C H A P T E R

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Numbers live. Numbers take on vitality.
Jesse Jackson

A good subtitle for this chapter is “Why Is It So Hard to Tell What’s

Going On?” We constantly hear economists—and politicians—dis-
agree vehemently about the likely consequences of various government
actions. Consider the controversy over the effects of reduced income tax
rates on the amount of labor that people supply. Conservatives argue that
lower tax rates create incentives for people to work harder. Ltberals are
skeptical, arguing that no major changes can be expected. Each side has
economists to testify that its opinion is correct. Is the cynicism expressed
in the following cartoon really surprising?
An important reason for the lack of definitive answers is that econo-
mists are generally unable to perform carefully controlled experiments
with the economy. To determine the effects of a fertilizer on cabbage
growth, a botanist can treat one plot of ground with the fertilizer and
compare the results with an otherwise identical unfertilized cabbage
patch. The unfertilized patch serves as the control group. Economists do
not have such opportunities. Although the government can change the
economic environment, there is no control group with which to make
comparisons. Therefore, we never know for certain the extent to which
changes in the economy are consequences of policy changes.
Lacking controlled experiments, economists use other methods to
analyze the impact of various government policies on economic behavior.
One of the most exciting developments in public finance in recent decades
has been the widespread use of modern statistical tools to study public
policy issues.
We will use the debate over the effect of taxes , on labor supply to
illustrate how empirical work is done in public finance. The general princi-
ples used are applicable to any number of problems.
 Part 2 Tools of public Finance

"That’s the gist of what I want to say. Now get me

some statistics to base it on.

One often hears the assertion that “The numbers speak for themselves.
he What do the numbers say about income tax rates and labor supply? Table
3.1 gives information on how the proportion of the last dollar of earnings
taken by the tax collector—the marginal tax rate—varied over the period
195a to 1992. The table also shows how the average weekly hours per

Table 3.I Income tax *ates and labor supply

Marginal Federal
Tax Ra te* Average Weekly
Year (percent) j-[ours

1955 20.00 59.6

1960 20.00 38.6
1965 l7 00 38
1970 19.50
1972 19.00 37
1976 22.00 36.1
1980 30.13 35
1984 28.70
1988 22.51
t992 22.65

* Al ten H. Lerman , “A rerage and Marginal Income Tax and

Social Security (FICA) Tax Pales for Foilr-Person Families at

1992,” Office of Tax Analys fs, Department of the Treasury,

'i Economic Report of the Presidea I, 1994. Washington, DC: US

Government Printing Office, 1994.
 Chaptes 3 Tools of Positive Analysis * 29

ory—can answer the question of how labor force behavior is affected by

changes in the tax system. Even intense armchair speculation on this
matter must be regarded with considerable skepticism.
Although we have developed the argument with a labor supply exam-
ple, the lesson is more general—One major purpose of theory is to make
us aware of the areas of our ignorance.

Theory helps to organise thoughts about how people react to changes in

Methods of their economic environment. But it usually cannot tell us the magnitude of
such responses. Indeed, in the labor supply case just discussed, theory
Analysis alone cannot even predict the direction of the likely changes. Empirical
work becomes necessary. The three types of empirical strategies are per-
sonal intervtews, experiments, and êconometrîc estimation. With each
technique, the connections to theory are vital. Theory influences how the
study is organized, which questions are asked, and how the results are
interpreted.

Interviews The most straightforward way to find out whether some government ac-
tivity influences people’s behavior is simply to ask them. In a crude way,
this is the kind of empirical “analysis” done by reporters. (“Tell me, are
you going to delay your retirement if the government lowers your Social
Security benefit?”) A number of sophisticated interview studies have
been done to assess the effect of taxes on labor supply. A group of British
lawyers and accountants were carefully questioned as to how they deter-
mined their hours of work, whether they were aware of the tax rates they
faced, and if these tax rates created any incentives or disincentives to
work. The responses suggested that relatively few people were affected
by taxes {Break, 1957, p. 549). A later survey of a group of affluent
Americans told much the same story. “Only one-eighth ... said that
they have actually curtailed their work effort because of the progressive
income tax ... Those facing the highest marginal tax rates reported
work disincentives only a little more frequently than did those facing the
lower rates” [Barlow, Brazer, & Morgan, 1966, p. 3].

