Tax credits tied to productivity can solve information problem

In my last column, I set forth arguments against tax credits that are used to entice specific companies to locate in a city such as Columbia.
The available evidence indicates that the local economy does not experience faster economic growth by using this so-called economic development policy. Indeed, the more credible evidence suggests that providing tax credits has deleterious effects on the local economy.
Tax credits need not be tied to industrial policy. Economic research explains how using a tax credit for a given income tax rate structure raises economic output by linking the credit to productivity. By solving a basic information problem, a tax credit induces workers to reveal their true productivity. Greater productivity responding to the tax credit raises total output.
However, the resulting income tax rate structure, with tax credits tied to productivity included, will most likely be regressive. Here, the term regressive refers to a tax structure in which the total income tax rate declines as reported income increases.
So, though the output gain is economically more efficient, the regressive income tax structure is politically unattractive.
Let me start by offering the economic rationale for tax credits. A necessary condition for the credit is an income tax. Suppose that no one can directly observe another person’s productivity. In other words, managers cannot discern between the underlying talents of two workers who produce the same quantity of goods and services. Accounting systems are designed to measure output per worker. Owners, however, cannot tell if Bob is extremely talented and hiding it or producing at his maximum efficiency. Hence, productivity information is hidden, and that problem leads to an inefficient level of output. It is impossible to identify two pieces of information, both productivity talents and effort, from one observation.
The inefficiency is an example of what economists call a market failure. Some will have the knee-jerk reaction that this market failure should be addressed by the contract between the company and the worker. For purposes of this argument, I am assuming that the company has developed the best contract possible, and I’m taking the tax rate structure as given. Any improvements, or efficiency gains, therefore, owe to changes in government policy.
Tax credits can effectively address the hidden information problem in the following way. By offering a tax credit, there is an incentive for the worker to reveal his or her true productivity talents. The argument is quite simple. Managers who know the true productivity talents of workers will observe that Bob’s productivity level rises. (Bob is very talented.) When his productivity increases, his wages will rise. Bob naturally cares about his after-tax wages. With the existence of the tax credit, he is willing to reveal his productivity talent and will work harder, which reflects his reaction to the higher after-tax wage rate offered.
Tax credits are one answer to this information problem. The argument made in the previous paragraph is a simplified version of research produced by Professor Narayana Kockerlakota and others.
The tax credit is a policy variable that lowers the income tax rate and thereby induces very productive people to reveal their true abilities. Because these productive people see their after-tax income go up, it becomes worth it to them to produce more goods and services. By creating the correct income tax structure, the government creates the right incentives for workers to reveal their “true” productivity levels, and society gets the efficient quantity of goods and services. The government can either set the income tax at the beginning or provide tax credits to those who reveal their high productivity through the normal reporting channel.
Thus, we have a case for tax credits. Rather than rewarding particular industries to influence their location decision, these tax credits are tied to those whose productivity is most valuable in the economy after their productivity has been revealed. Because the value of the worker’s marginal productivity, in practice, this means that the highest income earners would receive this type of tax credit. Or, the income tax structure could be regressive.
If we have to have an income tax, then it is reasonable to examine how the income tax rate interacts with the problem that no one can see a worker’s true productivity level. This hidden information problem creates inefficiency in the economy measured by reduced output and employment.
Interestingly, a tax credit tied to productivity level — tax credits are larger the more productive a worker is — can be used by governments to address the hidden information problem. The upshot is that the “net” income tax rate structure will likely be regressive. This is what economic theory offers as a solution to the underlying problem.
For many, they will cry that such a policy is unfair. But economics does not speak to fairness. It is better at quantifying the cost accompanying alternative policies.