Economists Do It With Models

A friend sent this to me, and I figured it was entertaining enough to warrant posting:

Suppose that every day, ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.

The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve. ‘Since you are all such good customers, he said, ‘I’m going to reduce the cost of your daily beer by $20. Drinks for the ten now cost just $80.

The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men - the paying customers? How could they divide the $20 windfall so that everyone would get his ‘fair share?’

They realized that $20 divided by six is $3.33. But if they subtracted that from everybody’s share, then the fifth man and the sixth man would each end up being paid to drink his beer. So, the bar owner suggested that it would be fair to reduce each man’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

And so:

The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $2 instead of $3 (33%savings).
The seventh now paid $5 instead of $7 (28%savings).
The eighth now paid $9 instead of $12 (25% savings).
The ninth now paid $14 instead of $18 (22% savings).
The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before And the first four continued to drink for free. But once outside the restaurant, the men began to compare their savings.

‘I only got a dollar out of the $20′, declared the sixth man. He pointed to the tenth man,’ but he got $10!’
‘Yeah, that’s right’, exclaimed the fifth man. ‘I only saved a dollar, too. It’s unfair that he got ten times more than I!’
‘That’s true!!’ shouted the seventh man. ‘Why should he get $10 back when I got only two? The wealthy get all the breaks!’
‘Wait a minute,’ yelled the first four men in unison. ‘We didn’t get anything at all. The system exploits the poor!’
The nine men surrounded the tenth and beat him up.

The next night the tenth man didn’t show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn’t have enough money between all of them for even half of the bill!

And that, boys and girls , journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

David R. Kamerschen, Ph.D.
Professor of Economics, University of Georgia
For those who understand, no explanation is needed. For those who do not understand, no explanation is possible.

Now this is clearly an oversimplification, but I think that the story illustrates a couple of relevant points. First, it is important to remember that people do have the ability to take their money and run if taxes get too high. Granted, this works better when avoiding local taxes as opposed to federal ones (since it’s easier to move to another state than it is to move to another country), but we see it happen all the time. (Either that or a lot of corporations REALLY love Delaware’s ambience.) Even if people don’t move, higher taxes for wealthy individuals increase the incentive for them to structure their income and assets so as to minimize the taxes that they pay, so a tax hike is not a clear win.

Second, the story illustrates the principle that people often focus on the relative magnitude of changes rather than the relative magnitudes of the resulting levels. Above, the people were arguing over how to split the refund without ever stopping to think about the level that each of them started at. This is likely because the people were accustomed to the status quo and had implicitly designated it as fair, and thus the new proposal amounts to a deviation from fairness. See how the framing of a policy can be so important?

Shocking advice, I know. That said, I hadn’t realized how ridiculous the ads could get until I saw one from the McCain camp that stated (I seriously paused my Tivo and went to the computer when I saw it): “Obama has no background in economics…who advises him? The Post says it’s Franklin Raines for advice on mortgage and housing policy. Shocking…” (In case you don’t know, Franklin Raines was the head of Fannie Mae until 2004, when he resigned amidst controversy regarding accounting irregularities.) Okay, I get that this is not exactly the sort of thing that Obama would want to brag about. However, I would argue that whether he had tried to get crafty with accounting rules has little impact on his knowledge of financial markets (especially since he was Clinton’s budget director- it’s not like he’s not qualified).

But I digress, as usual…what got me so irritated by the commercial is the fact that it is very well known, at least in the economics community, that Obama has put together an impressive team of economic advisers, including respected academics such as Austan Goolsbee, at least until recently. (Other people seem to randomly know this as well. For example, one of my friend’s medical interns bragged to me that he got to take a class with “Obama’s economic adviser”, as if I didn’t know him by name.) I’m not sure that McCain really wants to go down this path, since his economic credentials and advisers really don’t need the scrutiny, especially since McCain himself admits “The issue of economics is not something I’ve understood as well as I should.”

In case you’re curious:

In looking for a list of McCain’s economic advisers, I instead found a list of “Economists Who Endorse the McCain Economic Plan”. There are some impressive names on the list, but a. it’s unclear if they advised in any official capacity (their names aren’t mentioned in the adviser article below), and b. since most economists lean to the right (at least on fiscal matters, being all free market advocating and such), it’s unclear how to interpret the support. I do it interesting that the majority of endorsers seems to be from schools in swing states (I’m talking to you, Ohio). Here is a very interesting and rather in-depth article that outlines the economic advisers for both camps. McCain’s advisers seem to be more corporate-y and Washington-y than I would expect. Also, my girl crush on Laura Tyson has been renewed due to her involvement in the Obama campaign.

I am happy to see that the Washington Post caught on to this, since I am guessing that their readership is larger than mine. For your viewing pleasure, the link even includes the video of the commercial (which is has been paused on my TV for 45 minutes now).

(Note: My argument should not be taken as support for one side or the other, it’s more of a “What the hell, people?” sort of thing.)