Good policy analysis requires thinking about overall effects of feasible policy options

A recent conversation with a reporter involved some discussion of how individuals frequently analyze the effects of public policies from a perspective that is too narrow. Good policy analysis requires looking at ALL the effects of a feasible policy package.

Here is what I mean. All too frequently, individuals want to generalize from how a policy affects them personally to how it affects the overall economy. But policy effects don’t work that way.

For example, consider my previous post on the effects of business tax cuts. A businessperson might understandably analyze the effects of general business tax cuts by generalizing from how the tax cut affects his or her individual business.  The logic might be: “A business tax cut for my business would encourage me to expand. Therefore, a general business tax cut will encourage all businesses to expand.” This seems like a simple use of common sense.

However, such a generalization is frequently invalid. For example, if I own a restaurant, and only MY restaurant’s taxes are cut, this gives me a competitive advantage in pricing, and allows me to gain market share. But if ALL restaurants’ taxes are cut, then total restaurant employment will only go up if total demand for restaurants goes up. This may happen to some extent if the general business tax cut leads to lower restaurant prices, and those lower restaurant prices cause consumers to substitute purchases at local restaurants for some other goods and services. But the empirical data suggest that this consumer demand response will be modest.

Furthermore, the tax cut will be financed in some way. If it is financed by reduced employment or take-home pay of K-12 teachers, then this may reduce demand for local restaurants. This indirect effect of the business tax cut on local restaurants must also be considered in a good policy analysis.

The above example is of this “individualistic” perspective leading to exaggerated ideas about the effects of business tax cuts. But this same individualistic perspective can lead to exaggerated ideas about the effects of public spending increases.

For example, some analyses of K-12 education spending or early childhood spending argue that this spending will provide large stimulus for the economy.  The thinking again generalizes from what happens if we provide funding to expand an individual preschool to expand.  The thinking is: “This preschool will order supplies from local stores. The additional preschool teachers will go out and buy goods and services locally. All of this stimulates the economy.”

However, we must also consider that any expansion of education spending requires increased taxes that will to some extent reduce consumer demand. It turns out that realistic analyses suggest that the net effects of the taxes and spending on local consumer demand will be positive. But the net positive effect is considerably smaller than would be predicted by only looking at the spending side.

Either state tax cuts or spending increases would have considerably larger economic impacts if these policy changes were magically financed by an obligation-free contribution from someone from outside the state. If Bill Gates for some odd reason decided to pay for your state’s tax cuts or increased spending, such a policy change would always be 100% an economic stimulus.  But in the real world, policy impacts depend upon tax cuts or spending increases have productive effects on the economy that exceed the NEGATIVE effects of financing those tax cuts or spending increases. This is a higher hurdle for public policy to clear, and one that many proposed policies cannot clear.

Early childhood programs happen to be one of those policy areas in which public spending on high-quality programs is unusually productive. That is why early childhood programs can have large positive economic effects even once we allow for the negative economic effects of the increased taxes needed to finance early childhood programs.

About timbartik

Tim Bartik is a senior economist at the Upjohn Institute for Employment Research, a non-profit and non-partisan research organization in Kalamazoo, Michigan. His research specializes in state and local economic development policies and local labor markets.
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