Why much of what we're told about taxes is off beam

There are lots of ways to describe the subject matter of economics, but the ponciest way is to say it’s about “the study of incentives”. It’s true, but a less grandiose way to put it is that conventional economists are obsessed by prices and not much else.

If you’ve heard someone being accused of knowing “the price of everything, but the value of nothing”, that phrase could have been purpose-built for economists. Read on and you’ll see why economists so often make bad predictions and give bum advice.

The early weeks of most courses in economics are devoted to explaining the economists’ version of how markets work. How the demand for a particular good or service interacts with the supply of the particular item to determine its price.

Over time, movements in the price act as signals to both the buyers of the product and its sellers. A rise in the price tells buyers they should use the now more-expensive product less wastefully, and maybe start looking for some alternative product that’s almost as good but doesn’t cost as much. On the other hand, a fall in the price tells buyers to bog in.

To the sellers, however, the price signals sent by a price change are reversed. A price rise says: this product's now more profitable, produce more; a fall in the price signals that supply is now less profitable, so produce less.

You can see how changes in the price act as an incentive for buyers and sellers to change their behaviour.

You see too how, following some disturbance, this “price mechanism” acts to return the market for the product to “equilibrium” – balance between the supply of it and the demand for it. It sets off what real scientists call a “negative feedback loop”: when prices rise, it acts to bring them back down by reducing demand and increasing supply; when prices fall, it brings them back up by reducing supply and increasing demand.

Note that all this is about changes in relative prices – the price of one product relative to the prices of others. It ignores inflation, which is a rise in the level of prices generally.

The way economists think, taxes are just another price. And there’s no topic where people worry more about the effect of incentives than taxes – particularly the effect of income tax on the incentive to work.

Consider this experiment, conducted in 2018 by two (married) economists from the Massachusetts Institute of Technology, Esther Duflo and Abhijit Banerjee, with Stefanie Stantcheva of Harvard. Duflo and Banerjee were awarded the Nobel prize in economics in 2019.

The three surveyed 10,000 people from all over America, asking half of them questions about how people would react to several financial incentives. Half of these respondents said they expected at least some people to stop working in response to a rise in the tax rate, and 60 per cent expected people to work less.

Almost half of the 5000 respondents expected the introduction of a universal basic income of $US13,000 ($17,000) a year, with no strings attached, to lead people to stop working. And 60 per cent thought a Medicaid program (providing healthcare for people on low incomes) with no work requirement would discourage people from working.

But here’s the trick: the economists asked people in the other half of their 10,000 sample the same questions, but how they themselves would react, not how they thought other people would. Their responses were significantly different, with 72 per cent of them declaring that an increase in taxes would “not at all” lead them to stop working.

As Duflo and Banerjee summed it up in their book, Good Economics for Hard Times, and in an excerpt in the New York Times, “Everyone else responds to incentives, but I don’t”.

It’s possible those people could be deluding themselves – after all, most people believe they’re not influenced by advertising, when it’s clear advertising works – but in this case the hard evidence shows financial incentives aren’t nearly as influential as is widely assumed.

The first place to see this is among the rich. “No one seriously believes that salary caps lead top athletes to work less hard in the United States than they do in Europe, where there is no cap. Research shows that when top tax rates go up, tax evasion increases . . . but the rich don’t work less,” they say.

And we see it among the poor. “Notwithstanding all the talk about ‘welfare queens,’ [and the use our Morrison government has made of similar talk to justify keeping the JobSeeker dole payment low] 40 years of evidence shows that the poor do not stop working when welfare becomes more generous,” they say.

“When members of the Cherokee tribe started getting dividends from the casino on their land, which made them 50 per cent richer on average, there was no evidence that they worked less.”

It’s true that in many circumstances – but not something as deeply consequential as decisions about how much work to do – differences in prices will influence the choices people make. In a supermarket, for instance, many shoppers will reach for the cheaper jar of peanut butter.

But when we’re making decisions about bigger and more consequential issues – such as whether to work and how much of it to do – monetary incentives such as the rate of tax on it, go into the mix with a multitude of other, non-monetary incentives.

Such as? “Something we know in our guts: status, dignity, social connections. Chief executives and top athletes are driven by the desire to win and be the best. The poor will walk away from social benefits if they come with being treated like a criminal. And among the middle class, the fear of losing their sense of who they are,” Duflo and Banerjee conclude.

Why do economists so often make bad predictions and give bum advice? Because they keep forgetting that a model of economic behaviour that focuses so heavily on prices leaves out many other powerful incentives.

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Boards and managers responsible for reducing banks' value

Too few of us realise it, but we should thank God (and my new best friend, Peter Costello) for our independent central bank. Prime ministers and treasurers seem to say little that’s not point scoring, and Treasury is now highly politicised, but we can always rely on Reserve Bank governors to be frank about what’s happening in the economy and what should be happening.

Last week the latest of our straight-shooting governors, Dr Philip Lowe, offered his conclusions on the shocking revelations of the banking royal commission. His wise words are worth recounting at length, to be sure you don’t miss them.

As Lowe reminds us, finance is all about trust. The first line of the voluntary “banking and finance oath” (which more bankers should now be taking) says “trust is the foundation of my profession”.

Australian banks have a strong record of being worthy of the trust that is placed in them to repay deposits, but in other areas trust has been strained.

The royal commission has highlighted three issues where work is needed to restore the public’s trust. First, Lowe says, “the inadequate way in which banks have dealt with conflict of interest issues”.

Second, “the way that poorly designed incentive systems can distort behaviour – promoting a sales culture at the expense of a service culture, and promoting the short term at the expense of the long term”.

Third, “the fact that the consequences for not doing the right thing have, in some cases, been too light”.

Central to fixing these breaches of trust is creating a strong culture of service within our financial institutions, Lowe says. This starts with correcting the system of internal reward established by the board and management.

“The vast bulk of the people who work for Australia’s financial institutions do want to do the right thing, and they do want to serve their customers as best they can. But, like everybody else, they respond to the incentives they face.

“If they are rewarded on sales or short-term objectives, it should not come as a great surprise that that’s what they prioritise.”

