives Often Fall Short

Editors’ Note: Adapted from The New York Times, October 26, 2019.

By Esther Duflo and 

[The authors were just awarded the Nobel Prize in economics.]

At least since Adam Smith and his famous B’s (“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest.”), a fundamental premise of economics has been that financial incentives are the primary driver of human behavior. Over the last few decades, this faith in the power of economic incentives led policymakers in the United States and elsewhere to focus, often with the best of intentions, on a narrow range of “incentive-compatible” policies.

Financial incentives are nowhere near as powerful as they are usually assumed to be.

This is unfortunate, because economists have somehow managed to hide in plain sight an enormously consequential finding from their research: Financial incentives are nowhere near as powerful as they are usually assumed to be.

We see it among the rich. No one seriously believes that salary caps lead top athletes to work less hard in the United States than they do in Europe, where there is no cap. Research shows that when top tax rates go up, tax evasion increases (and people try to move), but the rich don’t work less. The famous Reagan tax cuts did raise taxable income briefly, but only because people changed what they reported to tax authorities; once this was over, the effect disappeared.

We see it among the poor. Notwithstanding talk about “welfare queens,” 40 years of evidence shows that the poor do not stop working when welfare becomes more generous. In the famous negative income tax experiments of the 1970s, participants were guaranteed a minimum income that was taxed away as they earned more, effectively taxing extra earnings at rates ranging from 30 percent to 70 percent, and yet men’s labor hours went down by less than 10 percent. More recently, when members of the Cherokee tribe started getting dividends from the casino on their land, which made them 50 percent richer on average, there was no evidence that they worked less.

And it is true of everyone else as well — tax incentives do very little. For example, in famously “money-minded” Switzerland, when people got a two-year tax holiday because the tax code changed, there was absolutely no change in the labor supply. In the United States, economists have studied many temporary changes in the tax rate or in retirement incentives, and for the most part the impact of labor hours was minimal. Nor do people slack off if they are guaranteed an income: The Alaska Permanent Fund, which, since 1982, has handed out a yearly dividend of about $5,000 per household, has had no adverse impact on employment.

Does Free Money for All Add or Subtract Jobs?

In Alaska, which has been paying a dividend to residents since 1982 — an average of about $5,000 per household every year — evidence suggests that it has not decreased participation in the labor market.





Employment has tracked that of similar states since the dividend began. It did not lag, as might be expected (people would work less thanks to extra income). Instead, extra spending may have led to more commerce that kept people in the work force.

The part-time employment rate also rose, diverging from similar states. One possible reason: More spending, and commerce, drew people into the part-time work force.

On the flip side, when jobs vanish and the local economy collapses, we cannot count on people’s desire to seek out a better life to smooth things out. The United States population is surprisingly immobile now. Seven percent of the population used to move to another county every year in the 1950s. Fewer than 4 percent did so in 2018. The decline started in 1990 and accelerated in the mid-2000s, precisely at the time when the industries in some regions were hit by competition from Chinese imports. When jobs disappeared in the counties that were producing toys, clothing or furniture, few people looked for jobs elsewhere. Nor did they demand help to move or to retrain — they stayed put and hoped things would improve. As a result, one million jobs were lost and wages and purchasing power fell in those communities, setting off a downward spiral of blight and hopelessness. Marriage rates and fertility fell, and more children were born into poverty.

Despite this, the faith in incentives is widely shared. We encountered this mismatch firsthand, when, in the fall of 2018, we (along with the economist Stefanie Stantcheva) conducted a survey of 10,000 Americans. We asked half of them what they thought someone should do if he or she were unemployed and a job was available 200 miles away. Sixty-two percent said the person should move. Fifty percent also said that they expected at least some people to stop working if taxes went up, and 60 percent thought that Medicaid beneficiaries are discouraged from working by the lack of a work requirement. Forty-nine percent answered yes when asked whether “many people” would stop working if there were a universal basic income of $13,000 a year with no strings attached.

