Rational Behavior and the Crash of 2011

In a recent Wall Street Journal piece, supply side economics guru Arthur Laffer has a chilling prediction for the US economy.  According to Laffer, the scheduled expiration of the Bush tax cuts at the end of 2010 has companies and wealthy individuals accelerating production and income into 2010 to avoid higher taxes next year.  This generates an artificial boost to economic activity in 2010, but will be a sharp drag on the economy next year.  Laffer says the most likely outcome is the US falls back into recession, the so-called “double dip.”

Few others seem to be talking about this impending financial car wreck. And I have to wonder why.  The Bush tax cuts contained a “sunset” provision because otherwise they would not have passed.  Republicans always assumed no Congress would want to be responsible for a sharp tax hike, and extending the tax cuts would be simple.  But the current congressional leadership has shown little interest in taking up the issue. If Dr. Laffer is right, a last-minute action to prevent a tax increase would be useless:  companies and individuals would already have accelerated production and earnings, borrowing from growth they would have generated in the future so it’s taxed at 2010’s lower rates.  My question:  was this behavior predictable?

Traditionally, economic models assume people act rationally. In recent years this been the source of much debate among economists. Indeed, the very idea that most people act rationally seems preposterous.

Stories of people acting bizarrely are interesting, and pepper news reporting. It’s easy to get the impression that most of your fellow citizens are several ice cubes short of a tray. But I’m convinced the vast majority of the decisions we make are perfectly logical FOR US. This is especially true where our economic well-being is concerned. Studies of street level drug dealers have shown how rational their completely unregulated pricing structures are. Factors such as supply/demand, the likelihood of being arrested, the likelihood of being punished, etc. determine selling prices for drugs that make a lot of sense.

This leads to my thesis that applying a little common sense, one can often predict the result of  government policies. Merely ask yourself “what would I do if I were in this position?” It’s easy. Let’s play.  In 1990 the federal government passed a special luxury tax of 10% on items such as yachts, jewelry, and furs. What would you do if you were shopping for a yacht? You might suck it up and pay the tax. Or you might scale down your purchase to a cheaper yacht. Or you might delay or completely abandon your purchase. No doubt each camp would attract some people, but the inescapable conclusion is that overall yacht sales would be lower than without the extra tax. This is exactly what happened. Many employees at yacht builders lost their jobs. Instead of raising revenue, the drop in sales resulted in less tax dollars for the government. In 1993, the tax was repealed. But what about Laffer’s example?

If I knew my tax rate for 2011 were going up substantially, would I try to accelerate income into this year? As my friends in Nawlins say, “hell yeah!” To the degree they can (and Laffer claims there’s a lot of flexibility), companies and wealthy individuals would be crazy if they didn’t try to pull as much income as they can into 2010 from 2011. And what is the likely result? Laffer mentions two government subsidies from the past year: cars for clunkers and the $8000 mortgage tax credit. Both programs were very popular, and accelerated car and home sales respectively while they were in place. But after they ended, sales plunged. It’s obvious that people who might have bought cars in the next few months made sure to buy them when the lucrative subsidy was in place. And home buyers who might have closed later in the spring or summer jumped to take advantage of the tax credit expiring in April. Perfectly rational, and perfectly predictable.

So is Laffer right about the prospective double dip? There are many factors that determine economic growth. But there’s little doubt that next year’s impending tax hike will cause many companies to accelerate income into this year. As a result, 2011 growth will have a big chain around its neck. Unless Congress gets busy shortly on extending these tax cuts, I wouldn’t bet on any upside surprises next year.

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