Using sticker shock to clarify the costs of deficit spending

How do behavioral economics apply to deficit spending?

Can cognitive economics explain the effects of tax policy?

I attended the National Tax Association’s spring symposium today, and heard a fascinating presentation by Raj Chetty, a “wunderkind” economics professor from Harvard, on using “behavioral economics” (sometimes now referred to as “cognitive economics”) to better understand the effects of tax policy. Among the many interesting behavioral studies of his that Raj summarized today, one focused on how the “salience” of taxes (how obvious taxes are) matters in terms of how those taxes affect economic behavior. The hypothesis was that the more visible or obvious taxes are, the bigger the behavioral responses would be. Raj described how he conducted an experiment involving price tags in a drug store, where for a period of time the price tags on a certain subset of items (hair accessories, actually) in one particular store were elaborated upon, such that the (usual) price before taxes and the gross-of-sales-tax price (referred to as the “total price”) were displayed. (You can find a photo of these price tags in this slide presentation.) Comparing with the appropriate “controls” (demand for other goods in the same store with ordinary price tags, demand for the same type of (hair accessory) products with ordinary price tags in other stores), Raj and his coauthors found that when the sales taxes and gross prices were spelled out on the price tags (note: taxes were not raised, just clarified), sales of those goods (quantity demanded) fell. Raj had a funny story about how the store manager did not let him use the special price tags on a larger class of goods, because he had a hunch Raj’s hypothesis would prove right!

It got me thinking on the spot about how this bit of behavioral economics applies to deficit spending. The reason why deficit financing of government spending and tax cuts proliferates is because it’s (falsely) perceived as “free”–or at least as less painful (less costly) than having to come up with offsetting tax increases or spending cuts. When in fact, economically at least, exactly the opposite is true. Even leaving aside the riskiness of high deficits and debt to the stability of our entire economy, there’s at least the objective and easy-to-quantify cost of the compounding interest on the added debt.

So what if every time a deficit-financed spending program or tax cut is proposed, the CBO puts a “price tag” on it that is not just the standard legislative cost of the spending or tax cut, but the gross-of-interest amount, maybe under various assumptions about how long paying down that debt will be put off? Just for example, if the Bush tax cuts that President Obama wants to extend (all but the top two brackets) are extended and deficit financed (as the President proposes, and remember, these Bush tax cuts are exempt from Obama PAYGO rules), the gross-of-interest “price” would not be “just” $2 trillion over ten years, but maybe over $5 trillion over ten years if you count the compounded daily interest and assume the paying down of principal doesn’t begin for 20 years. (I got that by assuming a 5 percent annual interest rate, but you can play around with different rates and terms using this handy dandy compound interest calculator here.)

In other words, this would spell out for people–the politicians and ordinary citizens alike–that a deficit-financed tax cut today just means a several-fold tax increase (on our kids) later. And the later “later” is, the larger the “multiplier” on that future tax increase (or spending cut).

I guess this seems the opposite of the “dynamic scoring” of tax cuts that some conservatives who embrace supply-side economics advocate as a way of reducing the officially-scored costs of tax cuts. But if deficit-financed tax cuts were to be truly “dynamically scored,” not only would the direct costs of compound interest count against it (which is all I’m here suggesting be added to the “price tag”), but the adverse effects of reduced public and national saving on economic growth would raise, not lower, the costs.

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