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Incentives and illusory tax cuts (What effect will Obama’s tax plan have?)

“Incentives are important.” It is one of those lines I use over and over in my class. It’s one of those keys ideas I stress with the hope (futile though it may be) that it will stay with my student beyond the end of the semester.

I won’t give my whole lecture, but a few details: People take actions which they believe will increase their own personal utility. Since most of us have utility functions which increase in wealth and decrease in work, you generally need to offer us compensation for labor. The more labor you want me to undertake the more you need to compensate me. So, most organizations offer a contract that either has an explicit bonus element or implicit element “bonus” such as continued employment to get the employees to overcome effort aversion. (If you are really interested, look up agency theory and information asymmetry. I can recommend a really good book.)

Now, these incentives can have value destroying ramifications for the organization if they are not well thought out. Examples are incredibly abundant, but the most recent one is the ACORN situation. While there are likely additional political issues, it appears that much of the problem stemmed from a contract in which the employees earned additional compensation for each new registrant combined with no oversight of performance. The result is easily foreseeable had anyone cared to think about it for a moment. If you want to consider a tax incentive, consider all those people who bought Hummers and got tax deductions because the Hummer was so heavy that it counted as a construction vehicle. Would they have all bought Hummers without the tax break? I know of several personally who could not have afforded otherwise. I am sure that is not what was intended when the law was written, but that is how it was used.

Why do I bring this up? Well, I want to point out a couple of articles on Obama’s proposed tax policy. Though the first is a tad more serious than the second, they both address the effect that Obama’s proposed tax policy will have on individuals’ incentives to work.

http://online.wsj.com/article/SB122385651698727257.html?mod=...

In particular, I would like to draw you attention to the graph in the first article (I would repost it here and save you the link, but I wasn’t sure how to get permission). Note that the marginal tax rate (the tax rate on the next dollar you earn) goes up for every income bracket. (The chart does make some assumptions such as having a child in college so that one can take advantage of Obama’s plan). The effect is particularly strong for those earn under $40k or more than $100k.

How can this be? Basically, the refundable tax credits Obama is offering phase out as income rises. Consequently, someone earning less than $40k would lose up to $.40 of every additional dollar earned.

Now, think about what that does to the incentive to work harder by taking some overtime, working a second job, or simply leaving for a slightly higher paying position. Those earning less will have a strong incentive to simply stop and allow the government to pay them.

And just for fun, consider the other end of the spectrum:
http://gregmankiw.blogspot.com/2008/10/blog-post.html

To some extent, the question of what is “best” here comes down to opinion about what you want to achieve. However, if you want encourage growth in the economy; it seems like a particularly bad idea to decrease individuals’ incentives to work. If you want to help out those who are less well off, it seems a particularly bad idea to increase their marginal tax rate.

I acknowledge the necessity of taxes to fund legitimate government endeavors, but we need much more careful thought about the incentives that any tax program will create.
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Jorge Montero
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That little graph isn't substantiated by anything said in the article. I find it hard to believe a graph like that without seeing some of its real assumptions, especially when it comes from a partisan think tank.

Which taxes increase so much as to double the marginal tax rate of someone doing 42K? Or the huge hike at 100K?
 
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thorndor wrote:
How can this be? Basically, the refundable tax credits Obama is offering phase out as income rises. Consequently, someone earning less than $40k would lose up to $.40 of every additional dollar earned.


So they earn $1 more, and lose $.40 of that dollar in tax credits.

They're still $.60 better off. How is that a disincentive?

There are reasons to argue against Sen. Obama's tax plans (I'd like to see some of them sunset as the environment changes - like the clean vehicle credits). It's also certainly valid to ask if they're all appropriate. But them as a disincentive to work? Not until the dollars result in net losses or very close to net losses.

