Edward Prescott is the co-winner of the 2004 Nobel Prize in Economics. He shares the prize with his colleague, the Norwegian Finn Kydland. In addition to serving as the senior monetary adviser at the Federal Reserve Bank of Minneapolis, Prescott is professor of economics at Arizona State University and very much an iconoclast. Prescott and Kydland won this year’s Nobel for their work on the “time inconsistency problem” and business cycles. But these days the Nobel laureate is talking a lot about tax and work effort — much to the delight of supply side economists.

Just days after winning the Nobel, Prescott raised eyebrows when he called the President’s recently extended tax cuts too modest on CNBC. “What Bush has done has been not very big, it’s pretty small,” Prescott told the financial cable television program.

In an Op-Ed article in the Wall Street Journal recently, Prescott claims that there is substantial room for further tax cuts. (1) In making his argument, he draws on his own academic work on labor supply and tax rates. In a seminal paper published last February, Prescott found that Europeans work less than Americans for reasons that go beyond cultural differences and the mandated European 35-hour-work week.2 In fact, during the early 1970s Europeans actually worked slightly more than Americans.

Today, says Prescott, the lack of the European work effort is due largely to taxes. Europeans are taxed far more than their American counterparts and for that reason have a great disincentive to work. Europeans prefer leisure to work because the rewards of any extra work effort are taxed away. Because marginal tax rates in the United States are lower, Americans work 50 percent more than Europeans (See chart above). This is standard supply side theory: Taxes do matter and workers respond to incentives. Writes Prescott “The high labor supply elasticity does mean that . . . promises of payments to the current and future old cannot be financed by increasing tax rates…These promises can be honored by reducing the effective marginal tax rate on labor and moving toward retirement systems with the property that benefits on margin increase proportionally to contributions.”3

In this light, we must ask why the United States doesn’t further reduce tax rates and why it doesn’t reform social security by moving toward privatization. The conventional wisdom that opposes tax cuts suggests that any reduction in taxes would increase the federal deficit. In fact, Senator Kerry, leaning on economic advisors such as former Clinton Treasury Secretary Robert Rubin, argued throughout the campaign that the United States should raise taxes – preferably on the wealthy – to close the budget gap. Prescott considers this kind of thinking to be nonsense.

Using the only measure of debt that matters — the amount of privately owned government debt as a percent of national income (GDP) — we can see that the 1993 tax increase did little to stem the increase in debt. (See chart below) Only when the late 90s boom took off did the debt as a percentage of national income decrease.

(1)Edward C. Prescott, "Why Do Americans Work More Than Europeans?" Wall Street Journal, 21 October 2004, Sec. A. p. 18.
(2)Edward C. Prescott, "Why Do Americans Work So Much More Than Europeans?” Federal Reserve Bank of Minneapolis Quarterly Review 28, no. 1 accessed 29 November 2004 at http://minneapolisfed.org/research/qr/qr2811.pdf.
(3)Ibid., 11.

Sources for Charts: World Taxpayers Association, (http://www.worldtaxpayers.org/; Congressional Budget Office (http://www.cbo.gov)

*BHI Intern Carina Cilluffo assisted in the preparation of this article.

Posted on 01-Dec-2004 9:58 AM