WHY TARGETED TAX CUTS WON’T WORK

INITIAL ASSUMPTIONS

Assume that we have a market for, say, college education, which is in equilibrium. It is in equilibrium because the colleges (private, not-for-profit, state-funded, etc.) have found the revenue-maximizing price to be $1000, and everyone who can afford that price is already going to college.

Every consumer of college education decides for himself what the value of that service is to him. Some are willing or able to pay more than others, as shown in Table 1. It really makes no difference whether they determine that price from value or budget, since the effect is the same. The demand curve for consumers might look as it does in Figure 1.

Consumer 1 is willing to pay up to $4000 for college, while consumer 10 is willing to pay up to $450. This could be because Consumer 1 is able to afford that, or that he is willing to do what is necessary to obtain that amount of education. Perhaps Consumer 1 is willing to sacrifice time with his friends in order to get grades good enough to win academic scholarships, or perhaps Consumer 1 is willing to take the risk of borrowing that much money.

Since the price of college is $1000, Consumers 1 through 5 are willing and able to go, while 6-10 are not. Perhaps this is not fair, or perhaps their values are arranged such that college is simply not the highest priority. This is understandable since many people might have other, more pressing needs, such as the need to work multiple jobs to feed their children. They may simply not have the confidence to go to college, or they may already be working in a high paying job and have no desire to quit. In any event, this is the situation that exists before a targeted tax "cut", or what should properly be called a college subsidy.

THE PROGRAM

Now we introduce the "cut" in its form as a deduction. Assume that these college students are paying income taxes with a 25% marginal tax rate. They will still be willing to spend as much out of their own pockets as they did before, but now we have to account for the increase in funds that don’t come (directly) from their own pockets. In other words, if you were willing to spend $1000 before, and now the government is going to give you $250, you should be willing to spend $1250 total for college, since the total effect on your own pocketbook is unchanged.

How much college can they afford now?

Solving for NP, we get

For a marginal tax rate of 25% and an original price of $1000, the rational or value-maximizing consumer will now be willing to spend $1333 for college. A consumer who was originally willing to spend $825 will now be willing to spend $1100. It appears for the moment that this plan has worked: it enabled a consumer who didn’t have sufficient resources to now be able to afford college tuition.

Table 2 shows the new demand schedule for all consumers, and Figure 2 shows the shift in the demand curve. There are two equivalent ways of describing this, each equally valid. Since the curve is now shifted to the right of the original, it appears to show that for any given price, there are more consumers willing to purchase the product, which was the desired effect. But because the new curve also appears to be shifted up, it may be interpreted that consumers are willing to pay more for any quantity purchased.

The simple, first approximation that we have so far considered assumes that the colleges passively accept this new situation. However, the second interpretation of the demand curve shift will not be lost on a diligent and responsible administration or board of regents. It is axiomatic that all organizations would like to have more resources than they do right now, because they can all identify areas that they would like to improve. These might include such noble causes as better teacher pay, more support staff, more scholarships, better dormitories, better lab facilities, and so on, or they might be under pressure from the alumni to build a bigger football stadium. It is always easy to justify more spending, especially if you are handed the revenues on a silver platter.

To look at this another way, let us go back to the original situation. In that case, Consumer 1 was willing to pay $4000 for a college education that only cost $1000, reaping a surplus value of $3000. The difference between the two prices is what Marshall called "consumer surplus". This oft-overlooked detail is precisely analogous, even symmetric, to producer profit.

Trade consists not of two people trying to get the best of the other, but rather of two people cooperating for mutual advantage. The lesson is more obvious in barter exchanges, and the introduction of cash doesn’t change the logic of the situation, but rather only the appearance. If I were, say, a hungry electro-optical engineer trying to trade my services for food from farmers, I suspect that I would starve to death. There simply would not be enough farmers simultaneously looking for a camera operator. However, since I can trade my services to an employer for cash, and then I can trade that cash for food, I can support my eating habits with my abilities. In each exchange, both parties to the trade profit. The difference is that in the first trade, I pocket cash, while my employer keeps the benefit of services rendered, and in the second, I eat the food while the supermarket pockets the cash profit. I see the cash benefit in the one case, but don’t count the non-cash benefit in the second case. We tend to observe and note the profit of the person or company that trades goods for cash, while discounting and/or ignoring our own "profit", or consumer surplus.