Edit: The source of the graph is also a group that's not necessarily unbiased. Just as I don't trust either campaign's estimates for the real cost of their healthcare proposals, I don't trust these guys for tax rate analysis.
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GAWD wrote:

hey ... y'know what? I just got an idea ... Chad, Richard, et al ... I can save all you capitalist pigs the trouble by just sending you my bank account info: you can just wire me your redistributed wealth directly. devil

Dude, Chad willingly support Obama in paying more taxes for his higher income. I think that is to be respected.

So, be nice. Or he will have more disincentive not to work harder.
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perfalbion wrote:


So they earn $1 more, and lose $.40 of that dollar in tax credits.

They're still $.60 better off. How is that a disincentive?



It is a disincentive relative to where they are now. If you marginal tax rate increases it will decrease your incentive to work relative to your current situation.
 
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GAWD wrote:

I can't wait for my check ...

Perfectly rational at least in the short term.

GAWD wrote:

hey ... y'know what? I just got an idea ... Chad, Richard, et al ... I can save all you capitalist pigs the trouble by just sending you my bank account info: you can just wire me your redistributed wealth directly. devil

Actually, if we are going to redistribute wealth (which I am not completely against in all cases) this would be a far more efficient method.

GAWD wrote:

"From each according to his ability, to each according to his need" --Karl Marx


Why is it that so few are actually willing to think? The consequent changes in behavior that a Marxist system brings about are obvious. Why do we seem to keep coming back and trying to use the same old tired out unworkable solutions? It's like continually reinventing the square wheel (there's a Far Side idea for ya).
 
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Latria wrote:
GAWD wrote:

hey ... y'know what? I just got an idea ... Chad, Richard, et al ... I can save all you capitalist pigs the trouble by just sending you my bank account info: you can just wire me your redistributed wealth directly. devil

Dude, Chad willingly support Obama in paying more taxes for his higher income. I think that is to be respected.

So, be nice. Or he will have more disincentive not to work harder.

Latria and GAWD,
check this out from the Massachusetts state government's site:

"Recent legislation has also given taxpayers the opportunity to elect to voluntarily pay tax at a rate of 5.85 percent on taxable income which would otherwise be taxed at 5.3 percent."

Hehe, I laugh every April when I see that.
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Quote:
So they earn $1 more, and lose $.40 of that dollar in tax credits.

They're still $.60 better off. How is that a disincentive?


Assuming that the graph is unbiased and the professor is marginally intelligent, the answer is pretty simple: time is often as important as money. Sometimes it's even more important. Look at it from the perspective of a person earning $15 an hour and realizing that after a certain number of hours they are forgoing time with family (or whatever is important to them) for a net gain of $9 an hour.

I don't know about you, but my kids are worth a whole lot more than $9 an hour. The more money I could keep, meaning the more I could do for my family's economic well-being, the more I might have an incentive to spend extra hours working. It's a trade-off and not everybody is willing to trade time for a decreasing return.

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GAWD wrote:
Jorge you didn't read the article very well. Richard essentially summarized in his post what the article says about the graph here:


I am sorry, you didn't read my post very well. Read my second paragraph.

I'm talking about tax INCREASES. The article talks about new rebates that phase out, and that is well and good, but a new rebate disappearing would put someone at the exact same spot they are now, not higher.

Therefore, I wanted to know how in the world the tax rate can go up 20% without the increases.

Next time, I'd appreciate if you made sure you spend more time figuring out what I meant before doubting my reading comprehension.
 
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JoshBot wrote:
Latria and GAWD,
check this out from the Massachusetts state government's site:

"Recent legislation has also given taxpayers the opportunity to elect to voluntarily pay tax at a rate of 5.85 percent on taxable income which would otherwise be taxed at 5.3 percent."

Hehe, I laugh every April when I see that.


I assume you took the unpatriotic route. shake
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hibikir wrote:
GAWD wrote:
Jorge you didn't read the article very well. Richard essentially summarized in his post what the article says about the graph here:


I am sorry, you didn't read my post very well. Read my second paragraph.