Pitfalls of interviews. However, interpretation of these survey results

requires caution. After all, just because an individual cannot recite his or
her tax rate does not mean the individual is unaware of the discrepancy
between before- and after-tax pay.
An old Chinese proverb counsels, “Listen to what a person says and
then watch what he does.” The fact that people say something about their
behavior does not make it true. Some people are embarrassed to admit
that financial considerations affect their labor supply decisions. (“I work
for fulfillment.”) Others complain about government just for the sheer fun
of it, while in reality they are not influenced by taxes. If you want to find
Part 2 Tools of Public Finance

out what radio station a family listens to, what makes more sense: to ask
them, or to see where the radio dial is set?

At the outset, we stressed that the basic problem in doing empirical work
in economics is the inability to do controlled experiments with the econ-
omy. However, the federal government has frtnded several attempts to
use experimental methodologies in the study of economic behavior. The
idea underlying these social experiments is illustrated by some work done
on unemployment insurance in the 1980s.°
Currently, a worker who loses her job receives a weekly unemploy-
ment insurance payment for a certain number of weeks. Policymakers
have long been concerned that this system discourages individuals from
finding new jobs and have sought alternative methods that might increase
work effort. In the experiment, unemployed people were randomly as-
signed into two groups. The control group received conventional unem-
ployment insurance as just described. The second group received a $500
bonus if they started a new job within 11 weeks. Any differences in the
behavior of the two groups could then be attributed to the bonus, allowing
one to determine its effectiveness.

PiWaIls of social experiments. Although experiments are a promising

way to learn about economic behavior, technical problems tend to dimin-
ish their usefulness. One reason is that the classical methodology for
experiments requires that samples be truly ranclom—the members of the
sample must be representative of the population whose behavior is under
consideration. In social experiments, it is virtually impossible to maintain
a random sample, even if one is available initially. Some people leave the
program to take new jobs. Others simply decide they don’t want to partic-
ipate. Because such people set/-select out of the sample, the characteris-
tics of the group left are no longer representative of the population.
In addition, unlike plants or laboratory animals, human beings are
aware they are participating in an experiment. his consciousness affects
their behavior. A related point is that people within the group may react
differently to a program when only a small number of participants are
involved than they would when the program is universal. Or an experi-
ment that lasts only a few months may produce different behavior from a
program expected to be permanent.
One thing is certain. Social experiments are costly. For example, an
experiment conducted to learn how the housing decisions of the poor
would be affected by rent subsidies cost $163.3 million. [See Ingram,
1985.) But such costs should be kept in perspective. It may be worthwhile
to spend a few million dollars to determine the efficacy of a program that
would involve the expenditure of billions of dollars.
2
Sec Meyer [1992J for further details.
 Chapter 3 Tools of Positive Analysis - 31

Laboratory experiments. Certain kinds of economic behavior can also

:/ be studied in laboratory settings, an approach often used by psycholo-
gists. An investigator recruits a group of people (subjects) who perform
various tasks. The investigator observes their behavior. To study labor
. supply, an investigator might begin by noting from the theory of labor
;. supply that a key variable is the net wage rate. A possible experimental
strategy would be to offer subjects different rewards for completing vari-
ous jobs and record how the amount of effort varies with the reward.
Laboratory experiments are subject to some of the pitfalls of social
experiments. The main problem is that the environment in which behavior
is observed is artificial. Moreover, the subjects, who are often college
undergraduates, are unlikely to be representative of the population as a
whole. However, laboratory experiments are much cheaper than social
experiments and provide more flexibility. Their popularity has been grow-
ing in recent years, and as we see in later chapters, they have provided
some very interesting results.

