Edward Prescott, PhD, and Norwegian-born Finn Kydland, PhD,won 2004's $1.3-million Nobel Prize ineconomics. Dr. Prescott is a decided promoterof tax cuts. In his view, PresidentBush's tax cuts should have been evenbigger. The Bush tax cuts are the typeof event that Drs. Prescott and Kydlandtheorize affects business cycles, sincelower income tax rates provide greaterincentive to work. According to theNobel laureates'hypothesis, realchanges due to outside forces (eg, oilprice spikes) and innovative technologies(eg, the Internet) have a greatereffect on business cycles than changesin demand. This position puts the pairin opposition to the dominantKeynesian theory of economics, whichholds that fluctuations in demand,whether positive or negative, are thedrivers behind business cycles.
The Nobelists'arguments could alsoaffect government policy. Their thesisadvocates that governments stick tolong-term economic rules rather thanseeking short-term fixes. For example,if the goal is to tame inflation, theFederal Reserve should hold back oncutting interest rates when the economyfalters. Even if the result is a short-termrise in unemployment, the economywill be better off over the long haulbecause it avoids the rampant inflationthat was the hallmark of the 1970s.
The effect of taxes on the incentive towork also has implications for the currentdebate on Social Security. Dr. Prescottpoints out that Americans work 50%more hours than the Germans or theFrench and attributes the difference tomarginal tax rates, which are far lower inthe United States. Trying to fix SocialSecurity by raising the tax rate will resultin fewer hours worked, which in turn willcut into any increased revenue from thehigher Social Security tax. The solution,Dr. Prescott says, is to encourage morework hours by lowering the effectivemarginal rate of taxes and developing asystem whereby retirement benefits arelinked more closely to actual contributions(ie, a privatized Social Security systemthat would turn payroll taxes intoindividual retirement contributions).