Returning to the original situation, we see that Consumer 1 is reaping a consumer profit of $3000, Consumer 2, $1100, and so on. The tax plan appears to increase the profit, producing "surplus profit". The colleges know this, and will attempt to "capture" as much of that surplus profit for themselves by charging more for education. How much more should they charge?

Again, assuming that the original situation was in equilibrium, and that $1000 was the profit maximizing (or loss minimizing) price for the University, what they need to do is capture as much as possible. They already have good data on their consumers’: colleges typically have extensive access to tax records from financial aid applications, and they have the ability to test consumer demand by running miniature controlled experiments with scholarships, grants, etc. Therefore, they will already know that the average consumer has a marginal tax rate of 25%, and the rest is simple: the new price should be $1333.

RESULTS

Note what happens because of this. First, the amount of education demanded at that rate will be five students, exactly what it was before. Although the first approximation analysis showed that Consumer 6 would be able to go to school with the credit, the second approximation analysis now shows that he will not be able to. Second, note that the price has now increased such that without the tax credit, Consumers 4 & 5, who could afford education without subsidy in the beginning, must now rely on it to afford school. Third, note that Consumer 7 was only $300 shy of being able to afford college, but now, counting the credit, he is $400 shy of it. If you don’t count the credit (remembering that you don’t actually get the extra funds until you actually shell out $1333 of your own money and then file for the credit on next year’s taxes), then he is $633 short of being able to go to college. It would not be surprising if he thinks that the cost of college is rising, and that the government needs to do something, like expand the tax credit.

It’s actually much worse than that. Remembering that early on, I assumed that everyone faced the same marginal tax rate - what if we now relax that assumption? Let us assume that Consumer 1 actually makes a substantial piece of change, and that he actually faces a 40% marginal tax rate. How much is the credit worth to him?

For a new price of $1333, and a marginal tax rate of 40%, Consumer 1 will get a $533 reduction in taxes. If he actually finds a school that charges the full $4000 that he is willing to spend before the tax credit, he will actually get a credit worth $1600. If he finds a profit-maximizing school that realizes what the credit is worth to him, he will get a credit worth $2667 on a tuition of $6667. What if we assume that consumer 4 is in the 15% tax bracket? He will get a $200 credit, giving him just a little more than enough to attend school (he was originally willing to spend $1200, and the college has increased the price to $1333). The credit is worth $0 to consumers 7-10, no matter what tax bracket they are in. This looks suspiciously like welfare for the wealthiest 1%, does it not?

IS IT JUST THE PROGRAM? OR IS IT GREED?

Why is it just the tax credit that is to blame for this situation? Can’t colleges raise prices any time they want? To be sure, a college can raise or lower their prices at will. But consider what would happen if they did so without the advantage of the tax credit.

Table 3 shows the total revenue for each price. If the price is set at $4000, only Consumer 1 is willing to pay it, so only one consumer attends. Total revenue is equal to total units sold times price, so at $4000/student, the total revenue is $4000. If the price drops to $2100, both Consumers 1 and 2 are willing to attend, so the total revenue is $4200 (two students times $2100). As you can see, I have constructed this example to match my assumption that the colleges would maximize revenue at $1000. (Rigorously, they would seek to maximize profit or minimize loss, but then we would have to examine their cost structures in much more detail)

Table 4 shows the demand schedules (price), the consumer surplus, the total revenue for the college, the additional consumer surplus, and the revenue gain before and after (old and new) the tax policy is passed. The politicians’ assertion of the program results would lead one to believe that consumer surplus would be calculated against the old tuition, as in the sixth column. When the colleges figure the system out and capture it themselves, consumer surplus will actually be that of the fifth column. Note that the difference is the revenue gain captured by the colleges, and that the fifth entry of last column is exactly equal to this. That fifth entry is the revenue total under the new scheme for five students (column four, fifth entry) minus the revenue total under the old equilibrium condition for five students (column two, row five). In this strawman example, the colleges captured all of the realized gains by raising tuition. Consumers 1-4 still have unrealized gains (column 8) that they could convert if they simply paid more tuition.
 

