Economy, Domestic Economy

Making State Policies Work

Post-Doc and Teaching Fellow at Alzahra University
Making State Policies WorkMaking State Policies Work

Why do economic policies have adverse effects?  This question has engaged the minds of almost all concerned people over many years.

A constructive answer should convince free market advocates of the advantages of limited government intervention. This is because this debate has given rise to less fruitful answers and ended up with distorted arguments.

Consider the following example taken from a field experiment: a primary school’s problem of parents picking up their children late. The school is forced to play babysitter and asks an economist for help.

The obvious response of the economist is to fine the parents at fault. When the school adopts this policy, more parents deliberately arrive late for their children because the fine makes it “okay” to make the school fulfill this task.

 The school goes back to economists, most of whom argue that the amount of fine was not enough. In other words, busy parents think the fine totally worth it, as children are safe and there is no guilt involved since they pay for it.  

Even a sharp increase in the fine would have lowered the number of latecomers, but would never make them change their habit forever. In fact, it is difficult to determine the optimal amount of fine that could deter late parents but also retain the customers. This is not only because some parents can afford the hefty fine but also because they don’t know in advance that they will be late.

The same also happens at the macro level and this explains the adverse effects of economic policies. A government implements a policy to change public actions, but finds the initial response to be counterproductive. Well, this is partially because the public can see what the purpose of the policy is and they react to minimize the implied cost or maximize the implied benefit.

On the other hand, the policy is trying to target human behavior and humans don’t necessarily behave in the way assumed by economic models. Hence, the counterproductive response leads to jittery decisions by politicians, as they doubt the policy’s underlying principles and change their wordings and decisions altogether, which further harm the market.

For example, to achieve a balanced budget, President Hassan Rouhani’s government tried to increase revenues through taxes. The tax reform can be summarized by a 1% increase in VAT, the introduction of taxes on empty houses and increase in penalty rate from 10% to 30%, in addition to boosting the probability of audit.

As the Iranian tax system relies on filled tax return forms by businesses on the assumption of true declaration, the government intends to increase revenues by going to workplaces and calculate the tax based on the available information.

As this tax calculation is not based on true profits and solely depends on the perception of the revenuer, it has given rise to a lot of complaints and the subsequent parliamentary questioning of Ali Tayyebnia, minister of Economic Affairs and Finance, which mollified the lawmakers.

In response to tax reform during a recession, some businesses opt for temporary closure. This leads to an increasing number of vacant shops and a large number of layoffs.

This is because businesses struggling to finance current expenditure are waiting for a pretext to close the whole business and changes in the tax system create the required incentive. At the time of recession, the government should follow the exact opposite path and provide tax breaks. This is because the closure of businesses means the whole economy is missing the return on investment by these businesses and more unemployed people on the dole will further suppress the economy. As a result of closures, government tax revenues also decline.

Even if the government wants to change the policy when its adverse effects become evident, it is not possible to do so in the short run. Changes in government budget, for instance, require time to go through the parliament and go into effect only when they are approved.

Thus, it is the matter of knowing the conditions of the economy in advance, a grasp of how major economic variables play out and predicting how individuals will react to them. So when the government estimation tends to be incorrect, it should avoid myopic  intervention and enforcement to achieve a change. How people feel about the authority has a huge bearing on their reaction.

Hence, instead of jumping into the fray and declaring that we will control a particular trend, the government can be more transparent and elaborate on the reasons why their forecast was wrong. The government should make the environment conducive for the desired public behavior by injecting confidence into the mrkets.