Uncertain policy has economic cost.
Published September 26, 2019
By John Hood
Progressives and conservatives argue about economic policy all the time. At government’s current size and scope, would it better promote long-term growth to raise taxes and spend more or to lower taxes and spend less? During a recession, should government try to bolster demand by running large budget deficits or should it economize to keep debt from exploding?
These are important questions. As you can guess, I find the conservative case more persuasive. While more public investment in some areas may have net economic benefits, I think the rate of return is likely to be larger if those resources are privately invested, instead.
But whatever you think government’s economic policies ought to be, consider this: there is an emerging body of evidence suggesting that the uncertainty of economic policy is itself harmful to the economy. When people can’t predict with at least some degree of confidence what economic policies their government will follow, they often delay consequential decisions and park their resources in safer, lower-yielding investments.
That may be a rational response to a loss of business confidence. Still, the broader costs can be considerable. Market economies thrive on risk-taking — be it an entrepreneur trying out a new idea, an investor taking a chance on an emerging technology, or a talented worker willing to move to another city or state to take a job at a start-up company. Some, perhaps even many, of these endeavors will fail. The ones that succeed, however, produce gains not only for the risk-takers but also for those to whom they sell goods and services or from whom they buy labor and materials.
Government policy certainly influences these decisions, positively or negatively. Even when the effect is likely to be negative, it’s still helpful to economic actors if they can predict the effect with some confidence.
For example, if there is a strong and predictable likelihood that a regulator will disallow a particular practice, a business can begin to develop an alternative. That alternative may well be costlier in time or money than the one the government will disallow. Nevertheless, the certainty of regulation helps the business adjust to new conditions at the lowest possible cost.
Similarly, when it comes to tax policy, it is better for the economy in the long run to keep tax rates as low as possible, consistent with the need to deliver basic government services. Redistributive tax policies are a net drag on job creation and growth, as the preponderance of empirical research confirms.
But also important is the stability of future tax rates. If investors can’t predict with some confidence the future tax consequences of current decisions, they may just hold onto existing assets or keep funds in cash. If a business owner can’t predict with confidence whether a lower tax rate in another jurisdiction will stay that way, she’s less likely to start or relocate an operation there.
In a paper just published in the Journal of Economic Dynamics and Control, two professors at the Singapore Management University used state corporate tax systems in America to test the proposition that policy uncertainty affects economic performance. Following the lead of previous scholars, who used searches of media databases to create state-by-state measures of policy uncertainty, the Singapore researchers generated state statistics on media coverage of corporate tax debates and then looked for a relationship with economic outcomes.
They found one. For every standard-deviation increase in policy uncertainty surrounding corporate taxes in a state, the growth in new business establishments went down by about two-tenths of a percentage point. “Our result clearly shows that tax uncertainty has a significant, negative impact on business activity in the United States,” they concluded.
I know we are going to continue to engage in spirited debate about taxes and other controversial issues. But lawmakers ought to take seriously the growing research literature on policy uncertainty. They should seek consensus when possible. When it’s not possible, they should strive for simplicity and predictability as they make policy changes.