Although this is simply an artifact of my setup, this is close enough to a real world situation to make the point. Furthermore, the logic of the situation is even easier to understand. If a college drops its price from the stable equilibrium price of $1000, more students will attend, but then the college has to hire more teachers, build more facilities, hire more support staff, and so on. If they were breaking even at $1000, then they will be losing at less than that because, although there are more students, they are collecting less money per student, while spending more on all students. Therefore, the rational college (one that acts in its own self-interest) will not lower prices unless it can first lower its costs through increases in productivity.

On the other hand, if a college raises its prices unilaterally (without the tax credit), then two things happen. First, some students will not be able to afford college at the new tuition, and the revenues will go down. But then something else will happen: the remaining students will realize that they can go to another school and reduce their tuition payment to its original level. It is therefore clear that the college cannot raise prices at will because consumers and competitors, acting in their own self-interest, will not allow them to do so.

Consider also what happens if the college fails to react to the tax incentive as I’ve described. If one college decides not to raise prices in line with the rest, they soon find that they cannot pay their teachers as well, provide the same level of facilities and support staff, or be as generous with their scholarships, in comparison with their former peers. By accepting less than the going rate, they are ensuring themselves of delivering a lower quality product compared to those other colleges. And the fact that the lower rates will, at first, attract more students to an institution already running at capacity will make the problem worse, as the student-teacher ratio soars, and the per student facilities decline. Fortunately for this rogue college, enrollment will drop as their comparative quality declines. By acting selflessly, they wind up producing less or lower quality education than if they act in their self interest.

SELF INTEREST

It is interesting to note that the economist’s assumption of rationality – of actions taken in self-interest, with specific goals and purposeful methods – is both a bug and a feature of the market. Before the tax credit is introduced, the self interest of the college, consumers, and competitors all work to produce a system that resists higher prices, but rewards productivity increases that lead to lower prices. Adam Smith said of this feature, "By pursuing his own interest [the individual] frequently promotes that of the society more effectually than when he really intends to promote it."

When the tax credit is introduced, self-interest becomes a bug. There is no good reason to suppose that the students that benefit from the subsidy have a higher moral claim to the benefits than any other member of society – including college professors and administrators, with the exception of the taxpayer whose money this is. But if we conditionally agree that college education is a good thing to have, then we must agree that the rationally self interested response of the colleges has negative results. Their automatic response to the tax incentive is to make college less affordable, especially to those who can least afford it from the outset. It is rather ironic that these programs begin with selfless motives and collective means, illustrating the remainder of Smith’s wry observation: "I have never known much good done by those who affected to trade for the public good."

A general tax cut will not have the same effect. A general tax cut will result in an increase in each consumer’s total budget, which does indeed mean that each consumer will have more available for tuition, which the colleges would like to capture. However, the consumer will also have more available for spending on food, clothing, shelter, transportation, and entertainment, so the college cannot be sure how much they can raise tuition based on the tax cut. Therefore, they will do so much more cautiously, if at all.

There is a temptation to look at the results of this type of analysis and to blame college administrators. "They are too selfish," people will whine. "They aren’t being selfless. They need to sacrifice their desires to the common good, the public interest." The lesson to be learned is that none of those sentiments are true. In fact, upon further reflection and close inspection, it should become clear that selflessness, the public good, and the public interest are precisely to blame for the increase in tuition, the decrease in educational opportunities and affordability, and the enhanced potential rewards for the wealthy.

