The Subsidy Problem

Over on the New York Times' Economix blog, University of Chicago Economics Professor Casey B. Mulligan has a good post about how government subsidies go awry. In the piece, he considers the proposed job creation credit for business. It sure sounds like a great idea, until you think about how businesses will actually react to it.

Mulligan begins by lamenting the problem with arithmetic: total new jobs equals jobs at the end of the year less jobs at the beginning of the year plus layoffs/quits during the year. Thus, in a perverse way businesses have an incentive to lay people off at the beginning of the year and hire more at year's end.

Even if you net out layoffs, there's still a problem. Mulligan explains:

. . . another way a business could enhance its new-hires tax credit is to lay off more employees last year, or at least delay last year's hiring until this year.

In this case, anticipation of a new hires tax credit was actually making the economy worse before it made it better.

That's exactly right. If savvy businesses know that they'll get a tax credit in 2010 for new hires, they'd have a concrete incentive to lay people off in 2009. They could even hire fewer people back in 2010 than they laid off in 2009 and still be ahead of the game.

This is a problem for most government subsidies: there's usually a way to work the system, resulting in businesses or individuals behaving in a way the government does not want them to. Do businesses act this way because they're evil? Not at all -- they're just rational. You can't really blame them for trying to take advantage of obtaining as much free money as possible if Uncle Sam is handing it out. After all, that's in shareholders' best interest.

So what's the answer then? Does the government just sit back and watch unemployment climb higher? Not necessarily. As I've mentioned before, I think the government can do a lot to calm panic. That was its single most important function during the crisis. The stress tests and money market intervention aimed squarely at that target. Even the stimulus actions can help to restore economic confidence, since the country might believe the interventions will help. An action like a job creation credit could have a similar effect. Sure, some business will work the system, but many will not, and job seekers might even be less discouraged with the news that businesses have some incentive to hire.

As for the job creation credit, I have mixed feelings for precisely the reasons that Mulligan cites. In general, however, with subsidies or even broader government intervention, the trick, I think, is not to go too far: the government can also create a negative perception of the economy through its actions if businesses and consumers believe it is going too far.

The government can only do so much to restore economic health. In fact, it can probably do far less than policymakers like to believe. At some point the economy needs to heal on its own. Washington can't leave the training wheels on forever. The hard part is determining the right time to take them off.