In the minds of economists, incentives can be negative (sticks) as well as positive (carrots). “One of the things that influences incentives is the consequences and penalties that apply when something goes wrong.

“Strong penalties can play an important role in incentivising good behaviour, and this is an area we should be looking it.”

But it’s worth distinguishing between the penalties that apply for poor conduct and those that apply for granting loans that can’t be repaid, Lowe says. “On conduct issues, we should set our expectations and standards high, and if they are not met the penalties should be firm.”

With bank lending, however, it’s trickier. “Even when banks lend responsibly, a percentage of borrowers will end up in financial strife and be unable to meet their obligations.

“We need banks to be prepared to make loans in the full expectation that some borrowers will not be able to pay them back."

Get this: “Banks need to take risk and manage that risk well. If they become afraid to lend simply because of the consequences of making a loan that goes bad, our economy will suffer.”

So it does seem true that Lowe fears the banks will overreact to the punishment and tighter regulation imposed on them following the royal commission’s findings, and that this could lead to them crimping economic growth.

(Just how concerned Lowe is about this is something the media can only speculate about. Top econocrats will always be sotto voce, for fear a loud shout of warning may be self-fulfilling. The media trumpet dire predictions because they don’t imagine anyone will take them seriously.)

Back on the public’s trust, having clear lines of accountability can help. But “we should not lose sight of the fact that it is the banks’ boards and management that are ultimately responsible for the choices that banks make. Creating the right culture is a core responsibility of boards and management.”

One thing that would help, Lowe says, “is for financial institutions to a have a long-term focus and reflect that in their internal incentives. Managing to short-term targets might boost the share price for a while, but this short-termism can weaken the long-term franchise value of the bank.

“I would argue that the franchise value is more likely to be maximised if our financial institutions have a long-term perspective, treat their customers well, reward loyalty rather than take advantage of it, and invest in systems and technology that deliver world-class financial services . . .

“Doing this would not only be good for bank shareholders, but also for the broader community.” Well said.

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We should rescue economics from the folly of neoliberalism

There's no swear word in politics today worse than "neoliberalism". It's badly on the nose, and the reaction against it has a long way to run. But what is it, exactly? Where does mainstream economics stop and neoliberalism begin?

The term means different things to different people. Professor Dani Rodrik, of Harvard, says in the Boston Review the term is used as a catchall for anything that smacks of deregulation, liberalisation, privatisation or fiscal (budgetary) austerity.

I've always thought of it as a fundamentalist, oversimplified, dogmatic version of conventional economics, one from an elementary textbook, not a third-year text that adds the complications of market power, externalities​ (costs or benefits not captured in market prices), economies of scale, incomplete and asymmetric (lop-sided) information, and irrational behaviour.

Rodrik's conception of the term isn't very different. He thinks mainstream economics needs to be rescued from neoliberalism because, as people heap scorn on it, we risk throwing out some of economics' useful ideas.

Which are? That the efficiency with which an economy's resources are allocated is a critical determinant of its performance. That efficiency, in turn, requires aligning the incentives of households and businesses with "social" costs and benefits (so as to internalise the externalities).


That the incentives faced by entrepreneurs, investors and producers are particularly important when it comes to economic growth. Growth needs a system of property rights and contract enforcement that will ensure those who invest can retain the returns on their investments.

And that the economy must be open to ideas and innovations from the rest of the world. Of course, economies also need the macro-economic stability produced by sound monetary policy (low inflation) and budgetary sustainability (manageable levels of public debt).

Does all that smack more of neoliberalism than mainstream economics to you? If it does it's because mainstream economics shades too easily into ideology, constraining the choices that we appear to have and providing cookie-cutter solutions.

"A proper understanding of the economics that lies behind neoliberalism would allow us to identify – and to reject – ideology when it masquerades as economic science. Most importantly, it would help us develop the institutional imagination we badly need to redesign capitalism for the 21st century."

There's nothing wrong with markets, private entrepreneurship, or incentives, Rodrik says, provided they're deployed appropriately. Their creative use lies behind the most significant economic achievements of our time.

The central conceit and fatal flaw of neoliberalism is "the belief that first-order economic principles map onto a unique set of policies, approximated by a Thatcher-Reagan-style agenda" – also known as the "Washington consensus".

Take intellectual property rights. They're good when they protect innovators from free-riders, but bad when they protect them from competition (as they often do when the US Congress has finished with 'em).

Consider China's phenomenal economic success. It's largely due to its orthodoxy-defying tinkering with economic institutions. "China turned to markets, but did not copy Western practices in property rights. Its reforms produced market-based incentives through a series of unusual institutional arrangements that were better adapted to local context," Rodrik says.

Some may say China's institutional innovations are purely transitional. Soon enough it will have to converge on Western-style institutions if it's to maintain its economic progress. Well, maybe, maybe not.

What neoliberal proponents of the single route to economic prosperity keep forgetting is that none of the economic miracles that preceded China's – in South Korea, Taiwan and Japan – followed the Western formula. And each did it differently.

Even among the rich countries we see much variance from the neoliberal cookie cutter. The size of the public sector, for instance, varies from a third of the economy in Korea, to nearly 60 per cent in Finland.

In Iceland, 86 per cent of workers are in a trade union; in Switzerland it's 16 per cent. In America firms can fire workers almost at will; in France they must jump through many hoops.

Rodrik repeats an old economists' saying, one forgotten by the neoliberal oversimplifiers. "Good economists know that the correct answer to any question in economics is: it depends."

It depends on the particular circumstances, on how well your economic "institutions" (laws, official bodies, norms of behaviour) fit with those the model assumes to exist, on what you're trying to achieve, on your priorities, and on the political constraints you face.

As the Chief Scientist, Dr Alan Finkel, said when asked if he preferred his own emissions intensity scheme to Malcolm Turnbull's national energy guarantee: "There are a lot of ways to skin a cat."

Economics has many useful insights to offer the community. It must be rescued from neoliberalism because neoliberalism is simply bad economics.

