Market Distortion: What It Is and Why You Should Care

16739137-abstract-word-cloud-for-market-distortion-with-related-tags-and-termsGovernment policies are rarely implemented unless there is already strong grassroots support for them. Policies usually start out as “good ideas,” and passionate individuals and/or groups promote them to government for implementation. Unfortunately, many well-intentioned policies end up causing more problems than they solve because of a phenomenon known as “market distortion.”

Market distortions are changes in behavior on the part of businesses, households, or individuals for the purpose of reducing their taxes, increasing their subsidies, or avoiding extra regulatory burdens. When a government decides to tax or subsidize a company, group of individuals, or a segment of the economy, it “distorts” the economic outcomes that would otherwise occur in a market free from such intervention because the affected humans simply change their behaviors to capture the subsidies or avoid the higher taxes or extra work.

The Affordable Care Act (ACA), often referred to as “Obamacare,” is a good example of a government policy where the policy makers failed to accurately predict market distortions.  The ACA created what has come to be known as the “Employer Mandate,” whereas employers with 50 or more employees are required to provide their full-time employees with government approved health insurance or face stiff penalties.  Ironically, the ACA defines a full-time employee as anyone working 30 or more hours.  This has resulted in many companies avoiding the hiring of new full-time employees if it means the company will be subject to the employer mandate.  Additionally, some businesses are reducing worker hours from 40 hours per week to 29 hours and hiring more part-time workers to avoid the employer penalties.  While reducing worker hours was never the intent of the ACA’s designers, the policy has resulted in a market distortion.

Ironically, the ACA has also experienced the opposite market distortion among workers whose employers do not offer health insurance.  Because the ACA provides subsidies to pay the health insurance premiums of Americans below certain income thresholds, it has become financially savvy for many Americans to lower their incomes to qualify for ACA subsidies by reducing their working hours or declining promotions that come with pay raises.  By offering subsidies, the policy makers have created incentives for many Americans to produce less in order to continue receiving government financial assistance.  This in turn skews income comparisons because it is hard to discern which Americans are in lower income brackets due to social obstacles like racism, poor education, or broken families, or because they have been incentivized by the ACA to work less.

A market distortion phenomenon that has been in the news lately is the tax inversion.  A tax inversion takes place when a corporation merges with an overseas company in a country with a lower corporate tax rate,  and then relocates the corporation’s headquarters to the lower-tax nation, usually while retaining its material operations in its higher-tax country of origin.  Public opinion has put tremendous pressure on U.S. policy makers to ensure wealthy U.S. companies pay their “fair share” of taxes.  This has resulted in America having one of the world’s highest corporate tax rates.  To avoid paying such high corporate rates, companies have begun to “invert.”  One such high-profile case is Burger King, who recently bought the Canadian coffee and doughnut chain, Tim Hortons, and is planning on moving its headquarters to Canada.  Analysts predict Burger King will save hundreds of millions of dollars by inverting.  While the purpose of the high corporate tax rates was to ensure American companies paid their fair share, what has actually happened is some companies have found a way to pay no U.S. taxes at all.  Some economists argue that a better way to increase corporate tax collections is to reduce the U.S. corporate tax rate to a level it encourages U.S. corporations to keep their headquarters in the United States.

I am not suggesting that because taxes and subsidies cause market distortions we should never use them.  It just means we should be mindful that anytime we implement a new tax or subsidy people will adjust their behaviors to avoid what they perceive as penalties and pursue what they perceive as benefits.  Therefore, we should do our homework to ensure the market distortions created by taxes and subsidies do not cost more than the benefits we are seeking.

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