I'm talking about tax INCREASES. The article talks about new rebates that phase out, and that is well and good, but a new rebate disappearing would put someone at the exact same spot they are now, not higher.

Therefore, I wanted to know how in the world the tax rate can go up 20% without the increases.

Next time, I'd appreciate if you made sure you spend more time figuring out what I meant before doubting my reading comprehension.



I apologize for not going into more detail about this in my post.

Part of Obama's tax plan includes refundable tax credits. A tax credit normally results in a dollar for dollar decrease in your taxes. For example, their used to be tax credits for money lost on renting low income housing (which lead to some screwy tax shelters). Refundable tax credits are ones in which the government will pay you for meeting the condition even if you didn't pay taxes. So, your actual taxes are negative. This sounds good esp for someone who meets the conditions to take advantage of the system.

Let's ignore arguments about whether the government should redistribute wealth. Let's assume it is going to happen and focus only on how it happens. Under Obama's plan the government will pay you only if you meet certain conditions. As you work harder (earn more), the government ceases to pay you. Again, on the surface this makes sense. Why would we want to help out someone who doesn't need it?

The problem comes in when we look at the individual making the tradeoff. Each additional dollar you earn costs you your government check. So, individuals have a higher marginal tax rate (even though their actual tax rate might be negative) and consequently a lower incentive to put in the extra work it would take to move themselves into the "don't need it" category. Given that people are generally effort adverse to begin with, the rational thing is to simply take the government payment and enjoy working less. While this may be a boon to the individual, it seems easy to foresee societal problems: decreased GDP, etc.

Notice I am not arguing against the idea of wealth redistribution. That is a bigger topic with more issues. What I am trying to point out here is that this particular means of wealth redistribution is going to have incentive consequences. In this case, the obvious first consequence is a decrease in work effort which will further harm the economy.
 
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The analysis links that Richard provided make sense. Especially when taken in context with this 2001 Obama interview:

http://boardgamegeek.com/thread/350819

Thanks to GAWD for that link.
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I have a problem with this thesis on at least two fronts (the second of which may not apply depending on details):

First - the relationship between reward and effort is not linear, or even the same from person to person.

Second - conceptualizing the tax credit as a "reward" is problematic unless it is applied directly to the paycheck. I'm not familiar enough with the plan to know that particular detail, so if it is you can ignore this one. However if the credit is applied to the tax return then its impact on effort will be negligible at best, as the relationship between the two is not salient for the bulk of the year.

-MMM
 
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It's moot, anyway, because Obama's plan won't survive the first ten minutes of his administration.

His team will suddenly "discover" that the word wealthy needs to be redefined in order to make it work, and the middle class will have to "contribute" more and spending won't be curtailed (unless he decides to not only end the war but gut the military).

When it comes to candidates and tax plans, they are telling people something they think people want to hear.
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Octavian wrote:
I have a problem with this thesis on at least two fronts (the second of which may not apply depending on details):

First - the relationship between reward and effort is not linear, or even the same from person to person.


This is, of course, true on both points. Generally speaking most people prefer more wealth but each additional dollar means less to them (you first dollar is very important you millionth not as much) and people prefer less work with each additional "unit" of effort being more negative (you first hour of work is easy the hundredth in a week not so much). Where the individual trades off one for the other depends on that individual's utility function.

What I don't see is how this affects the basic point: If you decrease the amount of reward I earn from each additional unit of labor (which is what the Obama plan does for many people), I will opt to work less than I otherwise would have. Just ask the kid who is mowing your neighbor's lawn for $20 to mow yours (of the same size and difficulty) for $12. Some kids will do it, but fewer than if you offered $16 or $18 or $20.

Octavian wrote:

Second - conceptualizing the tax credit as a "reward" is problematic unless it is applied directly to the paycheck. I'm not familiar enough with the plan to know that particular detail, so if it is you can ignore this one. However if the credit is applied to the tax return then its impact on effort will be negligible at best, as the relationship between the two is not salient for the bulk of the year.