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Metrics-obsessed managers must be careful what they wish for

In decades to come, when the history of business endeavour in the early part of the 21st century is written, I predict it won't be kind to the great management fad of "metrics".

When you look at the terrible mess the Commonwealth and the other big banks have got themselves into, it's hard not to suspect that misuse of KPIs – key performance indicators – and incentive pay do much to explain their predicament.

It's not that I'm against measuring what can be measured about the activities of businesses. As a lifelong bean-counter, I'm a great believer in measurement as an aid to decision-making and accountability.

And it's certainly true that the digital revolution has made it much easier and cheaper to measure multiple dimensions of a business's activities.

No, the problem is the naivety with which so many top executives have leapt into the metrics fashion, seeing it as a magic answer to their management task, a simple and easy way to incentivise their troops and ensure they're all working to further the company's greater good.

Their trouble is that their inexperience in the measurement business stops them understanding its awesome power. Measurement's immense power for good – or ill.

Its ability to keep the business surging forward, or running off the rails. Indeed, its ability to convince you you're going great guns until the very moment disaster looms.

Use metrics as a substitute for thought rather than as an aid to hard thinking and there's a high chance it'll bring you undone.

The slogans of the metrics brigade say "you can't manage what you don't measure" and "what gets measured gets done".

Trouble is, that latter slogan is more a warning than a promise. The psychologist Martin Seligman observes that "if you don't measure the right thing, you don't do the right thing".

The notion that you can't manage what you don't measure is a trap. A smarter conclusion is that "not everything that counts can be counted". Lose sight of that and you're headed for mediocrity at best.

Which brings us to the importance of motivation. Money-obsessed managers who see attaching money to performance indicators as the perfect way to ensure people are motivated to achieve the firm's goals have failed to think hard about motivation.

Like managers, staff have many motivations, only one of which is to make more money. But there's plenty of research evidence that money tends to overpower other motives – even such a worthy (and, to bosses, cheap) motive as taking pride in doing your job well.

Attach monetary rewards to some dimensions of a person's responsibilities but not others and just watch as the non-incentivated dimensions are pushed to back of mind.

Give a pep talk about how important those other aspects are, and you won't be believed. Money speaks louder than words.

Then watch as the extra-reward-for-effort mentality takes hold. I'll try harder for extra money but, if you're not offering extra, why would I bother? Do you take me for a mug?

Two academics at Macquarie University, Associate Professor Elizabeth Sheedy and Dr Lyla Zhang, conducted a lab simulation using 306 financial professionals recruited with help from an industry body.

Participants were asked to do some simple analysis and then make up to 60 decisions about buying securities, granting loans and underwriting insurance, all within company policies designed to control the amount of risk it took on.

These policies could mean that potentially profitable deals weren't pursued, or that time was "wasted" that could have been devoted to generating profits.

Participants were randomly assigned to five different groups, which varied according to how employees were paid – fixed, or variable according to profits generated – and whether managers emphasised making profits or controlling risks.

"We found that when people had variable payments that [were] linked to profits, their compliance with risk management was significantly reduced," the researchers found.

"When managers and co-workers were also profit-focused, compliance reduced even further. Interestingly, the variable payments did not produce significant increases in productivity" relative to participants on fixed pay.

"On the other hand, when participants were paid a fixed amount regardless of profit, compliance with risk management policies was higher, although still not perfect."

The researchers conclude that "since incentives structures that are profit-based have an adverse impact on risk compliance and do little for productivity, such remuneration programs should be reconsidered".

"Our research shows that it is difficult to have high rates of risk compliance in the presence of profit-based payments. Staff are likely to believe that profit-based payments signal the true priorities of the organisation and they modify their behaviour accordingly."

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Profit motive drives business to bend rules

Sometimes I think economists are people who believe fervently in private enterprise and the profit motive, but have never actually met a business person.

That doesn't apply to economists working for business, obviously, but it applies very much to the econocrats who give advice on economic policy and even, I suspect, academic economists.

Living in Canberra doesn't help.

One of the advantages of spending your entire career in the private sector, as I have, is that it disabuses you of the notion of business people as model economic agents rather than hugely fallible human beings.

The economists' neo-classical model has an anti-government ideology hidden within it, which leads economists working in the public sector to idealise business people. They're rational operators and when they seem not to be that's only because governments have distorted the incentives they face.

Business people rational? Oh, you mean like the bosses at Fairfax Media? You mean the period when we had chief executives in and out the door in the space of a year or so? The stories I won't tell.

Business people don't have any better fix on what the future holds than anyone else, so often make decisions that turn out to be dumb. But they'll often realise that long before they pull the plug. And when they do they invariably blame the economy or government policy.

The economists' model and methodology lead them to ignore all motivations bar monetary incentives. Since most people have plenty of other motives – worthy and unworthy – for the things they do, this leads the economists to a host of wrong predictions.

But business bosses – from big outfits or small – would have to be the most money-motivated among us. Success is judged by the size of your package (even if it leaves you with no time to spend the stuff). Managers learn when they realise their staff isn't as money-hungry as they are.

Public sector economists say they believe in the profit motive, but they have no conception of what a powerful force it is and what unpleasant surprises it can give you when you unleash it.

It turns business bosses into short-term maximisers, willing to risk their company's future to make a quick buck. Alan Greenspan confessed that "those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief".

Years ago economists realised that public companies have an "agency problem" because the incentives facing the agents of its shareholder owners (otherwise known as chief executives) can conflict with the interests of those owners.

The economists decided the answer was to use incentives such as share options and performance bonuses to align the interests of agents and principals. It's been downhill ever since.

Why? Because money-hungry managers haven't been able to resist the temptation to game the system. It has probably done more harm than good.

Business people are so motivated by the profit motive they're always looking for loopholes and bending the rules.

This year's revelations about the behaviour of seemingly respectable firms in the way they pay casual employees suggests they may even go further than that – and that the designated regulators are mighty slow in doing their job of policing the regulations.

The econocrats don't seem to have realised that when you give people a chance to put their hand in the government's pocket, they go as crazy as people who take home all the shampoo and soap sachets from the motels they visit.

