Economic Models and Tax Policy

Over at Worthwhile Canadian Initiative (WCI), Stephen Gordon reasonably argues that economic models can be useful for policy analysis even if they lack the predictive power needed for forecasting. He writes:

A well-designed model will be able to reproduce the main features of interest of the real world. More importantly, it will also be able to reproduce the main features of interest of a world in which the policy under study did not take place.

It strikes me that such counterfactual analysis is always fraught with uncertainty, so economists (and other social scientists) should be cautious about their answers. But at least counterfactuals can help us ask the right questions.

A corollary to Stephen’s statement is that a poorly-designed model that fails to reproduce important features can lead to bad policy advice. As Iglika suggested, a misleading graph of the labour market (with quantity as numbers of jobs and price as nominal wage rates) is largely responsible for the knee-jerk opposition to minimum wages among many neoclassical economists.

I think that poorly-designed models also afflict tax policy, and WCI has recently showcased some important examples. Stephen has been promoting a conventional model of corporate taxes, which assumes that they apply to all operating profits.

This model ignores interest deductibility, Canada’s dividend tax credit, and the US government’s worldwide taxation of American corporations. These features mean that the minimum returns required to justify marginal investments are generally unaffected by Canada’s corporate tax rate.

Another recent WCI post repeats the model of sales-tax harmonization that seems to have taken over the minds of most mainstream Canadian economists. In this model, the HST is about removing sales tax from machinery and equipment to boost investment.

In fact, the previous Provincial Sales Tax already exempted much machinery and equipment. Most of the HST’s input tax credits will actually be for construction materials and intermediate goods.

On the whole, mainstream economists are too quick to discard institutional details in favour of abstract models. The institutional details often are, or should be, “the main features of interest.”


  • You mean like the fact that the Swedish tax regime punishes corporations who pass through profits to high executive compensation instead of investment?

  • Even the US corporate tax system has some (rather ineffective) limits on the deductibility of executive compensation.

  • Yah but the Swedes really punish wealth holding outside of the corporation. It is fun watching Swedish business men in bad clothes fight it out for control and driving away in modest cars.

  • Great piece Erin. I am reminded of work by economists on EI disincentives which ignores key institutional features of the EI system. Like the rather key fact that it is quite possible – indeed encouraged – to work while on claim if temporary work becomes available. THe EI payment is reduced, and the work counts towards a future claim. Yet almost all models assume being on claim means being unemployed continuously until the end of the claim. This sounds trivial but it undermines supposedly robust findings that EI eligibility undermines work incentives.

  • Counterfactuals, I have read a series of conterfactual political science stories about everything from development to state formation and every time I walk away saying “maybe.” The most famous contemporary counterfactual argument is of course the American and British dissembling on Iraq. Much of what social scientists study are conjunctural, transient events which cannot be unwound out of their context. The level at which counterfactuals work is the same level at which theory works and theory only works (in the social sciences) at a very high level of abstraction. Which is fine, but the most you get at that level of inquiry are dogmatic truisms that really do not require any empirical confirmation.

    I go to bed every night knowing that capitalism is a dynamic economic system which given the profit motive tends towards the increasing commodification of daily life and activities and tends towards ever increasing levels of productivity. What I can’t tell you or myself is if in absence of CIT cuts Canadian GDP per capita will be higher or lower than it would have been with the cuts. And really that is what Gordon’s post is about. He believes given the model kicking around in his head that they have to increase productivity thus no cuts means a lower productivity trend rate of growth.

    As a policy maker why would I invite Gordon to do policy analysis for me (or his students) when I can telegraph both his and his students factuals and counter-factuals? It is just a rhetorical strategy to present the same theory twice. And repetition is the oldest trick in the propaganda racket.

  • have a look at the book 13 Bankers and you will have yourself so full of counter factuals you will have a gall bladder attack.

    (oh those are painful- I am thinking gall stones may be the solution to greening the planet- once you get them, any red meat with fat in your diet becomes a demonic menace . I wonder if I get it removed will I somehow get back to my food world of Clockwork Orange? (not the movie, just the meaning of it)) Although potentially maybe all economists need to watch the movie and undergo treatment for violent tendencies- yes even the progressive ones- as judging by the theories, practice and outcomes, nobody has ever got it right and as it is outlined in the book 13 bankers, we have learned nothing.

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