-MMM


Your argument is that we can just fool people. That might be true for a year until people figure it out. I doubt it will take that long. As I said above, incentives are important. We act in ways they believe will increase our own utility. We aren't always smart about this and we have near term bias. Still, this isn't that hard to figure out. Certainly after the first year when my neighbor who goofed off gets a government check and I who worked over time don't, the point will sink in.
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Quote:
Certainly after the first year when my neighbor who goofed off gets a government check and I who worked over time don't, the point will sink in.


It might take a year for some, but a sizable number of those unimportant "middle American workers" are not dumb when it comes to personal finance. Take the example of the family with small children. The mother and father, if they are budget-minded will quickly figure out that increasing their income by mom going back to work will not be worth it financially.

Why not just take it easy, she stays home and they collect a large check come year end? Liberals ought to argue that such a scenario makes the "family values" mantra easier to satisfy.

For me, it would be real simple to "work" the system. I have one child who will be worth $$$ to me (tax-wise) for a minimum of 12 more years. By taking a fairly low-paying job I can collect someone else's money every year to make up the difference. On top of which, I can still sell on eBay, do odd-jobs for cash, do contract writing and let it go unreported, not claim poker winnings, and a veritable cornucopia of other income-producing activities that will be virtually 99.9999% off the radar.

One of the huge problems of the old tax system (1970's era) was the roughly 30% of income earners who just flat didn't pay. Didn't report,. Didn't do anything. The IRS would have to have hired a couple of million extra people just to try and identify them. Yes, it was estimated at 30% of the work force at one point that avoided any sort of income tax by just failing to report.

Now what would we have? Well, a system where not being on the radar is harder, but where faking out the radar is easier.

Whether you do or don't like the concept of income redistribution, the fact remains that when you start handing out money for just drawing breath there will be a giant sucking sound directly from the government coffers and into the pockets of folks who understand the way things really work on the street.
 
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Here's a pro-Obama economist's response, for the truly interested:

http://econ4obama.blogspot.com/2008/08/obamas-tax-plan-and-b...

Edit: And here, also, is their response to Mankiw:

http://econ4obama.blogspot.com/2008/10/greg-mankiw-tackles-t...
 
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thorndor wrote:
It is a disincentive relative to where they are now. If you marginal tax rate increases it will decrease your incentive to work relative to your current situation.


This argument doesn't hold water, though. For a retailer to sell an item for $100, he'll have to pay something like $65-75 in costs to acquire the item and run his store. Why isn't that a disincentive to run a store?

It's also worth noting that the tax rates we're discussing have to be the marginal rates actually charged before deductions. So the net impact will be less than the quoted figures. And at a 60% rate of return, it's not like it's wasted time.

And note that I'll likely be among those that see exactly those types of rates of return or see my taxes go up (variable compensation can be a bitch that way). I won't complain.
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DWTripp wrote:
For me, it would be real simple to "work" the system. I have one child who will be worth $$$ to me (tax-wise) for a minimum of 12 more years. By taking a fairly low-paying job I can collect someone else's money every year to make up the difference.


I'd really like to know how specifically you'd do that. You might bring in enough money to eke by, but you're certainly not going to break the bank and are very likely to hover around the poverty line.

Federal programs don't provide for much more than that, and neither do most state programs.
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travistdale wrote:
Here's a pro-Obama economist's response, for the truly interested:

http://econ4obama.blogspot.com/2008/08/obamas-tax-plan-and-b...


The funny part about this is that it agrees exactly with the point I am making. You just have to ignore all the bits about how anyone who bothers to point out that the real effect of Obama's tax plan is evil, liar, etc, etc. Oh, and you have to ignore all of the facts that are irrelevant to the discussion. Whoever the authors are seem to want to obscure the issue of marginal tax rate by discussing tax rates which actually a different issue.