In the rush to get new homes built before the goods and services tax was imposed on them in July 2000, punters pushed up home prices by a lot more than the 10 per cent tax they were avoiding.

For an example of business people doing crazy, destructive things to get into the government's coffers, look at the operators willing to risk the lives of the kids installing pink batts.

This kind of money-madness seems to happen every time the other-worldly econocrats persuade the government to "contract out" the provision of some government service and invite private businesses in on the act.

The latest is for-profit providers of vocational education exploiting the government's HECS loan scheme by offering students a free laptop if they sign up for dubious courses.

By now, such an outcome was eminently predictable. Government incentives often induce people, whether punters or profit-seekers, to do greedy, dishonest and even self-destructive things.

Working for government seems to convince economists that, if they couldn't only get to meet a business person, he or she would be a wonderful, caring human being.

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Econocrats propose same old answer to all problems

If Malcolm Turnbull wants policy reforms that make the economy more innovative and agile, he should think long and hard before accepting advice from the economists in Treasury and the accountants in the department of Finance.

If you want innovation and agility, the last people to whom you should look for help are the two professions that, in their approach to problems new or old, demonstrate minimal innovation or mental agility.

I wouldn't want to call them insane, but they certainly recommend the same solutions over and over, while expecting different results.

The trouble with both professions is that their expertise is so narrow: they know a lot about just one aspect of the problem and little about all the other aspects, which they tend to ignore - while failing to warn their clients to match their advice against the advice of experts in other areas.

In the case of economists, they know what the economy needs, but they don't know much about what the economy needs and, thus, how to go about getting it.

For instance, economists see consumption as "the sole end and object of all economic activity". So they're experts on consumption, are they?

Well, no, not really. They couldn't, for instance, tell you how to maximise the utility you derive from your spending on consumption. Not their department. Better to ask a psychologist.

Economists know that improving productivity is the key to achieving faster economic growth and ever-rising material living standards. In fact, in the long run productivity is "almost everything".

So, could you give us a list of 10 things we could do to lift productivity? Well, no, not really. We don't actually know much about how you get productivity, we just know it's a great thing to have.

Of course, we do know a key source of productivity improvement is technological advance. Great, so how does technological advance work? Sorry, we haven't studied it much. We did have a go at developing an "endogenous growth theory" in the 1980s, but we soon gave up.

So what exactly is economists' area of expertise? They'd never admit it, so I'll tell you: prices. They know heaps about how the price mechanism works (given a host of mainly unrealistic assumptions), but not much else.

To make it sound sexier they may tell you economics is "the study of incentives". But in the economists' lexicon, incentives is just a synonym of prices. That's because economics pretty much ignores anything that can't be quantified, so the only incentives economists are conscious of are monetary incentives.

This assumption - that the power of monetary incentives is quite unaffected any other motivations (e.g. Turnbull only knocked off Tony Abbott because prime ministers are paid more than ministers) - does much to explain why the solutions economists propose often work so badly, with so many "unintended consequences".

Note that, in the mind of an economist, things like taxes and wages are just prices. This does much to explain economists' apparent obsession with taxation. It's a government-controlled price that seems to have much to do with the things politicians worry about these days.

It's a way for economists to appear to have useful advice on problems they don't really know much about.

Q: How should we encourage people to work more? A: cut the company tax rate and the top rate on individuals.

Q: How should we encourage people to save more? A: cut the company tax rate and the top rate on individuals.

Q: How should we encourage people to invest more? A: cut the company tax rate and the top rate on individuals.

Q: How should we encourage innovation? A: cut the company tax rate and the top rate on individuals.

Q: How can we make the economy more agile? A: cut the company tax rate and the top rate on individuals.

In sum, their preferred advice on such questions is: get the [monetary] incentives "right" and stand back.

Anything more specific to suggest? Yes, prime minister. Increase the tax incentives for spending on research and development. Give more money to scientific outfits like the CSIRO.

But haven't you guys been advising governments for years to keep cutting R&D tax breaks and money to CSIRO? Yes, prime minister, but that was when we wanted to cut the budget deficit and didn't care how we did it. Then, we didn't give a stuff about innovation and agility.

How come your advice on tax reform invariably favours high income-earners? Because when you're giving advice on matters you don't know much about, it's much less critically scrutinised when it happens to favour the rich and powerful.

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KPIs a dumb way to encourage good performance

You've been doing good work lately, and the boss is thinking of acknowledging your contribution. How would you like to be thanked? With a bonus, or with some kind of award?

If you want the money rather than the glory you'd be in good company. That's how most bosses want their own good work rewarded (and arrange their compensation package accordingly).

And it's how almost every economist would advise your boss to reward you. But don't be so sure it is what you really want, what would yield you the most lasting satisfaction.

One of the big issues in business - particularly big business - is how best to motivate and reward good performance.

Since economics is defined by some economists as the study of incentives, you'd think this was right up their alley. But economics is so focused on monetary incentives that most economists tend to assume away any non-monetary motivations.

They'll tell you the best way to "incentivate" people is performance pay: promise them a particular bonus provided they meet the targets you've set on a few "key performance indicators". Apart from that, just pay the good performers more than the poor performers.

But there's a lot more to human motivation than that and, fortunately, some economists are starting to take a less narrow approach to the topic. One is Professor Bruno Frey, of the University of Zurich.

In a paper with Jana Gallus he discusses The Power of Awards and puts them into the context of other forms of reward. Money is obviously the most common form and it has the great advantage of "fungibility" - you can spend it however you choose. And it can be applied marginally - do a bit more, get a bit more; do a lot more, get a lot more.

A second form of reward is non-monetary, but still a material award: fringe benefits, such as a company car or a particularly attractive office. These have the disadvantage of lacking fungibility (I might prefer money to a car), but usually carry a tax advantage. Even a corner office brings me status that isn't taxed.

Money and cars are "extrinsic motivators" - you do a good job as a means to getting what you really want. The message is slow to get through to business, but among behavioural economists there's now more interest encouraging "intrinsic" motivation - you do a good job because it makes you feel good. You're good at what you do and you enjoy doing it. You like knowing you've done a lot to help your customers.

