Summer School 2: How taxes change behavior and the economy

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0:52Welcome back class to Planet Money Summer School, the only economics degree that comes with UV protection for the beach, SPF 50. This season, we're talking about political economy, which is a fancy way of saying the role that the government has in our economy. And if you've been paying attention these days, you might have noticed that the government is all up in every part of our business. Today is class number two, taxing our way to a brighter tomorrow. I'm Robert Smith. One big reason to pay attention to what the government is doing is because they are doing it with our money. We ask more of our government and then they ask more of us through our taxes.

1:31At the very beginning of our country, Congress was desperate for money. They levied taxes on imported goods. Yes, a tariff is a tax. On things like whiskey, states taxed property. The first income taxes came to pay for the Civil War. Corporate taxes and sales taxes appeared in the early 1900s. The main thing taxes do is raise money. We all know this, right? Fund the military, insurance programs like Medicare and Medicaid, roads, bridges, all the stuff. That part is pretty straightforward. The more money you raise in taxes, the more you can spend without borrowing a ton of extra money. Today in class, we wanted to zero in on a different way to think about taxes, as a tool to shape the economy.

2:15Taxes can be used to redistribute income to those who need it the most. Taxes can stimulate or slow economic growth. Taxes can be used to influence our habits and maybe even save the planet. With great taxing power comes great responsibility. That's why some of us love to talk about taxes. Well, as a person, I probably don't love taxes, but as an econ professor, absolutely. It is our biggest fiscal tool. Hey, before you jump in, you have to introduce yourself to the class. Oh, man. I quit. I'm out. So my name is Derek Hamilton. I am a university professor and the Henry Cohen professor of economics and urban policy at the New School.

2:59And I run an institute on race, power, and political economy also at the New School. So taxes, ultimate tool of government. How does it work? How does the tax code change our behavior? How does it change society? It certainly changes behaviors. It can incentivize various things. For example, if we offer a tax rebate or subsidy for people to green their house to convert from gas furnace to electric furnace, well, that's a change in behavior that presumably is good for the environment. Not presumably, it's actually good for the environment. And the government's also making choices when it has things like deductions, right?

3:43It seems like, oh, deductions, it's just something I do on my tax forms. But they have made specific ideas that we want to let you keep that money so you will spend it for a specific purpose that we want you to spend it for. And famously, in the United States of America, we have a deduction you can take for interest you pay on your home mortgage, which encourages people to own homes rather than rent them. Exactly right. I mean, we have a society that a lot of people not only live in their home, many Americans use their home as a mechanism to save, a mechanism to grow their wealth. And the tax code has incentivized that.

4:26And with every change in the tax code, there are winners and losers. I always think of the different ways we tax forms of income. You know, a dollar isn't always a dollar. So a dollar made by a corporation, that may, you know, after accounting, get no taxes. A dollar made by selling something, capital gains, gets maybe a low tax rate. But a dollar at my job, at least the most recent dollar, gets taxed at a pretty high rate. Exactly. And you are describing the ways in which we structure behavior and, frankly, structure inequality by way of our tax code. So taxes reflect value. They reflect societal value.

5:07So if we tax wages at some rate and then we tax, say, capital gains, which is a form of income that's generated from owning an asset. Yeah, selling stocks. Selling stocks. Well, if we tax stocks at a different rate than we tax wages, that's reflective of values. Both of them generate revenue, but you could imagine that some people have greater access to wages versus some people have a greater wealth by way of reaping the rewards from, say, stocks, dividends from stocks. Well, over the course of today's class, we're going to hone in on some of the different reasons and ways that the tax code can change behavior, both for the good and for the bad.

5:52and remake society, as you say, Derek, in the form of our own values. There it is. After the break.

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6:58Our first case study in this summer school class deals with taxes as a way to redistribute income. We often think of taxes as taking money out of our pockets. But for some people, it's the exact opposite. The tax code is a mechanism by which government can literally put money in the hands of people. But it gets to choose which people. And it gets to choose which people. And the way it pulls off this trick makes all the difference, as we will learn in this classic Planet Money episode from 2013, hosted by Hannah Jaffe-Walt and Marianne McHugh. Tax day is coming up. People love to complain about it, but not this woman.

