Heuristics and Cognitive Biases in fiscal policy.

Synopsis: A bias has become evident in how governments tax and spend across most economies. Governments have increasingly focused on infrastructure such as roads and ports that create short-term jobs and do not cause people to develop advanced skills, indispensable for tech-related sectors. Rather than allow this bias to persist, policymakers should choose specific industries — such as automotive, industrial machinery, renewable energy, and pharmaceuticals — that will create sustained employment and up-skill the workforce and subsidize the wages in these industries. By reducing the cost of hiring new employees and training them, the government will create higher-skilled employment, wages will rise and tax revenues will equally follow suit. All this is only possible if fiscal policy prioritizes wage subsidies, infrastructure spending, and tax cuts continuing to play a limited role in other to support sustainable and inclusive economic growth.

Fiscal policy is defined as government spending, designed to support economic growth, higher levels of employment, and faster wage growth. In the last decade, countercyclical monetary policy has underpinned the broad consensus in economic thinking. However, fiscal policy has failed to achieve broader socio-economic objectives such as sustained employment and wage growth for workers. This is driven by biases in fiscal policy that advocate tax cuts and government spending in roads, ports, hospitals, and schools instead of advanced manufacturing in the auto sector, health care, and industrial machinery.

In addition to these regressive trends, fiscal policy has failed to account for the digital economy that is increasingly important to the global economy and has caused some countries to become and stay increasingly competitive. While some countries export agricultural products and crude oil, other export pharmaceutical and industrial equipment, software, vehicles, and electrical equipment. If the coming decade is to see protracted spells of sustainable economic growth, lower rates of poverty, and greater levels of higher-skilled employment; fiscal policy must begin to reflect the socio-economic realities as well as country-specific factors such as large informal sectors, exports of low value-added products and continued dependence on fossil fuels.

The climate catastrophe culminates years of environmental oblivion, as policy inertia and democratic muteness have allowed an unsustainable model of economic growth to persist. This ecologically damaging approach to economic growth is similar to attempting to move a car forward without a driver or a steering wheel. Whilst failing to steer government spending and debt issuances towards productive infrastructure that will create higher-skilled jobs across manufacturing, energy, and services, fiscal policy has adequately served as an automatic stabilizer during periods of macroeconomic stress. However, it has failed to form the basis of inclusive and sustainable economic growth.

A dominant narrative has emerged, clouding the level-headedness of mainstream economics! This can be termed a heuristic and before we continue, one should attempt to better understand what this means. A heuristic is a mental short cut that allows people to solve problems and make judgments quickly and efficiently.

Except, such decisions are not always effective as they can sometimes harbor grave implications. Take the economy; after a seemingly unforgettable WWII, the Bretton-woods agreement formed the basis for economic growth for the western world, culminating the formation of institutions such as the U.N, WTO, and IMF. These global institutions were the guardrails of global progress, supporting trade and the financialization of a now globalized world.

However, as the world seemingly progressed from barbarism — in rich countries only — governments had to design policies to support economic growth. This was quaintly termed — fiscal policy. The government adjusted spending on roads, waste management infrastructure, energy, and schools to create jobs and ensure people had money to spend. As economies became advanced with well-functioning electricity and water, hospitals to treat people and schools to ensure the population stayed educated, they had to create incentives for the private sector to create more employment, develop more competitive products such as iPhones, Spotify, electrical equipment and industrial machinery.

They resorted to — Reganomics — which includes cutting taxes and deregulating the economy to support and incentivize greater investments from businesses. This created some jobs in the late and early 2000’s to unprecedented levels, then the 2000 dotcom crash occurred and the 2008 great financial crisis followed suit. As technology became prevalent, manufacturing plants needed fewer people, companies needed fewer people as they automated their processes which were previously performed by humans.

If it took 200 people to make a car, technology made it possible to only employ 20 and maintain similar levels of output. Even as these trends became entrenched, policymakers continued to deregulate the economy and cut taxes. As they deregulated the economy, unions were banned in England causing workers to lose their rights. Working conditions plummeted and people’s wages began rising only slowly even as profits from these companies grew to unimaginable levels. Meanwhile, tax cuts did not cause businesses to invest in additional machinery as supply chains were controlled by robots and needed very few humans to do similar jobs. As such, tax cuts and deregulation caused employment in the short term, but the benefits do not outweigh the cost. In the 1950’s Nobel-Prize winning psychologist Herbert Simon suggested that while people try to make rational choices, human judgment is subject to cognitive limitations. These cognitive limitations have caused fiscal policy to continue to emphasize tax cuts and deregulation, even as the world is on the precipice of global catastrophe, highly indebted countries are unable to shoulder the health care needs of their citizens and individuals are increasingly poorer despite working longer hours. During the 1970s, psychologists Amos Tversky and Daniel Khaneman showed that biases influence how people think and the judgments they make.

The axiom that human judgment is flawed has never been truer. Policymakers have continued to cut taxes and deregulate the economy even as the externalities — negative impacts — have continued to mount. Note that this article does not argue against tax cuts or clever deregulation that will attract foreign direct investment and cause businesses to invest in a manner that creates sustainable employment.

