Positive Policy Analysis Is Hard

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Positive Policy Analysis Is Hard

• Why is it so hard to predict what will happen
  when government changes a tax or spending policy?
  
• Textbook Example Will lowering marginal income
  tax rates increase work effort and labor supply?
• Unlike the physical and natural sciences,
  difficult to perform carefully controlled
  experiments on the economy.
• Oftentimes, there is no control group or
  comparison group for a policy.

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Alternatives to an Experiment

• Use of statistical tools to study impact of
  public policies.
• Will use the debate over the effect of taxes on
  labor supply to illustrate how positive analysis
  is done in public finance.

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Role of Economic Theory

• Consider analyzing Table 2.1
• As marginal tax rates have increased, average
  weekly hours have decreased from 1955 to 2001.
• Can we conclusively say that taxes have depressed
  labor supply? No.
• Nonlabor income rose (dividends, interest)
• Attitudes may have changed

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Table 2.1
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Role of Economic Theory

• In reality, an unlimited number of factors change
  over time, and could affect labor supply.
• Economic theory helps isolate a small set of
  variables that are important influences on
  behavior.

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Role of Economic Theory

• Theory would suggest that person maximizes
  utility -- and would include factors like the
  persons own wage rate.
• Theory is often too simple may ignore important
  considerations. But whole point of model
  building is to reduce a problem to its essentials.

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Role of Economic Theory

• In this labor supply case, the after-tax wage
  changes with the policy.
• Theory predicts that the effect on hours is
  ambiguous.
• The substitution effect predicts that as the wage
  (price of leisure) falls, consumers substitute
  toward leisure.
• The income effect says that if leisure is a
  normal good, consumers consume less of it as
  income falls.
• Only empirical work analysis based on
  observation as opposed to theory can answer
  this question.

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Methods of Empirical Analysis

• There are three main methods
• Interviews
• Experiments
• Econometric studies

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Methods of Empirical Analysis

• Interviews
• Most straightforward way to find out whether a
  policy will affect behavior is to ask.
• Reporters often do this.
• Pitfalls of interviews
• The fact that people say something about their
  behavior does not make it true.
• People may be embarrassed about the subject or
  have other agendas.
• Can only do limited number of interviews.

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Methods of Empirical Analysis

• Social Experiments Although difficult, it is
  not impossible to run policy experiments.
• Requires random assignment.
• Pitfalls of experiments
• Selection issues, even if initial random
  assignment.
• Subjects know they are in experiment.
• Cost.

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Methods of Empirical Analysis

• Laboratory Experiments some economic theories
  are tested in laboratory settings, often with
  college students. Similar approach as used by
  psychologists.
• Usually offer different rewards.
• Setting is artificial, however.
• College students not really representative of
  population as a whole.

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Methods of Empirical Analysis

• Econometrics statistical analysis of data.
• Effects of policies are inferred from the
  analysis of observed behavior.

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Methods of Empirical Analysis

• Choose specific algebraic form to summarize the
  relationship. For instance

• Where L is hours worked, wn is the net wage, and
  A, X1, and X2 are other factors that affect work.
  ?0- ?4 are the parameters, and ? is a random
  error.

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Figure 2.1
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Methods of Empirical Analysis

• Ignoring all of the other factors except for the
  wage rate, the goal is to fit a line through
  these data points.
• No straight line can fit through them, but the
  purpose of multiple regression analysis is to
  find the parameters that has the best fit.
• The slope of such a regression line gives the
  regression coefficient on the wage rate.

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Methods of Empirical Analysis

• When ?10, the net wage has no impact on hours
  worked.
• When ? 1gt0, the net wage increases work.
  Substitution effect dominates.
• When ? 1lt0, the net wage decreases work. Income
  effect dominates.
• Presence of random error reflects influences on
  labor supply that are unobservable to the
  investigator.

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Methods of Empirical Analysis

• In practice, method does not always lead to
  conclusive results.
• After ? 1 is estimated, its reliability must be
  considered. Is it close to the truth? The
  standard error indicates how much the estimated
  parameter can vary from its true value, and when
  the standard error is small in relation to the
  estimated parameter, the coefficient is
  statistically significant.

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Methods of Empirical Analysis

• Pitfalls of econometric analysis
• Heterogeneity across groups
• Changes in parameters over time
• Omitted variables bias
• Some variables, such as motivation, are
  inherently unmeasurable.
• Reverse causality (simultaneity)
• Observed variables dont always correspond to
  theory
• Hours of work is not the same as work effort.

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Recap of Tools of Positive Analysis

• Role of Theory
• Methods of empirical analysis