Occam Razor in reverse

Posted: Feb 07, 2001 12:00 AM
One of the reasons why it is so hard to implement sensible economic policies in Washington is that Occam's Razor operates in reverse inside the Beltway. Occam's Razor says that when confronted with two potential solutions to a problem, one simple and the other complicated, the simpler one is usually the correct one. Unfortunately, inside the Beltway complicated solutions almost always win out over simple ones, even when it is obvious that the simpler one is better. There are many reasons for this. A lot of it simply has to do with making work for smart people. They have an incentive to make things that are simple seem complicated in order to create work for themselves coming up with equally complicated solutions. The truth, however, is that there are almost always simple solutions even to the most intractable problems. But just because the answer is simple doesn't make it simple to implement. As Ronald Reagan always used to say, there are simple solutions, just not easy ones. Nowhere is this truer than in tax policy. This brings to mind another concept known as Gresham's Law. Gresham stated that bad money drives out good. He was referring to debased coins that soon replaced those of full value in commerce, since both were required to be accepted at face value under the legal tender laws. So people naturally got rid of their bad coins as quickly as possible and hoarded the good ones. So, too, in tax policy -- bad tax ideas tend to drive out good ones. The history of tax policy illustrates this fact over and over again. What happens is that tax rates are raised to soak the rich. Little revenue is raised, however, because there are not many rich people and they are clever about finding ways to avoid taxation. So, to raise meaningful revenue, taxes eventually are raised on the middle class, which is induced to accept higher tax rates because of the much higher rates on the rich. Once tax rates are increased, it becomes almost impossible politically to cut them. Cutting rates only for the rich is unfair and a give-away to those who don't need it, it is always said, while cutting tax rates for the middle class costs too much in terms of revenue. This leads to complicated, halfway measures to lower the tax burden through tax credits, exemptions, exclusions and deductions. The result is that eventually we end up with a crazy-quilt tax system, such as we have now, in which no one actually pays tax rates anywhere close to what their income would nominally require. But to get their tax burden down to a tolerable level requires a huge investment of time and a willingness to continually rearrange one's affairs according to the dictates of the tax code. Thus we find people buying houses when they would really rather rent, because the deduction for mortgage interest and property taxes and freedom from capital gains taxes on sales makes owning too attractive, taxwise. For businesses, it is often the reverse, with leasing being better than buying equipment just because the tax code makes it so. Multiply these kinds of things throughout the economy and you have massive inefficiency and waste, malinvestment and unfairness, with tax burdens varying wildly among people and businesses with roughly the same income. Of course, the simple solution would be to sweep away the whole mess and start from scratch, with a low single tax rate on everyone and no deductions, credits, exclusions or exemptions. But that is too simple and therefore impossible to implement. Another simple solution to the problem of high tax rates would be to just cut them across the board, as George W. Bush has proposed. But such a solution is too simple even for his friends, some of whom have taken it upon themselves to come up with vastly more complicated and less satisfactory ways of doing the same thing. According to David Broder, two former Republican congressional staffers, Steve Hofman and Ed Kutler, are pushing a tax rebate proposal in lieu of Bush's tax rate reduction. Instead of cutting tax rates, they would have the government send out checks to people based on the size of the surplus. Not surprisingly, liberals love the idea. The day after the Broder column appeared, two liberal economists who have never seen a tax cut they liked made a similar proposal in The New York Times. To be blunt, the rebate proposal is terrible on both economic and political grounds. The economic case against rebates is well documented in the economic literature, much of it based on the experience of the 1975 rebate initiated by Gerald Ford. The problem is that rebates have no impact on incentives. They are just found money for people to spend without encouraging any additional work, saving or investment. Rebates don't even add anything to spending because of something called the permanent income hypothesis. People tend to treat tax rebates like windfalls and save most of it, which doesn't even add to national saving because it comes at the expense of lower government saving. The political argument is even stronger. Because they have no link to taxable economic activity, rebates will be treated not as a reduction in the tax burden, but as a new government entitlement program. And in short order, it will be as difficult to cut politically as Social Security. Many European countries have programs like this called family allowances, which everyone treats as free money. These allowances serve no useful economic purpose whatsoever but are now so deeply ingrained that their abolition is unthinkable. The Europeans are rapidly approaching the point where 100 percent of one's income is taxed, with huge tax rebates in return. Needless to say, incentives and growth suffer under such a system. To his credit, Bush seems to understand Occam's Razor. His tax plan may have its faults, but it has the great virtue of simplicity. It reduces the tax burden in a way that will encourage productive economic activity and does not involve the establishment of a new de facto entitlement program. Hofman and Kutler may think that they are just trying to be helpful, but they aren't. Enactment of their plan would be worse than doing nothing.