SELF SACRIFICE

I begin by asking, "How did such a program come into being?" It was created to promote the public interest, the public good, and self-sacrifice. The reasoning used to justify the program before its adoption seems so circular, since the proponents will, on one hand, declare that wealthy people have "too much", they need to "give back", they have "benefited on the backs of the working class", while on the other hand declaring that people need college education so they can prosper. Well, which is it? Is wealth evil, or desirable? Perhaps evil is desirable, in this philosophy. Perhaps the basis of these Good Samaritan sentiments is nihilism.

A politician declares that people must have the opportunities to pull themselves up from their poverty. Unfortunately, he has discovered a growing divide between the rich and the poor: the education gap. Obviously, he declares, there is a simple answer (this politician has never heard of H. L. Mencken). If you are against this program, you are selfish, mean, and hard-hearted. You are a Social Darwinist. You are working against the class interests of the poor, which are the public interest, and therefore, the public good.

If something is against your own interest, you are encouraged to subordinate your own interests to the nation (Fascism, or National Socialism) or to the class or proletariat (socialism or communism). In any case, you must selflessly yield to the vaguely defined "public good". It is tempting to think of the "public interest" as some combination of individual self interests, perhaps a common denominator, but that is not what is meant.

As Hayek reasons in The Road to Serfdom, we are not accustomed to thinking in terms of universal value systems. Certainly, each of us has his or her own value system in which we have arranged our wants, perhaps according to Maslow’s hierarchy (I find "wants" to be much more meaningful than "needs"). But I have no way of comparing my wants to yours, or ours to those of the rest of society. How do I know whether my desire for a Nintendo supersedes your desire for a new home computer? How do I know whether our desire for new tires supersedes the desire of someone in Alaska for new snowmobile tracks? It is literally impossible to arrange all of society’s wants into a single hierarchical arrangement and to label that, "the public good".

But to be selfless means precisely that: to subordinate your self interest to the societal hierarchy, which can never be determined. Recognizing this, various societies have substituted the decisions of a Maximum Leader, or the Will of the Majority for this "public interest", but neither of those has proven very successful. A single man, or a despotic legislature, charged with first determining the "public good", or "planning", and then with enforcing that plan, is very likely to act tyrannically. As Hayek explained, people with no morality of their own have the least compunction in imposing their plan on others, and therefore they tend to rise to positions of leadership in a society that preaches self-subordination. And when such men seek to quell the rebellious masses with bread and circuses – and tuition, health care, day care, prescription drug benefits, farm programs, and renewable energy incentive programs – we should be fully aware that the resulting problems were brought about not by selfishness, but by selflessness.

CONCLUSIONS

And the masses will be rebellious because of the results of those programs. As I argued above, targeted tax incentive programs are aimed at helping the poor to get educated in order to make up the income gap. But the analysis, and our experience with the Hope scholarship program, Social Security Medicare, Medicaid, etc., shows that it is typically those who least need the help that get it, while those who most need the help are injured. It should be no wonder that there is a growing divide between the rich and poor: the poor keep supporting politicians whose programs are intended to help them.

As Thomas Sowell points out, "What is politically defined as economic ‘planning’ is the forcible superseding of other people's plans by government officials." An analysis similar to the one above, mutatis mutandis, could be performed for any of the other thousands of plans imposed by the government in place of the plans of individuals. The peculiar ability of the government to extract revenues on threat of forced incarceration (normally called robbery or extortion), and then to hand that booty out on the basis of majority rule, allows it to create situations which transform self interest from an "undocumented feature" into a system "bug". While it is tempting to blame the traders who act almost automatically to the signals of the market, we should note that (1) it was not a problem prior to the intervention, and (2) no amount of encouragement to "act selflessly" will solve the problem. The players will – they must – continue acting in their own self interest because they literally have no way of knowing how to compare the values of other people. When the government takes money away with one hand, and then feeds it back with the other in reward for very specific behavior, it changes the rules of the game, forcing the actors to respond.

We shouldn’t be surprised when the actors’ response has unintended consequences. And we damn sure shouldn’t blame them. The blame lies a little closer to home, since we’re the ones who elect the politicians that pass the programs that change the situation.