Econometric
Ecoiiometrics is the statistical analysis of economic data. It does not rely
Studies on asking people for their opinions or subjecting them to/experiments.
Rather, the effects of various policies are inferred from the analysis of
observed behavior.° While economists are un,able to control historical
events, econometrics makes it possible to assess the importance of events
that did occur.
The simple labor supply model suggested that annual hours of work
(L) depend on the net wage rate (w ). (By definition, w — (I — r) w,
where i is the tax rate.] A bit of thought suggests that nonlabor income
such as dividends and interest (A), age (Jt), and number of children (X/
may also influence hours of work. The econometrician chooses a particu-
lar algebraic form to summarize the relationship between hours of work
and these explanatory variables. A particularly simple form is
(3.1)
The a’s are the parameters of the equation and e is a random error.
The parameters show how a change in a given right-hand side variable
affects hours of work. If ct = 0, the net wage has no impact on hours of
work. If n, is greater than 0, increases in the net wage induce people to
work more—the substitution effect dominates. If at is less than 0, in-
creases in the net wage induce people to work less the income effect
dominates.
The presence of the random error s reflects the influences on labor
supply that are unobservable to the investigator. No matter how many
variables are included in the study, there is always some behavior that
cannot be explained by the model.
" Note that econometric methods can also be applied to data generated by surveys and experiments.
 Clearly, if we knew the o’s, all debate over i:he effect of taxes on labor
supply would be settled. The practical side of econometrics is to estimate
the a’s by application of various techniques. T’he most popular method is
called multiple regression analysis. The heat of the debate over labor
supply indicates that this technique does not always lead to conclusive
results. To understand why, we consider its application to the labor sup-
ply example.
For this purpose, ignore for the moment all variables in Equation (3.1)
other than the net wage, so the hours of work decision can be written
simply as
= t, + at + s. (3.2)
Equation (3.2) is characterized as linear because if it is graphed with L
and iv, on the axes, the result is a straight line.
Suppose information is obtained on hours of work and on after-tax
wages for a sample of people. Plotting those observations gives a scatter
of points like that in Figure 3.1A. Obviously, no single straight line can fit
through all these points. The purpose of multiple regression analysis is to
find the parameters of the line that fits best.^ Such a regression line is
illustrated in Figure 3.IB. The regression line is a geometric representa-
tion of Equation (3.2), and its slope is an estimate of «i . (A parameter
estimate is sometimes called a regression coefficient.)
After ct is estimated, its reliability must be considered. Is it likely to
be close to the “true” value of o, ? To see why this is an issue, suppose
our scatter of points looked like that in Figure 3.IC. The regression line is
identical to that in Figure 3. lB but the scatter of points is more diffuse.
Even though the estimates of the n’s are the same as those in Figure 3. lB,
one has less faith in their reliability. Econometricians calculate a measure
called the standard error, which indicates how much an estimated param-
eter can vary from the true value. When the !itandard error is small in
relation to the size of the estimated parameter, the coefficient is said to be
statistically significant.
This example assumed there is only one explanatory variable, the net
wage. Suppose that instead there were two variables in the equation: the
net wage and nonlabor income. In analogy to fitting a regression fine in a
two-dimensional space, a regression.place can be fitted .through a scatter
of points in a three-dimensional space. For more than two variables, there
is no convenient geometrical representation. Nevertheless, similar mathe-
matical principles are applied to produce estimates of the parameters for
any number of explanatory variables (provided there are fewer variables
than observations). The actual calculations are done with computers.

• The best line minimises the sum of the squared vertica( distances between t]ne points on the line
and the points in the scatter. See Gujarati (1978] .
 Chapter 3 Tools of i'ositive Analysis 33

Figure 3.1 Multiple regression analysis

A.
A scatter diagram B. A regression line C. A regression line in a scatter
diagram with increased
dispersion

Slope of
regression line is

I ! °
°0j Intercept of regression line is o 0 °oJ • °

With estimates of the n’s in hand, inferences can be made about the
changes in L induced by changes in the net wage. Suppose n, = 100. If a
tax increase lowers the wage by 50 cents, then an individual will work 50
hours (100 x $.50) less per year.