But here is the twist: When we asked the other half of our sample the very same questions in reference to themselves, we got very different responses. Only 52 percent said they would move for a job, and this fell to 32 percent of those who were actually unemployed. Seventy-two percent of them declared that an increase in taxes would “not at all” lead them to stop working. Thirteen percent of respondents said they would probably work less if they received Medicaid without a work requirement; 12 percent said they would stop working if there were a universal basic income. In other words, “Everyone else responds to incentives, but I don’t.”

People Think Financial Incentives Work. But for Themselves? Not So Interested.

A survey asked one group how the population at large would react to several financial inducements. Another group was asked about their own reaction; these people were much less inclined to do any of the following, despite the same financial incentives.

If it is not financial incentives, what else might people care about? The answer is something we know in our guts: status, dignity, social connections.

If it is not financial incentives, what else might people care about? The answer is something we know in our guts: status, dignity, social connections. Chief executives and top athletes are driven by the desire to win and be the best. The poor will walk away from social benefits if they come with being treated like a criminal. And among the middle class, the fear of losing their sense of who they are and their status in the local community can be an extraordinarily paralyzing force.

The trouble is that so much of America’s social policy has been shaped by three principles that ignore these facts; to fix it we need to start from there.

First, most policymakers are convinced that not much needs to be done. In the fantasy world where most economic policy conversations about trade shocks and technological innovations take place, people quickly adjust to those changes — workers move smoothly from making clothes in North Carolina to folding clothes in New York or selling clothes online. But in the real world, it is unreasonable to expect markets to always deliver outcomes that are just, acceptable — or even efficient. Disruptions (because of trade, robots or anything else) provoke real suffering. A study in Pennsylvania found that when workers with long tenure got fired during mass layoffs, they were substantially more likely to die in the years immediately afterward.

Second, let’s drop the talk about “dependency” and “welfare cultures,” powerfully articulated by Ronald Reagan, and never really contested since then. (After all, it was under Bill Clinton that “welfare as we know it” was ended.) Government intervention is necessary to help people move when it makes sense, but also, sometimes, to stay in place without losing their livelihoods and their dignity. The success of the populist agenda came from casting the working class as the victims of a war waged against them and offering them the ersatz protection of various “walls.” To counter that, policymakers must acknowledge that those who struggle economically are, in a sense, society’s fallen heroes, and that we need to treat them as such.

A first idea here might be a G.I. Bill for the “veterans” of disruptions. Since 1974, the Trade Adjustment Assistance program has offered workers displaced by international trade extended unemployment benefits and up to $10,000 in education credit to help them retrain. The few people who had access to it were indeed more likely to end up in better jobs — in the 10 years after losing their jobs, workers who benefited from T.A.A. earned $50,000 more than those who did not. But as a federal program it remains minuscule — regions most affected by trade got a paltry extra 23 cents per head in T.A.A. money every year, compared with $549 in lost income.

T.A.A. could be made much more generous, both in its coverage and in the benefits it offers. Like the G.I. Bill, it could offer full tuition at public universities, up to a cap of several thousand dollars a month, and a housing stipend; in addition, there would be generous unemployment benefits, especially in the most severely affected counties. Perhaps more controversially, a second idea would be the equivalent of a Marshall Plan for the affected regions, with significant subsidies for firms to keep older workers employed.

Third, we should not be unduly scared of raising taxes to pay for these projects. There is no evidence that it would disrupt the economy. This is, of course, a touchy subject politically: The idea of raising taxes on anyone but the very rich is not popular. So we should start with raising the rates on top income and adding a wealth tax, as many have proposed. The key then would be to link the added revenue to efforts like the ones we describe above, which would serve to slowly restore the legitimacy of the government’s efforts to help those in need. This will take time, but we have to start somewhere — and soon.

Categories: Issues, Local, National

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