Simplicity vs Efficiency

on Oct 09 in Economics, Employment tagged by Trevor Hicks

I write a lot about how much I prefer government policies to have the virtues of simplicity and efficiency.  But often times, these virtues are at odds with each other. Indeed, much of the complexity that creeps in to policy is an attempt to wrangle the maximum possible efficiency out of whatever regulation or subsidy is on offer. Of course it is also often an attempt to hand out political favors, but I’m going to stick with an “ideal” version of Congress for this post that is genuinely trying only to benefit public wellbeing.

The source of the complexity is a distrust that the individuals involved will make optimal decisions. Bill Clinton once famously articulated his preference for government spending programs over tax breaks when the budget was in surplus in 1999 because “you wouldn’t spend it right.” Recipients of food stamps have to endure all sorts of byzantine rules about what can and cannot be purchased to make sure they buy the “right” foods. And now we have a proposal before Congress to do another round of economic stimulus, but this time via a payroll tax refund for creating new jobs.

Now we are talking about a stimulus plan I can get behind. There are huge problems in our existing stimulus plan that it avoids. The benefits are immediate, not dribbled out over several years. A blanket credit does not try to target winners or losers, if you reduce taxation on employment, employment should increase.

Unfortunately, the pursuit of maximum efficiency is introducing quite a bit of complexity which is, ironically, an enemy of efficiency. That is, I believe the attempt to get the tax credit just exactly perfectly right is counterproductive. The plan goes to great lengths to try to target the tax breaks for newly created jobs. Not only will this system be ripe for gaming, as quite convincingly illustrated by Greg Mankiw, but it seems superfluous. Obama talks a lot about jobs his program creates or saves. A payroll tax credit will be more effective if it simply applies to all legal workers, it won’t be targeted towards “new” jobs, but isn’t saving existing ones also a worthy policy goal? The efficiency loss with a blanket credit is that companies will also get tax breaks for all of the millions upon millions of jobs that weren’t in jeopardy. That is, a perfectly efficient policy would target the margin, credit would only be given for the jobs that are created or saved as a direct result of the policy in question.

But there is another rationalization for the blanket credit. Even with a big efficiency leak by crediting all the jobs that were not in jeopardy, the money is not gone to waste. Indeed, if the tax credit is temporary you would not expect it to impact worker’s wages. Employers would not pass the benefits through if they know that they will be on the hook to pay those higher rates without the tax credit next year. Stay with me a minute because this is a feature, not a bug. With a temporary tax break, the money drops down to corporate profits. In an age of tight credit, investment, expansion and growth have to be funded from profits. It should be noted here that I’m a weirdo that would prefer to abolish all corporate taxes - in a revenue neutral fashion by raising progressive income tax rates of course*. So the tax break would have a large stimulative effect beyond its direct subsidy of increased employment. And it’s just exactly the right kind of stimulus that addresses the biggest problem in the economy which is business’s inability to fund growth plans through debt.

So getting back to the larger point, what do you do when efficiency and simplicity are opposed? I think though efficiency is the more important goal, simplicity is usually the optimal choice. The pursuit of efficiency is often counterproductive when the additional complexity creates systems that are easily co-opted by rent-seeking corporate interests. Choosing simplicity often means that some ideal level of efficiency cannot be achieved, but I think will usually result, paradoxically, in a more efficient outcome than a policy that makes a futile aim for perfect efficiency.

*Regarding corporate taxation, if it could always and everywhere be simply a confiscation of profits it would achieve some of the progressive goals on which it is based. However, the reality is that corporations allocate their tax burden by some combination of reducing profits, reducing wages and raising prices. This allocation depends on the particular competitive situation in which it exists and is neither uniform nor easily predictable. So the reality of corporate taxation is that its burden is shared by shareholders, employees and customers in a completely unpredictable fashion. And even if it could be perfectly tuned to fall only on shareholders, note that more than half our population owns stocks and bonds if not directly, through mutual funds with no way to control the progressivity of its impact. So corporate taxation, in impact, is worse than regressive, it’s random. Better to simply do away with it and collect the money through higher normal income taxes which do a decent job of spreading the impact in a progressive fashion.