' Pitfalls of econometric analysis. There are dif‘ficu1ties involved in doing

econometrics that explain why different investigators may reach contra-
dictory conclusions. For example, implicit in Equation (3. 1) is the as-
sumption that the same equation can describe everyone’s behavior. How-
ever, different types of people may have different hours-of-work
equations. Married women may react differently than married men to
change in the net wage. Similarly, the young and the old have different
behavioral patterns. Grouping together people with different behavior
results in misleading parameter estimates. Investigators generally do not
know beforehand along what lines their samples should be divided. Some-
what arbitrary decisions are required, and these may lead investigators to
different results.
A related problem is that the parameters may change over time. The
female labor supply equation using data from 1960 woeld very likely show
different results from an equation using 1995 data. In part, this would be
due to the impact of the women’s movement on attitudes toward work,
and hence, on the values of the a’s. More generally, the reality that
econometricians seek to understand is constantly changing. Estimates
obtained from various data sets may differ even if the techniques used to
obtain them are the same.
In addition, for an estimate of o; to be reliable, the regression equa-
tion must include all the relevant variables. Otherwise, some effects that
are actually due to an omitted variable may be attributed to the net wage.
Important variables are sometimes left out of an equation because infor-
Part 2 Tools of Public Finance

mation on them is simply not available. For example, it is very difficult to

obtain reliable information on people’s sources of nonlabor income. Sup-
pose:
1. As nonlabor income increases (other things being the same),
people tend to work less.
2. There is a tendency for people with high wages also to have
high nonlabor income.
If nonlabor income is omitted from the equation, part of its effect on hours
of work would be attributed to the wage, and the estimate of a, would be
lower than its true value. In general, an estimate of o; is biased unless all
the other variables that affect hours of work and that are also systemati-
cally related to the net wage are included.
A more severe version of this problem occurs when a potentially
important varlable is inherently unmeasurable. Attitudes such as aggres-
siveness may influence work decisions, but there are no satisfactory ways
for quantifying these attitudes.
Sometimes there are controversies over which variables should be
included in a regression equation. Should an individual’s educational level
be included? Some argue that education affects attitudes toward work and
therefore should be included as an explanatory variable. Others believe
education affects work decisions only to the extent that it changes the
wage, and therefore should not be included. While economic theory helps
give some structure to the search for explana.tory variables, it is rarely
definitive. Different investigators make different judgments.
Difficulties in measuring variables can also make it hard to obtain
reliable estimates. Consider problems in measuring hours of work. Super-
ficially, this seems like a straightforward issue—merely find out how
much time elapses at the workplace. But a better measure would consider
coffee breaks and “goofing oif” time. These are obviously more difficult
to measure. Measuring the wage rate also presents substantial problems.
Ideally, the computation should include not only what a worker receives
in the paycheck at the end ot the week, but also the value of fringe benefits
—pension rights, insurance programs, access to a company car, and so
forth.
Finally, an important assumption is that variables on the right side of
the equation affect the left-hand variable, but IIOt vice versa. If this is not
true, serious problems arise. Suppose that i of Equation (3.1) is found to
be positive. One interpretation is that when the net wage increases, peo-
ple choose to work more. Another plausible interpretation is that employ-
ers pay hiBher wages to people who work longer hours. Indeed, wage
rates might affect hours worked and simultane.ously hours worked affect
wages. If so, then the estimate of a generated by multiple regression
analysis does not correctly measure the effect of changes in the net wage
on people’s work decisions.
 Chapter 3 Tools of Positive Analysis

Several statistical techniques are available for dealing with this simul-
taneity problem. They tend to be complicated, and different techniques
can lead to different answers. This is another source of discrepancies
in the results of econometric studies.

For those who seek to describe economic behavior, theory plays a crucial
role in helping to isolate a set of potentially important Variables. Empirical
Remarks work is then needed to see whether the theory is consistent with real-
world phenomena. Currently the most widespread method of empirical
work in economics is econometric analysis, because 'economists tend to
be most comfortable with results based on data from real-world environ-
ments. I-lowever, honest econometricians may come to very different
conclusions. The data they use are imperfect, and implementation re-
quires that assumptions be made. Reasonable people can disagree on the
proper interpretation of a particular set of “facts”:
Facts are simple
and facts are straight
Facts are lazy
and facts are late
Facts all come with points of view
Facts won’t do what I want them to.5