The way to foster intrinsic motivation is to treat your staff well, of course, but the key is to give people discretion in the way they do their jobs. It's the opposite of trying to tie them up with KPIs.

Frey and Gallus say awards fall somewhere between these two approaches - they're extrinsic, but often not material. They include titles, prizes, orders, medals and other decorations. They are ubiquitous in society, if not business.

They're widely used in public life (various ranks of the Order of Australia), the entertainment industry (Oscars, Grammys, Logies), journalism (Walkleys, journalist of the year), sport (Brownlow medal, Dally M medal, Olympic medals), academia (fellowships of prestigious scholarly bodies, honorary doctorates, Nobel prizes) and the Catholic Church (canonisation and papal knighthoods).

The point is that the many advantages of awards suggest they should be used more in the business world.

For one thing, they're cheap to confer, but highly valued by the recipient because of the recognition as well as status they bring - provided you don't give out too many, make them too easy to attain or award them to the clearly undeserving.

More significantly, they avoid the drawback of KPIs and performance pay. The authors say such inducements are appropriate only if the performance criteria are precisely determined and measured. But for many complex activities, this is  not possible.

If it isn't, KPIs encourage what social scientists euphemistically call "strategic behaviour" - gaming the system by performing well only on those dimensions that are measured.

Monetary rewards may reduce work effort by crowding out intrinsic motivation, training people to try hard only when there's money to be gained. Why spend time helping a colleague when this might help them achieve their KPIs at the expense of your own?

The authors say monetary rewards don't induce employee loyalty. They're a strictly commercial transaction. But awards do encourage loyalty, as well as intrinsic motivation.

Overpaid chief executives shouldn't assume their workers are as materialistic as they are, nor should they imagine their firm would do better if their workers' materialistic tendencies were heightened.

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Selfish pseudo-economics fights deficit levy

If you want to see a classic example of selfishness posing as high principle, look no further than the fuss big business's high income-earners are making over the deficit/debt levy/tax expected to be imposed in Tuesday's budget.

Jennifer Westacott, of the Business Council of Australia, said "raising Australia's already high dependence on personal income tax will place an increased burden on workers [note that word] and could weigh down an already sluggish economy. If we are serious about lifting our productivity and competitiveness, we should be lowering taxes, not increasing them."

Dale Alcock, of the home builder ABN Group, said the tax could dissuade people from working hard to earn more. The "government needs to get its own house in order first and get its government departments working efficiently. Once you've done that, then come back and talk to us."

Sound like a convenient argument to you? Now try this for logic: he would prefer an increase in the rate of the goods and services tax that, by its nature, raised revenue from wealthy, high-consuming individuals, as opposed to a class-based deficit tax.

So a tax increase paid by everyone would be preferable - why? Would it be fairer? Better for the economy? - to a tax limited to high income-earners.

Innes Willox, of the AiGroup business lobby, said the levy "will only serve to dampen our economy at a time when we need growth". A one-off debt levy on "people who are working, who are contributing to our economy, who are spending at a time when our economy is already fragile, we think is deeply problematic".

So what are you saying, Innes? Better to take money off people who don't work - say, the elderly, the unemployed, sole parents with little kids? People who don't work don't spend? People who spend don't contribute to the economy? I'm not following you.

According to the Financial Review, a senior Liberal figure, who did not want to be identified, said the tax increase was not just a broken promise but poor economics and an attack on the Liberal Party's base.

"We didn't vote for a f---ing Abbott government to increase taxes, did we?" he said. Ah, do I detect a note of self-interest creeping in among the high-minded concern for the health of the economy?

Trevor Evans, of the National Retail Association lobby, said the tax would reduce discretionary spending and damage economic confidence. "A debt levy, even a temporary one, on medium- and higher-income earners would damage consumer confidence at a critical time," he said.

Great argument, eh? Anything you don't like the sound of - especially since you and your mates will be paying it - is a bad thing because you just know it will wreck confidence. My old boss Vic Carroll used to speak with cynical amusement about the "easily frightened fawn of business confidence". Do anything business doesn't fancy and the economy will stop dead.

Speaking as one who's been on the top tax rate since 1982-83 - when it was 60 cents in the dollar, and stayed there for another three years - and escaped it for just one year, 2008-09, when Peter Costello's salary sacrifice superannuation rort was at its height, all this is self-serving rubbish.

Yes, as a failed accountant I do keep a record of income tax I pay, though it goes back only to 1969-70. And do you seriously believe being on the top tax rate has discouraged me from working hard or aspiring to be editor?

Do you think money's the only thing I get out of my job? Do you worry I might quit Oz to be economics editor of The New York Times or The Wall Street Journal? (Tip: not many vacancies in the Big Apple for people who think they're hot shots from Down Under.)

Do you think being on the top tax rate - and hence a pretty flash salary - has discouraged me from saving much in the past 30 years? Do you think my obscenely taxpayer-subsidised super payout won't be as big as a lottery win?

And though all my fellow victims on the top rate don't get the ego reward of having their opinions broadcast to the world, do you think senior executives, people in financial services, city lawyers, medical specialists and the like get no satisfaction from being a winner in the socio-economic status race, or from having kowtowing underlings to boss about?

As best I can determine from the leaks seeping under the door of the Prime Minister's press office, Joe Hockey plans to impose a 1 percentage point tax levy on the part of individual taxpayers' earnings that exceeds $150,000 - or maybe $180,000 - a year.

If so, someone on $200,000 is facing a punishing tax increase of $500 a year, or $9.60 a week. Really? That's what's going to destroy incentive, swell the brain-drain and foster rampant tax avoidance, not to mention stuff economic growth?

Estimates by Ben Phillips of the University of Canberra point to about 650,000 people earning more than $150,000 a year, making up the top 7 per cent of taxpayers.

If the threshold turns out to be the higher $180,000, this would affect 400,000 people, making up the top 4 per cent of taxpayers. (Note how quickly the number of people affected falls as you move further away from the median taxpayer's income of about $55,000 a year.)