7:35Yay! I'm so happy. That is Lynn Matthews. She's a FedEx package handler, and I met her at a pro bono tax center in Newark, New Jersey, when she stopped in to get help filing her return. She was even singing while she waited.

7:55And that's because for Matthews, tax time is bonus time. For people like her, that bonus can be a big one. It can be more than$5 ,000. Often it's more than you paid in taxes for the entire year. Lynn Matthews is one of nearly 30 million people who receive this bonus. It doesn't sound exciting when you see it on the tax form. It's got a very technical, kind of boring-sounding name. It's the Earned Income Tax Credit. But Lynn Matthews doesn't find it boring at all. Earned income credit

8:39I'm so happy I'm happy, yay! The earned income tax credit is one of the biggest cash transfers we have in this country. More than$60 billion last year handed from wealthier Americans to poorer Americans. You'd think there'd be a lot of discussion about this, right? Right. And yet the surprising thing is almost everyone who looks at the earned income tax credit, the EITC, pretty much likes it, right? That's exactly right. It's been expanded by every president right and left since the 1970s. I'm talking Reagan, Clinton, both Bushes and Obama. As I was reporting the story, I talked to more than half a dozen economists left and right, and pretty much all of them said that the earned income tax credit does exactly what it was designed to do.

9:27The architects of the EITC wanted to help poor people and at the same time encourage them to work. And by God, they did. It worked. You know, the rocket was launched and it hit the moon. This is Richard Berkhauser of Cornell University, And he told me that you do not see that kind of success very often when it comes to programs for the poor. I'm not exaggerating when I'm telling you, look, I've been doing public policy since the 1970s. And there's not a hell of a lot of these programs where you can see the tremendous change in the behavior of people in exactly the way that all of us hoped it would happen.

10:02So, Marianne, can you just lay out how it works? Okay, so very simply, the U.S. government says, if you work but you're still poor, we're going to give you a bonus. And if you have kids, it's going to be a big bonus, a big chunk of money. It could be more than a third of what you made all year, and it comes in one big lump sum. Review, please. When I was at the tax center in Newark, I met this woman named Miriam Ochoa, and she says she still remembers the first time that she got it. I say, are you serious? This is for me? It was about$3 ,000, and that's after making only about$9 ,000 the whole year working part-time at a bank.

10:42And living on$9 ,000, that is really hard. Ochoa had to seriously save every penny of her money. She told me that on her long commute to work, she remembers going past this one McDonald's every day and smelling the french fries, but telling herself, You have to say no, because I have to pay my rent. living on$9 ,000 is clearly very difficult. And if you want to design a policy that's going to help poor people, giving them$3 ,000 more, that seems like a pretty intuitive thing to do. But the EITC, the more you learn about it, the more counterintuitive it seems. So let's just walk through this. So imagine, you know, the way American policymakers have thought throughout history about helping poor people.

11:26You imagine the poorer someone is, the more help they need. So the more money you want to give them. So for example, you get food stamps or you get subsidized housing, you get, you know, free government health insurance if you're poor. And if you start working and make enough money, you get kicked off food stamps or you get kicked out of your housing, you know, or you no longer have government health insurance because you no longer have need. And for most of us, we look at that and say that makes a lot of sense. And there's certainly lots of good arguments for why these programs are useful. But when economists look at that, they see something different.

12:01They see that you're actually paying people to stay poor. Right. So when they designed the earned income tax credit, economists were coming from a totally different direction. They did an economist mind flip. They said if the ultimate goal is to help people move up the economic ladder, then you have to pay them to move up the economic ladder. Somebody like Miriano Choa, when she made$9 ,000, she got a$3 ,000 bonus. When she made$15 ,000, four years later, she got$4 ,000 from the EITC. Then that's the sort of economist mind flip, right, is the more you make, the more the EITC pays you. And that's a pretty radical change.

