Five Lessons from Economists WILLIAM F. FOX Director Center for Business and Economic Research University of Tennessee September 2006

2 Five Lessons Economists Offer Incentives Affect Behavior – Expect the Effects The World Is Complicated but Simple Models Work Well The Obvious Is Not Always the Best Explanation for Behavior Decisions Should Be Based on Marginal Effects Long-Run Revenue Performance Is the Key

3 Incentives Matter – So Plan Tax Policy Accordingly Taxes affect how people behave, though not to the Laffer extent Where people shop What people buy How much people work Taxes affect how business behaves Where they invest Reporting versus real effects Policy also affects how government behaves Thus, revenues and economic performance must be carefully considered

4 The World Is Complicated, but Simple Models Often Work Well Theoretical models by their very nature abstract from many factors Are essential to frame our thinking and empirical analysis Optimal tax policy models assume away many possible issues, but are useful for designing policy

5 The Obvious Is Often Not the Best Explanation for Behavior This explains much of why understanding must be placed in the context of a model Freakonomics Difference between correlation and causality Reduction in tax rates and revenue growth

6 People and Businesses Make Decisions on Marginal Effects At least they should! High marginal rates affect behavior even if the average tax burden is low Of course, it is important to carefully determine what is meant by marginal

7 Revenue Performance Should Be Evaluated in a Long-Run Context The underlying relationship between revenues and the economy is more important than the current year’s revenues and current behavior Fiscal conditions should be evaluated in the context of structural balance – the growth path of expenditures relative to the growth rate in revenues