What gets me in all the propaganda above is the evidence the disease of fiscal monoculism has reached epidemic proportions. This is the sickness that allows people to see only one side of the budget.

A budget deficit, for instance, can only ever be caused by excessive government spending, never inadequate tax revenue. And though an increase in taxes would kill consumer demand, equivalent cuts in government spending would have no adverse effects. Can't see it, myself.

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We risk letting lawyers stifle innovation

If our business people, economists and politicians are genuine in their desire to lift our productivity, rather than just moan about the Fair Work Act, they'll put reform of the regulation of intellectual property high on their to-do list.

Unfortunately, the minor changes to intellectual property regulation put through Parliament last week, to the accompaniment of great self-congratulation by the Gillard government, suggest the professed true believers in productivity improvement just don't get it.

If we're really concerned to encourage invention, innovation and creativity, nothing could be more central than the way we regulate intellectual property. But I get the feeling a lot of people have lost sight of what we're doing and why we're doing it.

So let's start with the basics. When governments grant patent or copyright protection they are intervening in the market to give particular individuals or businesses a monopoly over the commercial exploitation of that idea for up to 20 years.

When you've got a monopoly you're able to charge higher prices than if you had competitors selling access to the same idea. So why on earth would a government grant such favours?

Well, the rationale is to increase the monetary incentive for people to come up with inventions, innovations and creations that benefit the community. If I dreamt up some new thing, but other people were immediately able to copy it and compete with me, I wouldn't get much reward for my effort and ingenuity.

In which case, people like me won't be trying very hard to come up with new ideas. So the government grants inventors and creators a temporary monopoly over their idea to encourage more good ideas.

The point to grasp is that this approach involves a trade-off. The government imposes a cost on the community by effectively allowing rights-holders to overcharge for their products, but it does so in return for the greater benefits this brings to the community.

This suggests, first, that governments should never grant rights or enhanced rights to individuals and firms unless it's clear the granting of those rights leaves the community better off. Second, governments should always be checking to ensure the benefits to the public from the protection of intellectual property exceed the costs to the public of that protection.

Were the public costs ever to exceed the public benefits, the entire economic justification for the artificial creation of property rights would evaporate. It would be a classic instance not of "market failure" but "government failure".

The reason reform of intellectual property should be high on the productivity promoters' to-do list is that we seem to be drifting ever closer to the point where its costs exceed its benefits. That seems particularly true in the United States - and we look to be going the same way.

The US plays a pivotal role in the globe's intellectual property. It's at the frontier of technological change and creativity, and is a net exporter of intellectual property to every country in the world. Increasingly, intellectual property, designs for new machines, pharmaceuticals, electronic gadgets, films, TV shows, books, recordings and much else, is the main thing the US sells the world.

These days, making the world a safer, more profitable place for American intellectual property is the main objective of US trade policy - as we found when we negotiated the misnamed free-trade agreement with the US in 2004. We were pressured to make our laws fit with the Americans', and we'll get more pressure to become more like them in all future trade negotiations.

So what's the problem? Much of it is that the whole area has been taken over by lawyers. It's become hellishly legalistic, complicated, loophole-ridden and expensive. In the process, the lawyers have lost sight of the economic object of the exercise. It's become an area of endless battles between businesses arguing over their rights.

The other part of it is that powerful industry groups have taken to lobbying politicians to change the law in ways that advance their interests without benefit to the public. And US businesses increasingly engage in game-playing in the hope of ripping each other off.

American pollies are often persuaded to extend the life of intellectual property protection retrospectively, which obviously does nothing to encourage innovation in the past.

The patent system has been extended to cover software (which was already copyright) and even business methods. It's too easy to get a patent - you can get them for very obvious ideas - and patents can be too broad, covering yet-unthought-of uses.

You can get a patent for something that's very similar to someone else's patent. But because they're handed out so easily, you often don't know whether a patent is valid - whether his patent beats your patent - unless you spend between $5 million and $7 million battling it out in court. The high cost of litigation means big businesses regularly intimidate small businesses.

This problem of "fuzzy boundaries" to patents is so bad some businesses make a living as 'patent trolls' buying up dodgy patents, then threatening to sue legitimate patent-holders. The victim pays what amounts to protection money to avoid the higher cost of a court battle.

You've no doubt heard of the huge patent battle between Apple and Samsung being fought in courts around the world. Which side has the legitimate patents for tablet technology?

Pharmaceutical companies use a trick called "evergreening" to stop their patents expiring, which would have allowed competition from generic drug producers to slash the prices they can get for their drugs.

The owners of intellectual property rights often attempt to use them to protect themselves from losing business to firms developing more innovative ways of doing things.

Just as undesirable, researchers trying to develop better products can be held back by the prohibitions or high costs imposed by existing patent holders (some of which may not be legit).

It's got so bad in the US that, according to the calculations of a leading academic campaigner for patent reform, James Bessen, of Boston University school of law, for all US patents bar those for chemicals and pharmaceuticals, earnings from their patents are more than exceeded by the cost of litigation to protect those patents. He calls this a "patent tax".

If he's right, the intellectual property system has degenerated to the point where it's actually inhibiting innovation. We're being forced to pay higher prices, but getting nothing in return.

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Give and take: The new tax is a piece of cake

Years ago, the Keating government had a problem with pensioners wasting taxpayers' money on prescriptions. Knowing their elderly patients got their prescriptions free, doctors were happily issuing ones their patients might or might not end up needing and pensioners were taking them to the chemist and getting them filled, just in case. Many of these often very expensive drugs were not used.

So the government decided to impose a nominal fee on pensioner prescriptions of $2 a pop, just to make people think twice about whether they'd be needed. But, anxious though it was to save big money by reducing the waste of taxpayer-subsidised pharmaceuticals, the government had no desire to leave pensioners out of pocket. It worked out the average number of prescriptions pensioners had filled, multiplied it by $2, and increased pensions by that amount.

I dredge up this story because it may help you understand something about Julia Gillard's planned carbon tax that many people find puzzling.