12:42You know, it was in the 90s that the EITC was created in a big way, right? And that was when we were reforming welfare as we know it. So welfare up until that point had, for the most part, given people money because they proved that they had need. And then it would take that money away if they started working and made too much money. So the EITC was this new approach to that problem. Yeah, it's this very delicately designed equation. You start out, you make more and more money, you get bigger and bigger bonuses. And then at some point you peak somewhere, say, between$12 ,000 and$20 ,000, depending on how many kids you have.

13:18and then the bonuses start to get smaller again. But even when the bonuses are getting smaller again, they're not getting smaller so quickly that it makes you want to stay at a smaller salary. Right. And for Ochoa, this was like magic. When she first started getting the EITC, she was working part-time. She was caring for a son who was in special ed. She was on food stamps and she was in debt from her divorce. And since then, with help from the EITC, she has paid her debt. She's gotten off food stamps. She went to school for accounting And when she was unhappy with the Newark high school her son was going to have to enroll in, she managed to even move to a better school district.

13:54I found an apartment there, and I changed my son's life. Could you have moved to a nicer neighborhood with nicer schools without the earned income tax credit? No. No, no, no. Because my income is low. It's low income. OK, so we've got this delicately designed equation that actually pays you more the more money you make to help you move up the economic ladder. And then we have the second magic ingredient that makes the earned income tax credit so successful. And the second is that it just pays you cash. Like it follows a very simple idea that economists love, which is that the best way to help poor people is to give them cash and trust them how to spend it best.

14:39And this kind of aid to poor families and economics is called a cash transfer. And right now, the majority of the assistance the government offers to poor people is not cash. We're not spending a lot of time handing over cash. The government is giving poor people things like health care or vouchers for housing, food stamps, things called in-kind transfers. There are a lot of economists out there who really prefer the cash transfers to the in-kind transfers. And it's not just economists. If you ask someone like Ray Osorio, recent father of these two twin boys you hear napping loudly in his living room, cash is the only kind of help he wants.

15:22I know. I know how to spend it. For everybody else. I can't speak for everyone else. I'm not sure. What he needed was some cash to invest in his business. He wanted to start a luxury car service, get a fancy ride to shuttle around actors and diplomats. and he knew a lot of people like that because of his years working in the hotel industry. So when his twins were born, he actually cashed out his 401k to buy this fancy car. He started his business and is going along, but slowly, and he had just run out of all of his savings when he found out that he qualified for the earned income tax credit this year.

15:58And he said he was, quote, delighted. I was like, wow, that's incredible. That's a really nice number. That's more than a third of what you made last year, right? Definitely is. And it was incredible. So you're like, woo, we're going on vacation. Not at all. Not at all. I'm just looking down. I'm just trying to focus on the future. Hopefully my business will bring me plenty of vacations later on down the line. So we've got two EITC poster children here, Ochoa and Osorio. And there are millions more whose lives have really and truly been changed by this policy. But before we get too happy, Hannah, I do need to say that the EITC doesn't solve every problem.

16:41First of all, it only helps people who are working. If you don't or can't work, there's nothing in it for you. Some people that should get it don't, and some people game the system. They get it when they shouldn't. And there are a lot of economists who argue that if you didn't have in-kind transfers like food stamps or government health care, the EITC wouldn't be so successful. It has to exist alongside those other programs. Because a lot of people who are on EITC are also getting food stamps or getting those kinds of supports as well at the same time. Yes, it's different in every state, but certainly people benefit from both at the same time.

17:14OK, so maybe those things help the EITC be super successful. But still, the things that economists love about it, those things really do work.

17:27Marianne McKeown and Hannah Jaffe-Walt from 2013. In the United States and all around the world, the rich get taxed at a higher rate than the poor. But it took a while in the United States to come around to this sort of system that we have now. The founders of the United States did not include the idea of an income tax in the Constitution. And it wasn't until the Constitution was amended in 1913 that we got what we know as a permanent progressive tax system. Professor Derek Hamilton, what does that mean? It's progressive. And, you know, this doesn't mean politically progressive. It means it's economically progressive.