I said above
thorndor wrote:
individuals have a higher marginal tax rate (even though their actual tax rate might be negative) and consequently a lower incentive to put in the extra work it would take to move themselves into the "don't need it" category.


There is no dishonesty in that statement. Your article makes a big point that people with lower incomes will be better off because the government will give them more money; that the Obama plan is more "generous". Let me expand my example above to illustrate the point.

Consider 2 situations:
A kid is earning $20 to mow a lawn and has the opportunity to mow another lawn for $20. The kid will weigh the benefits of $20 against the time and effort and decide whether to mow the additional lawn.

A kid is earning $20 to mow a lawn and has the opportunity to mow another lawn for $20. His grandmother is giving him $8 to help cover some expenses, but has said that once he is earning $40 she is going to use it for other purposes. Now, if the kid mows the next lawn the net gain will be $12.

Supporters of Obama and the article above will quickly point out that the kid in the second example is getting $28 and is therefore better off than the kid in the first example who is only getting $20. They are correct to do so: All else equal $28 is better than $20.

HOWEVER, the kid in the first example has a much stronger incentive to take on the additional job because the marginal value to him is $20 as opposed to $12. (I would have thought this sort of things would be easy for gamers to see, but maybe I play different sorts of games.)

Now, if the economy has a lot of people in this situation and many of them decide to take the money from grandma (Obama) rather than working the additional hours productivity will suffer. We as a society might decide that it is important to give money to those with less, but using the tax code to do it is rife with problems.
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perfalbion wrote:
thorndor wrote:
It is a disincentive relative to where they are now. If you marginal tax rate increases it will decrease your incentive to work relative to your current situation.


This argument doesn't hold water, though. For a retailer to sell an item for $100, he'll have to pay something like $65-75 in costs to acquire the item and run his store. Why isn't that a disincentive to run a store?

It's also worth noting that the tax rates we're discussing have to be the marginal rates actually charged before deductions. So the net impact will be less than the quoted figures. And at a 60% rate of return, it's not like it's wasted time.

And note that I'll likely be among those that see exactly those types of rates of return or see my taxes go up (variable compensation can be a bitch that way). I won't complain.


I am sorry you are having such a hard time understanding this. Possibly I am not communicating clearly enough and part of the problem may be in your misunderstanding of terms like "marginal tax rate". Please consider the example I posted just now about the kid in two different situations. The key is to consider changing from one situation to another. That should hopefully make things clear.
 
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thorndor wrote:
I am sorry you are having such a hard time understanding this.


I don't believe I've been condescending or snooty towards you. I'd appreciate it if you didn't take such an approach towards me.

Quote:
Possibly I am not communicating clearly enough and part of the problem may be in your misunderstanding of terms like "marginal tax rate".


I understand what marginal tax rates are, and don't appreciate the implied tone of your chosen language.

Quote:
Please consider the example I posted just now about the kid in two different situations. The key is to consider changing from one situation to another. That should hopefully make things clear.


I had just read your example and was about to reply to it. Perhaps I should do so in a way that implies that you're an idiot since you've chosen to do so in your response to me?

One presumes that the motive of the boy in your example is to maximize his income. In such an event, there is no possible permutation of the constraints you've detailed that mowing the second lawn would cause the boy to fail to do so by mowing the second lawn. Hell, he might even be able to take pride in the fact that Grandma ended up with $8 more to spend on herself. His profit margins are still intact, his net income increased, and he has made money. That he made less money than he might have with an unlimited subsidy is true. That this is somehow a problem is not.

We have had a progressive tax system that placed higher burdens on higher incomes for decades. This is an appropriate means of distributing taxation because it's probably not best for the nation to put people in the street with insufficient funds to feed themselves by taxing them to that point. Phase outs of credits, deductions, and things like the AMT do create breakpoints in our system that are artificial and occasionally make earning additional more expensive from an overall tax perspective than not. However, that is difficult if not impossible to avoid. At least, not unless you'll be designing a system that makes use of logarithms to determine final taxes.