As employment became precarious, people voted for populist outcomes to protest against a seemingly unfair system

As employment became insecure, policymakers failed to target specific industries that will create lasting employment and cause workers’ wages to rise on a sustainable basis. As economic hardship grew, the incentive to maintain the status quo grew inconsistent with workers’ expectations. The onset of populist outcomes is evidence of this across some advanced and emerging market economies. In other words, by failing to prioritize wage subsidies that would have enabled workers that previously lost their jobs to be retrained in higher value-added industries caused them to vote for populists leaders that only served to inflame discontent rather than pursue any credible policy changes. Not only would this have limited the negative socio-economic effects of technological disruption, but policymakers would also have targeted priority industries and cause them to become competitive. For example, 640 million Africans do not have access to electricity or do not have access to electricity and the per capita consumption of energy in sub-Saharan Africa (excluding South Africa) is 180 kWh, compared to 13,000 kWh per capita in the United States and 6,500 kWh in Europe. Access to electricity is not only crucial to educational and health outcomes but can also serve to reduce the cost of doing business and unlock economic potential in manufacturing, transport, and business services. Subsidizing wages in the renewable energy sector will go a long way to address power outages and create highly skilled jobs for installations, grid monitoring, and manufacturing of key components. As the governments deregulate and reform the power sector, reducing the cost of hiring new employees will cause wind and solar companies to hire more people.

By increasing the number of people employed in the formal sector, the government will also benefit from increased tax revenues. As such, the heuristics that have come to underpin fiscal policy must be shunned, to enable policymakers to prioritize sectors that will boost the productive capacity of the economy and create long-term sustainable employment.

Wage Subsidies will lessen the incentive for workers to vote for populist leaders

In advanced economies, wage subsidies can be used to ensure people are retrained in sectors that require higher levels of human capital such as machine learning, artificial intelligence, and advanced manufacturing. Such an approach would have averted populist outcomes that saw the emergence of Brexit in the U.K., Donald Trump in the U.S., and Victor Orban in Hungary. Policymakers should shy away from cognitive biases and reductionist fiscal policy. Some countries such as Britain have used apprenticeships to train young unskilled workers in advanced manufacturing in the auto sector, electronics, and aerospace. Such logical policies should form the basis of future fiscal policy, more so, for developing economies that are highly dependent on fossil fuels and export low value-added products.

Rather than rely on the biases that underpin tax cuts and deregulation as the only credible way to economic growth; targeting higher value-added sectors such as renewable energy, cloud computing, financial technology, construction, research, and development. This will cause employment to rise in the formal sector and standards of living for Africa’s growing youth will rise exponentially. Meanwhile, there is a clear incentive for governments to subsidize wages in sectors that will support economic development. As the number of software developers, researchers, scientist, administrative staff, and engineers rise, the revenues from taxes will equally follow suit. Furthermore, as more people become trained in these sectors, they are likely to find higher-paying jobs, which are usually reserved for engineers from advanced economies.

Debt levels will rise, policymakers should prioritize more productive investments

African governments will inevitably get highly indebted in the coming decade; it is imperative that additional debt is used to create lasting employment for the workforce that is increasingly employed in the informal sector. Africa’s debt has risen sharply in the last decade as investors around the world have swamped into developing and emerging market economies in search of higher yields. Between 2012 and 2017, domestic debt rose by 9% to 31%, while external debt grew from 14% to 23%, illustrating the need for lending to be re-directed towards more productive sectors. COVID-19 has caused policy rates in advanced economies to fall, which will see a recovery in inward FDI as the economic fallout from the virus wanes and economies reopen. The biases that underpin deficit-financed spending are accurate for developing economies, but rather than emphasize the nature of the debt, the quality of spending will determine the effectiveness of additional lending. It is not a difficult ask for governments to at once pursue development objectives of poverty reduction whilst placing the economy on a more sustainable trajectory by prioritizing high value-added economic activity. Placing debt on a sustainable trajectory, inclusive economic growth, and climate-centric policy are not mutually exclusive. Furthermore, this tenet is consistent with concerns on debt sustainability, that have come to underpin the African discourse, but placing debt on the sustainable trajectory is only possible with smart investments in energy, manufacturing, and services.

Africa will need to indebt itself in order to grow and 20% of the worth of global negative-yielding debt will cause FDI inflows

The IMF writes that 20% of debt across the world is currently yielding negative interest rates. i.e. earning no money. This means investor appetite will ultimately awaken and investments in cash-strapped developing economise will resume. Policymakers should ensure that inward investments are directed towards renewable energy, manufacturing, and services such as cloud computing, Fintech, data management systems, and software. Africa cannot grow without further indebting itself, unless “autarky” becomes the order of the day and evidence-based policy takes hold.

The narrative at the IMF and most multilateral institutions such as the Asian Development Bank and African Development Bank have changed to reflect the socio-economic realities that inevitably accrue to crises such as the COVID-19. Rather than tell governments to save and thereby spend little to nothing on their economies, it is now widely accepted that countercyclical fiscal policy can reduce the negative impact of a financial or economic shock.

It is now time to go further, fiscal policy can no longer emphasize tax cuts and deregulation as this is outdated and economically counterproductive. Policymakers must use a mix of wage subsidies, tax cuts, and deregulation to create sustained economic growth, employment, and prosperity. In doing so, not only do they increase the quality of their tax base, but they can also tailor investments in sectors that will cause the economy to grow at a faster pace and reduce the structural inequities that are inevitably latent in globalization.

The heuristics that have come to underpin fiscal policy have impeded economic development, stalled technological progress, and accentuated dependence on the informal economy. Economic logic suggests that wage subsidies will create better jobs, sustained increases in wages, and inclusive economic prosperity. Rather than overemphasize the role of tax cuts and deregulation, wage subsidies are a credible way to increase the value-added to both products and services produced in developing economies. A set of biases have to come to underpin the design and implementation of fiscal policy, but this need not be the case as the salience of smart investments and tech-centric growth can serve as the basis for inclusive economic growth and faster repayment of current debt burdens.

Reference List.

1). African Development Bank. (2020). Light Up and Power Africa — A New Deal on Energy for Africa

Written by

I am an economist and contributor to Nkafu policy, a think tank. I cover global economic, fiscal and monetary policy with policy and asset price implications.

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