If Gillard is imposing a carbon tax to raise the price of electricity and gas, with some flow through to the prices of other items, so as to discourage us from using so much fossil fuel, why is she undoing the effect by giving us back most of the tax we'll pay as cuts in income tax and increases in pensions and family benefits?

What's the point of this money-go-round, as Tony Abbott calls it? How can it do any good?

Though the carbon tax will raise about $9 billion a year in revenue, raising revenue is not its primary purpose. Rather, its purpose is to change people's behaviour. And one of the most basic ideas in economics is that the best way to change people's behaviour is to change the prices they face. If there's some activity you wish to discourage, raise its price relative to all the other prices people pay.

When, after a cyclone, the price of bananas shoots up relative to the prices of other fruit, people tend to buy fewer bananas and more apples and oranges. When the price of beef rises more than other meat, people buy less beef and more chicken.

The thinking is that if you raise the price of fossil fuels and emissions-intensive goods relative to the prices of all the other things people buy, they'll change their spending in ways that reduce the use of fossil fuels.

It's not necessary to leave people worse off to get them to change their spending patterns. And since the primary purpose of the carbon tax is to change relative prices rather than to raise revenue, you may as well return the revenue to people by cutting income tax and increasing benefits.

(You can't give back all the revenue because you're using part of it for other purposes, so you favour low- and middle-income households and let higher-income households take it on the chin. Since your calculations about how much the carbon tax will cost people are based on averages, and not everyone fits the average, you give low-income households a bit more than the average so fewer of them are undercompensated.)

Now, you may say finding ways to cut your use of electricity and gas isn't as simple as buying apples rather than bananas, and you'd be right. There are ways to reduce energy use around the house, but I suspect the main way people will respond is by buying a more energy-efficient model the next time they're replacing an appliance.

If you think no amount of energy saving in the home is likely to bring about the degree of reduction in fossil fuel use we needed to achieve, you'd also be right.

People have an automatic tendency to apply government moves such as this to themselves and their homes but, in fact, the relative price change is directed mainly at the big industrial users of electricity and, more particularly, the generators of electricity.

It's when their existing power stations come to the end of their useful lives and are replaced by less-polluting generators that the big steps forward will be made.

The government claims the changes it will make to the income tax scale - lifting the tax-free threshold from $6000 a year to $18,200 - is a major reform, meaning about a million people will no longer have to submit tax returns.

Tony Abbott counters that it's a terrible change: "This is the first time in a generation that marginal tax rates have been increased." The bottom tax rate of 15 per cent is to be increased to 19 per cent, and the second rate of 30 per cent increased to 32.5 per cent.

Both sides are playing on the public's ignorance of the complexities of the tax system, in particular the operation of the "low-income tax offset" of $1500 a year, which lifts the present effective tax-free threshold from $6000 to $16,000, but is then clawed back after people's incomes exceed $30,000 a year, at the rate of 4? in the dollar.

Under the new arrangement, this offset will be cut to $445 a year and its rate of withdrawal cut to 1.5? in the dollar. When you take this into account, Labor's grand reform becomes a minor reform. Most of the million people aren't paying tax under the present system, they just have to put in a return to claim the offset.

As for Abbott, the change will involve no increase in anyone's effective marginal tax rate. All it means is that the hidden 4 per cent rate at which the offset is withdrawn will no longer be hidden.

The carbon tax is neither as good as Gillard claims nor as bad as Abbott claims. Funny, that.

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Looking to Aristotle for a guide on reform

How things have changed. When I was growing up Labor portrayed itself as the party of reform, out to fix an unjust world. The Liberals were conservatives, satisfied with the world as it was and trying to keep change to a minimum. Needless to say, the Libs kept winning.

These days, however, both sides portray themselves as parties of reform. And the faster the world changes the more certain both sides become of the need for further reform - even if, as with Work Choices, the new lot's reform is merely to reverse the reforms of the previous lot.

There is one small problem with all this reform: it's not always clear the changes actually make things better. The pollies see things that aren't working well, make changes intended to improve the situation, but often don't succeed. Then they, or their successors, do more in the same vein or try the opposite approach, with neither seeming to work.

When politicians see institutions they think aren't performing - the health system, the education system, the courts, the banks - they tend to apply one of two tools. The first is to toughen up the rules and regulations governing the institution; be more explicit about what people are required to do.

The second is to sharpen the incentives (and disincentives) faced by people in the institutions. With private-sector institutions - banking, for example - the approach is usually to reduce government regulation and then rely on competition and the profit motive to improve performance.
With public-sector institutions - health and education, say - the approach is to impose numerical tests and targets (''key performance indicators'') and maybe introduce monetary rewards for good performance.

As the international experience with banking indicates, the reformers sometimes alternate between the two approaches when they find the other hasn't worked. After the Great Depression we tightly regulated the banks, but in the 1980s we decided they weren't performing well and the answer was to deregulate them. Now, after the global financial crisis, the world has swung back to thinking tighter regulation is the key to better performance.

A long memory, however, suggests it won't be that simple. Why is it that neither rules nor incentives seem to do the trick? And what else can we do that stands a better chance of working? Well, while I was away on holiday in Italy I read a book that offers some answers. It's Practical Wisdom, by Barry Schwartz, a professor of psychology at Swarthmore College in Pennsylvania, and Kenneth Sharpe, a professor of political science at the same college.

It's noteworthy that both approaches proceed from a low opinion of the people working in these institutions: they don't really care about their work. The notion that tightening up the rules will improve the performance of practitioners assumes they are dumb (they don't know the right thing to do) and uncommitted to doing their job well. The notion that introducing numerical targets and monetary incentives will improve performance assumes practitioners are lazy and motivated only by self-interest. Both approaches are top-down: the politicians know what should be done to improve the performance of the courts or whatever, and seek to impose their judgment on the practitioners.

That gives us a clue as to why neither approach is particularly effective. Both are demoralising - in both senses of the word. They reduce the practitioners' scope to exercise their discretion when objectives conflict (as they often do in this increasingly complex world) and the circumstances of individual cases differ.

This demotivates professionals as well as removing the moral element from their jobs. They become responsible for obeying rules or meeting targets, not ensuring the ultimate objectives are achieved.