Now I'm sorry that my suggestion that the marginal take-home after taxation of 60% that we're discussing is somehow still an incentive to go out an earn a buck strikes you as inappropriate. Given that the income levels we're talking about are approximately twice the poverty level, I suspect that the earners we're discussing will only be seeing an actual bump in the 5-10% range for their overall marginal tax rate and the "pain" won't be so pronounced. I'm also sorry that you've chosen to ignore the idea that this is a reflection of the raw tax rate and not the actual net tax rate after all deductions and credits (which often reduce the real tax rate by 40-60% for many filers in the income range we're discussing). So that 40% marginal rate is likely to translate into something closer to a 18-25% real rate.

But the idea that making a 60% profit on top of the annual incomes we're discussing for a very specific and carefully crafted example designed to find the "problem spots" in a proposed policy somehow gives the people earning that money a reason not to make an additional 60% minimum take-home pay (assuming zero deductions and other credits) is, frankly, ludicrous.

Should we be discussing Mr. McCain's tax plan that provides less benefit for this hypothetical couple making $40,000 in terms of raw rates, provides a larger break to those making $400,000 (which is unlikely to provide as much stimulus to our economy since we dervie 70% or so of our GDP from consumer consumption), and costs the nation more overall?
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thorndor wrote:

The funny part about this is that it agrees exactly with the point I am making. You just have to ignore all the bits about how anyone who bothers to point out that the real effect of Obama's tax plan is evil, liar, etc, etc. Oh, and you have to ignore all of the facts that are irrelevant to the discussion. Whoever the authors are seem to want to obscure the issue of marginal tax rate by discussing tax rates which actually a different issue.


Where do you get that they calling anyone evil? They use some mildly strong language, calling the piece they are criticizing "deeply dishonest," but this is backed up with some pretty reasonable factual analysis. Their criticism is of the article, not of the people that wrote it, and I'm not sure why you would characterize it otherwise.

It's true that they make no attempt to argue the point that the tax code creates disincentives to work. As they say, "that sort of observation won't win you the Nobel prize." What they argue is that the chart, which you highlighted in particular, is misleading, because it is a very special case, and doesn't reflect at all the effect on marginal rates for most families. Furthermore, the authors of the chart didn't source the numbers or detail the calculations involved, so a detailed analysis is impossible.

Second, you say that they are obscuring the issue of marginal rates. Aren't you also obscuring the issue of marginal rates by in the title of your post by referring to "illusory tax cuts." What is this phrase supposed to mean, other than to imply that people's after-tax incomes won't actually increase?

The real debate is whether or not the benefit of increasing the incomes for many poor and middle income families through Obama's tax plan is worth the possible effect of work disincentives arising from an increase in marginal tax rates. It's a debate worth having, but you can't have it without correct and complete analysis.


 
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Quote:
At least, not unless you'll be designing a system that makes use of logarithms to determine final taxes.


Now this is something that I could get behind.
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thorndor wrote:
Generally speaking most people prefer more wealth but each additional dollar means less to them (you first dollar is very important you millionth not as much) and people prefer less work with each additional "unit" of effort being more negative (you first hour of work is easy the hundredth in a week not so much). Where the individual trades off one for the other depends on that individual's utility function.


Actually, I was referring to psychological literature that suggests that increased reward can and does lead to decreased intrinsic interest in the work itself, which affects productivity.

I'm not arguing against the idea that rewards can be a motivational tool. But it isn't quite as simple as that either.

Quote:

Your argument is that we can just fool people.


No...my point is that, in many cases, rewards don't work that way. It's rudimentary behaviorism. Immediate feedback as a consequence of action is far more influential than feedback given once a year for an entire year's work. There is no doubt that some people can be disciplined to see the long view, but from a visceral (and motivational) stand point such a reward structure is not going to have much of an impact on most people's perceptions.

-MMM
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