In the introduction we provided intuition on the meaning of an MVPF estimate. In this brief tutorial we explain how the MVPF can be used to compare the efficacy of different policies.
We begin with a simple example. Imagine that a government has decided to spend money on a new proposal. They are deciding between decreasing tax rates on the high earners or funding a job training program for young adults.
Let us assume that the high-income tax break has an MVPF of 2 and that the job training program has an MVPF of 1.5.
Why might the tax cut have an MVPF of 2? Because the reduction in taxes could cause high-income individuals to work more. In that case, recipients of the tax break would pay more in taxes and the government would recoup some of the cost some of its initial expenditure.
Why might the job training program have an MVPF of 1.5? Because the job training program could help raise worker wages. In that case, the trainees would benefit from the higher earnings and the government recoups some of its costs via higher taxes.
So, which of these policies should the government implement? The tax cut or the job training program?
That depends. The MVPF doesn’t tell us which policy to implement, it tells us about the tradeoffs between policies.
In this example, the MVPF tells us that implementing the tax cut will provide $2 for rich individuals for every $1 it costs the government.
The MVPF tells us the job training program will provide $1.50 for job training enrollees for each $1 it costs the government.
Citizens and their government must then decide how they feel about that tradeoff. Do they value $2 in the hands of the high income taxpayers more than $1.50 in the hands of low-income workers?
Or do they prefer to redistribute $1.50 to the low-income worker by taxing away $2 in benefits from the high-income worker?
The value of the MVPF is that it frames this tradeoff. It allows us to compare two very programs and weigh the relative value of each.
This previous example has demonstrated how the MVPF can be used to decide between two different types of spending.
The logic of the MVPF can also be applied to identify efficient ways for the government to raise revenue. This idea is best illustrated with a real-world example.
In 1993, President Clinton signed into law a major tax reform. The following two policies were key provisions of the bill:
An expansion of the earned income tax credit (EITC), a tax credit for low-income earners. This policy increased government spending.
An increase in the top marginal tax rate from 31% to 39.6%. This policy increased government revenue.
The MVPF helps us to evaluate the combination of these two policies. It helps answer the question: should the government have increased the EITC and paid for that policy by increasing top tax rates?
We begin by examining the MVPF of each provision
Research suggests that the MVPF of the EITC expansion was 1.12. In other words, if the government spent $1 on the EITC, that would provide $1.12 in benefits for EITC recipients.
(The benefits here are higher than the costs because the EITC helps low-income workers re-enter the workforce, pay higher taxes and receive less financial support from the government.)
Research also suggests the MVPF of the top tax rate increase was 1.85. In this case, raising $1 in government revenue from high income workers results in those workers losing $1.85 in benefits.
(This ratio is close to 2 because higher taxes caused high-income workers to earn less and, consequently, pay less in taxes.)
With these MVPF estimates, we can examine the effects of a combined policy that raises top tax rates and uses that money to fund the EITC. If the government takes away $1.85 in benefit from high earners, the MVPF tells us that will raise $1 in additional revenue.
The government can then use that additional $1 in revenue to provide $1.12 to EITC recipients.
In other words, this combined policy provides $1.12 in benefits to EITC recipients for each $1.85 in benefits it takes away from high earners. The MVPF measures the cost of redistribution from high-income to low-income Americans.
The key here is that, once again, the MVPF does not take a stand on whether the government should engage in redistribution. Rather it helps simplify that debate by quantifying the tradeoffs associated with such redistribution. It is then up to society to decide if that tradeoff is worthwhile.