Modern jobs are multi-faceted, with multiple objectives. Numerical targets and monetary incentive payments inevitably narrow practitioners' objectives and increase their focus on monetary rewards, driving out other motivations.

And when you eliminate the moral element you encourage people to try to beat the system. The more rules you make, the more you encourage demoralised workers to look for loopholes. The more you measure people's performance with numerical indicators, the more you encourage them to game the system. Whatever elements of their performance aren't covered by a performance indicator will be cannibalised to help achieve those you are measuring.

Under both approaches quantity improves at the expense of quality, partly because quantity is easy to measure and quality is hard.

So what's the answer? Schwartz and Sharpe say that, though we will always need rules and rewards in the running of institutions, increasing the emphasis on rules and incentives discourages and diminishes the third, more elusive element needed to make institutions work well: what Aristotle called phronesis and translates as practical wisdom.

People exercising practical wisdom use their skills and experience to achieve to the best of their ability the ''telos'' or true purpose of their activity. Practical wisdom involves finding the right way to do the right thing in the particular case you are dealing with.
People are motivated to exercise practical wisdom not to obey rules or increase their income but because they know it's the right thing to do, to benefit their students, patients, clients or customers and obtain personal satisfaction in the process. It's about intrinsic motivation - doing a good job for its own sake - rather than the extrinsic motivation of obeying rules or making more money.

Institutions would work better if, rather than discouraging practical wisdom by tighter rules and bigger incentives, they gave practitioners more flexibility to innovate, improvise and generally exercise their own judgment in doing the right thing by the individuals they help. Reformers haven't got far by assuming doctors, teachers, judges, public servants and the rest are dumb and lazy and must be compelled or bribed to do better. Why not assume the majority of these professionals want to do a good job and give them more scope to do the right thing in the right way?

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Gillard's Law of economics at a crass roots level

Frederick Taylor, the American inventor of "scientific management" a century ago, believed workers were dumb and lazy. So the tasks they were required to perform had to be broken down into the simplest of steps and they needed to be closely supervised. The only way to motivate them was by paying piece rates - what today we'd call "performance pay".

I'm sure Julia Gillard would never admit to regarding "hardworking Australians" as dumb and lazy. But she believes school teachers need to be spurred to greater effort by "a bonus payment under a new performance framework".

This is in addition to her plan for rewards of up to $100,000 to the 1000 schools that each year show the most improvement in attendance, literacy and numeracy or, in the case of high schools, year 12 results and the number of students going on to further education, training or work.

Top performers, about 10 per cent of teachers, would receive annual bonus payments of between $5400 and $8100, determined by the achievement of their students, their contribution to the school community and their participation in extracurricular activities.

I doubt the wisdom of this idea. I can understand why company boards feel they need to pay executives extra money to get off their backsides but teachers are meant to be professionals and it's a strange way to treat professionals.

Gillard professes to hold teachers in great respect (do I feel an election coming on?) but I suspect many of them would be amazed to hear it.

It's said the one thing economists agree on is: incentives matter. Trouble is, most economists assume the only incentives that matter are monetary. It wouldn't occur to them that offering teachers money for "contributing to the school community" contains a contradiction.

Teachers contribute to the school community and take part in extra-curricular activities because they want to. I've seen teachers putting extraordinary amounts of their time and effort into preparing kids for a school play, coaching debating teams and so forth. They do it because they regard the activity as worthwhile and of benefit to their kids, but also because they enjoy doing it.

It would be nice to think these intrinsic motivations - doing things for their own sake - could be pepped up by adding money (an extrinsic motivation, where you do things because of external benefits they bring). That's what economists assume can be done. Gillard, clearly, has started thinking like an economist.

But as I discuss in my new book, The Happy Economist (Allen & Unwin), psychologists have discovered it doesn't work that way. Economists have something called Gresham's Law: bad money drives out good. It turns out monetary motives drive out non-monetary motives.

Once you start paying people to do good works the selfish, materialist mentality takes hold and they stop doing those things unless they're paid. People who did good works because it made them feel good about themselves no longer feel that way. Those who contribute to the school community without winning a bonus may be discouraged in their well-doing.

So, should this scheme be implemented, don't expect a surge in School Spirit (as it was called at my school) and don't be surprised if it leads to a decline in teachers' second-mile contributions.

If I'm right, we will have discovered Gillard's Law.

This crass attempt to motivate teachers is symptomatic of the election campaign. More than ever it's been obsessed by money: budget deficits, public debt, wasteful spending. The only major non-monetary issue has been our intense objection to foreigners entering our territory without permission.

Both sides conduct their campaigns on the assumption we're quite selfish and mesmerised by money. For individuals, both sides have rolled out monetary bribes: cash for clunkers, higher family benefits for the parents of teenagers, incentives for age pensioners to do paid work, a more generous paid parental leave scheme. For marginal electorates, a new road or building.

Although it's been hidden by the negativity of this campaign and its obsession with budgeting, the underlying assumption of both sides is that the job of governments is to continually raise our material standard of living because this is what will make us happy.

They seem oblivious to the evidence, recounted in my book, that decades of rising living standards have done nothing to increase people's happiness or "subjective well-being".

It's time politicians reached a more enlightened view of what they could do to increase national happiness. They could start by rethinking their attitude to work.

The economists' model assumes we work only for the money it brings us. The rationale for Work Choices was: give employers more freedom to hire and fire, to call people in to work at times when it best suits the business without penalty payments, and the greater efficiency with which labour is deployed will raise our material standard of living to the benefit of all.

In truth, most people gain a lot of satisfaction from their work. That satisfaction can be diminished if people become less secure in their jobs and in the hours and days of the week they'll be required to work. An understanding of this seems implicit in Labor's opposition to Work Choices and in Tony Abbott's promise not to reintroduce it.

But why not make that understanding explicit? If work is a primary source of our happiness - as the evidence says it is - why not encourage employers to see the provision of secure, satisfying work as an end in itself, a primary reason for the existence of the business?

Why not help employers see that happy workers contribute more to the success of the business (or the school) - as the evidence increasingly says they do?

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