18:04Essentially, it means the more you have, the higher the tax rate you have to pay. And in the old days, there was this really wide range. If someone was poor, they would maybe not pay anything in taxes. But for the very richest of Americans at a certain point during the last century, I think their marginal tax rate was up to 70 percent on that very last dollar that they earned. This is a classic example of a progressive tax code, but some American taxes are regressive. What's a regressive tax and what's an example of that? A flat tax is a regressive tax. Everybody pays 12 percent? Everybody pays 12 percent of their income.

18:42That's regressive because some people just have lower incomes. When we think about consumption taxes, those are regressive taxes. Consumption taxes meaning like sales tax. A sales tax. Everybody who buys a bagel in New York City pays, I think it's like almost 9 % of the price tag, something in there. Getting up there. 9 % of a bagel doesn't mean very much to me, perhaps, but it might mean a lot to somebody who's making a very low wage. Yeah. If a bagel costs$10, that dollar that goes towards taxes for somebody who earns$1 ,000 a week is much less than somebody who earns$100 a week. So we have this progressive income tax code in the United States, and maybe you can say we do it because it's the right thing to do.

19:30But there's an economic way to think about progressive taxation, and that's through this concept called marginal utility. Marginal utility is the use that you get out of every extra dollar, let's just say. You hand me a dollar, put it in my pocket, maybe send it through the wash, maybe put it in the bank account. I won't necessarily spend it because I have extra money. Or you hoard it. You save it away. Or if you give a single dollar to someone who is making below average wages, they're more likely to spend it. Or as we heard in the story, invest in their business or even go to Disneyland. How does this marginal utility play into thinking about taxes?

20:13Is it literally that like a dollar means less to me than it does to them? You know, the concept of marginal utility is often thought about in an individual perspective. And indeed, there is this other concept in economics called diminishing returns. Explain that. It simply means the more you have of something, having an additional unit of it at some point begins to tail off in terms of increasing value to you. So we can give a simple example. if you have$100 and you get an additional dollar, well, going from$100 to$101 might be less valuable to you than going from, say,$1 and getting an additional dollar.

20:56Double money. Yeah. And we can think of it in a literal sense in terms of being able to simply buy things. When you want to buy food, for example, if you have a whole lot of money, getting an additional dollar is not going to make that much of a difference in your consumption habit for food. But if you're lower income, getting additional dollars or an additional dollar will indeed lead to a bigger effect in terms of what you can actually consume. So if you're building a tax code and you know this economic principle, do you literally think, well, not that I'm taking from the rich and giving to the poor, but you're thinking like a dollar means less to a rich person?

21:40than it does to a poor person? Well, if you ask them, they might tell you, no, it means the same to me. But also in economics, we know that revealed preference often happens through some behavioral thing. Don't tell me what you value. Show me what you value. But we can go a little deeper, Robert. We actually get to define value. We actually get to use our tax code. We get to, as a society, make choices of what we value. So we may not like the fact that poor people simply don't have enough money to eat. So as a society, we can ensure that people have enough money to eat. And furthermore, not only will they have enough money to eat, they can use that additional money in ways to invest in their own productivity that becomes more valuable than that single$1 would have been to somebody who's already wealthy.

22:33And as we heard from the earned income tax credit story, people across the political spectrum, they're okay with that. Coming up on our taxing episode of Planet Money Summer School, if the tax code can send money to the poor and even help them invest in their own futures, what other magical things can it do? Can it save the planet? After the break.

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24:16Learn more at Insperity.com slash Tiger. Okay, class, it's about to get nerdy in the summer school. We're going to talk about a dead economist, an impossible-to-understand equation, and somewhere in there a way that the government can nudge businesses to do what's right for society. It's a case study from Sarah Gonzalez and Jacob Goldstein, and it's the story of Arthur Pigou and the thing that he invented called Pigouvian taxes. Pigou was born in England in 1877. OK, sounds like the beginning of a story. And for 35 years, Pagu was the only professor of economics at Cambridge University. And he started when he was really young, 30.