This does not mean we should abandon all hope of learning about the
factors that influence economic behavior. The economist researching an
empirical question will doubtless come across a number of studies, each
making somewhat different assumptions, eactt emphasizing a somewhat
different aspect of the problem, and each therefore arriving at a somewhat
different conclusion. In many cases one can reconcile the different studies
and construct a coherent picture of the phenomenon under discussion.
Feldstein [1982b, p. 830] has likened the economist who undertakes such
a task to the maharajah in the children’s fable about the five blind men
who examined an elephant: -
The important lesson in that story is not the fact that edéh blind man came
away with a partial and “incorrect” piece of evidence. ›The lesson is
rather that an intelligent maharajah who studied the findings of these five
men could probably piece together a good judgmental picture of an ele-
phant, especially if he had prexionzl y seen some other four-footed animal.
On the numerous occasions throughout this book when we refer to
the results of empirical studies, the caveats presented here should be kept

Flo Eyed and Painless ” O 1980 Bleu Disque Music Co. , I nc„ Index Music, Inc. , and
E. G, Music, Ltfi. by permission of David Byrne and Bjan Eno.
 Part 2 Tools of Public Finance
in mind. In cases where the profession has failed to achieve consensus, the opposing views are discussed. Bu
• because economists are generally unable to
r‹:rform carefully controlled experiments with
tf e economy, the effects of economia policy
m e difficult to determina.
Economic theory helps specify the factors
that might affect a given kind of behavior.
Generally, however, theory alone cannot say
ia‹aw important any particular factor is.
ü mpirical research attempts to measure both
the direction and size of the effect of govern-
ment policy changes on behavior. Common
types of empirical studies are interview stud-
res, social and laboratory experiments, and
er:onometric analysis.
• fr terview studies consist of directly asking
;oi:ople how various policies affect tiieir be-
in‹ivior. However, people may not actually
react to policies in the way they say they do.
• Social experiments subject one group of peo-
ple to some policy and compare their behavior
with that of a control group. Problems can
arise because the experiment itself may affect
like economists, astronomers are generally
u aable to perform controlled experiments.
Set astronomy is considered more of an
%:‹act science than economics. Why?
, In 1994, President Clinton argued that to get
v›eIfare recipients to work more, they should
!ose their eligibility for payments after two
y:•ars.
. Does the theory of labor supply
tell you if this view is correct?
people’s behavior, because it is difficult to
obtain a random sample, and because social
experiments are quite costly.
® Laboratory experiments are used to study
some types of economic decisions, but in the
artificial atmosphere subjects may not repli-
cate real-world behavior.
° Econometrics is the statistical analysis of
economic data. In econometrics, the effects of
V Ous policies are .inferred from observed
behavior.
• Techniques such as multiple regression analy-
sis are used to pick the “best” paramü ters for
the model. Knowing the parameters allows
one to piedict the effects of policy changes.
• Econorti,etrics is not without pitfal.1s. i\4isIead-
ing results are obtained if data froin greafly
dissimilar groups are combined; if important
variables are omitted; if the wrong mathemati-
Cal form is adopted; if variables are incor-
rectly measured; or if there is simultaneous
causatipn between variables.
b. How would you construct a suryey to
investigate this issue?
c. If you were to conduct an experiment to
investigate the issue, would it be a social
or laboratory experi¡nept? Why? Describe
your experimenJ:.
d. How would you conduct an econometric
investigation? Which data would you
need? Which algebraic function would
you choose?
t
 Chapter 3 Tools of Positive Analysis
e. In any of your studies did you consider
variables other than the size of welfare
payments? If so, why did you choose
them?
In 1994 the National Cancer Institute stated
that there was no conclusive evidence that
regular mammograms reduce the rate of
breast eaneer deaths for Women under 50.
The American Medical Association dis-
agreed, and recommended that women in
their 40s have regular mammograms. Relate
the problems faced by researchers trying to
determine the usefulness of mammograms to
the problems faced by economists trying to
determine the effects of economic policy.
In the 1970s, researchers at the RAND Cor-
' * 37
poration conducted a social exp eriment to
investigate the relationship between health
insurance coverage and health c are utiliza-
tion. In this experiment, samples of inaivia-
uals were induced to trade their n ormal insur-
ance policies for new RAND @Ol ic ies that
offered various coinsurance rates (i.e., differ-
ent rates at which the insurance would reim-
burse the individual for health care ex-
penses). In 1993, the Clinton adm inistration
used the results of the RAND experiment to
predict how health care utilization would
increase if insurance coverage were made
universal. What problems might arise in using
the so.cial experimentation results to predict
the impact of universal coverage?