1.3 Key Principle of Economics: People Respond to Incentives
Another major principle of economics is that people respond to incentives. Incentives Inducements to act in certain ways. are inducements to act in certain ways. Depending on their structure, incentives can either encourage or discourage particular behaviors. Suppose you’re walking down the sidewalk, and you see a penny. Do you stop and pick it up? If not, would you stop for a nickel? A dime? A dollar? Incentives, as in this case, often appear in the form of benefits. Benefits, in turn, encourage rewarded behaviors. Incentives imply that if you want people walking down the sidewalk to stop and bend over, you can get them to do it by leaving a coin on the sidewalk. If you want a greater proportion of the people to bend over, leave a bill instead.
Incentives can also appear in the form of costs. Suppose, gentlemen, that you’re one of the cheapskates willing to pick up a penny from the sidewalk. Now, suppose that you’re not on the sidewalk when you spot the gleam of copper, but are at the altar exchanging your wedding vows. Do you pick up the penny now? Because no matter what everyone tells you, this day belongs to your bride, and she’s just being nice by letting you share it. And if you interrupt her day in the middle of the “Do you takes” to pick up a penny (or a dime, or a quarter), you will never be allowed to forget it. The simple lesson is that one way to discourage particular behaviors is to increase the costs associated with them.
Perverse Incentives
Perverse incentives exist when programs designed to discourage particular behaviors end up encouraging them instead. What flaw in the “less swearing” plan creates perverse incentives? How can that flaw be corrected?
It’s important for policymakers to understand incentives. Governments can use the power of incentives to encourage behaviors that society wants more of, and to discourage behaviors that society wants less of. The U.S. government, for example, uses both benefits and costs to encourage you to drive a more fuel-efficient automobile: You qualify for a tax credit if you purchase a plug-in hybrid car, but you may pay a surtax if you choose a gas guzzler instead. The government also encourages altruism by allowing you to deduct charitable donations from your taxable income; it encourages communities to build large-scale tornado shelters by helping to pay for their construction; it nudges individuals to lead healthier lifestyles by taxing cigarette purchases. Not all incentives need to be measured in dollars: The government enacts laws to discourage crime; the incentives those laws create are often measured in time (twenty years to life, for example) rather than money.
All incentives, whether they appear as costs or benefits, work by changing the trade-offs individuals face. That makes some options appear more attractive and others less so. If the trade-offs change enough, people may be convinced to act in ways that they ordinarily wouldn’t.
Application 1.3: Dying to Save Taxes
Social scientists have long known that people have some ability to control the timing of their deaths. They often remain alive long enough to observe religious holidays, see offspring born, or reach landmark birthdays. So, if people can control the timing of their deaths for social and religious reasons, can they do so if it’s to their financial advantage? In other words, does death respond to incentives?
Economists Joshua Gans and Andrew Leigh addressed that question by examining changes in Australian estate tax law. The estate tax gives the government a financial claim on the accumulated wealth you leave your heirs. In 1979, Australia reduced its federal estate tax from 27.5% to 0%. The tax was broadly based: About one in ten people were subject to it. So, for significant numbers of Australians, the ability to delay death until the tax expired could add thousands or even millions of dollars to their survivors’ inheritances.
Were people able to delay their deaths to take advantage of lower tax rates? After looking at the number of deaths reported in Australia each day, Gans and Leigh say yes. In the week before the estate tax expired, death totals were unexpectedly low: About 50 fewer people died than the long-run trend would have predicted. In the week after the tax was abolished, 50 extra people died. This suggests that those 50 people were able to delay their deaths by a week, solely to take advantage of favorable changes in tax law. Given the overall number of deaths in Australia, Gans and Leigh conclude that about half of the people who were eligible for the estate tax managed to delay death to avoid taxation!
How did they do that? Some people asked for extra medication, and some delayed removing life-sustaining medical devices. Some may have even asked their doctors to illegally postdate their death certificates. But at least some of the response can be attributed to sheer stubbornness: People simply willed themselves to live a bit longer, until the time and the tax were right.
The results of the Gans and Leigh study have been confirmed using data from Sweden. In addition, using historical data from the United States, economists Joel Slemrod and Wojciech Kopczuk have shown that the opposite holds true as well: Estate tax increases may induce people to accelerate their deaths. This leaves us with little doubt about the deadly effects of January 1, 2011, when the U.S. estate tax rose dramatically from 0% to 35%.
You can’t take it with you . . . but you can leave less to the government.
© Shutterstock
See related problem 4 at the end of this section.