Chapter 2 – Tools of Positive Analysis

1. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 2 – Tools of Positive Analysis Public Finance

2. Policy Analysis Is Hard • Why is it so hard to tell what’s going on with government actions? • Consider lowering income tax rates. Will lowering taxes 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.

3. 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.

4. 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

5. Table 2.1

6. 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.

7. Role of Economic Theory • Theory would suggest that person maximizes utility -- and would include factors like the person’s 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.

8. 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.

9. Methods of Empirical Analysis • There are three main methods: • Interviews • Experiments • Econometric studies

10. 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.”

11. Methods of Empirical Analysis • 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.

12. Methods of Empirical Analysis • 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.

13. Methods of Empirical Analysis • Econometrics – statistical analysis of data. • Effects of policies are inferred from the analysis of observed behavior.

14. 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. α0- α4 are the parameters, and ε is a random error.

15. Figure 2.1

16. 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.

17. Methods of Empirical Analysis • When α1=0, the net wage has no impact on hours worked. • When α1>0, the net wage increases work. Substitution effect dominates. • When α1<0, the net wage decreases work. Income effect dominates. • Presence of random error reflects influences on labor supply that are unobservable to the investigator.

18. Methods of Empirical Analysis • In practice, method does not always lead to conclusive results. • After α1 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.

19. 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 don’t always correspond to theory • Hours of work is not the same as “work effort.”

20. Recap of Tools of Positive Analysis • Role of Theory • Methods of empirical analysis