Understanding
Incentives in Economics: 5 Common Types of Economic Incentives
What Is the Definition of
Incentives?
In the most general terms, an incentive is anything that motivates a person to
do something. When we’re talking about economics, the definition becomes a bit
narrower: Economic incentives are financial motivations for people to take
certain actions.
What Is the Difference Between Extrinsic vs. Intrinsic Incentives?
There are two types of incentives that affect human decision-making: intrinsic
and extrinsic.
Intrinsic incentives.
Intrinsic
incentives come from within. That is, a person with an intrinsic motivation
wants to do something for their own sake, without outside pressure or reward.
The intrinsic incentive is that feeling of personal fulfillment and
satisfaction that people get from doing certain things, like learning a new
skill just for the fun of it.
Extrinsic incentives.
Extrinsic
incentives involve providing a material reward (like money) for accomplishing a
task or threatening some punishment for failure to do so. By definition, all
economic incentives are extrinsic motivations.
5 Common Types of Economic Incentives
The most common type of economic incentive system is payroll: A paycheck
motivates people to show up to work and perform their duties. Yet there are
other types of economic incentive structures as well. Here are five common
examples.
Tax Incentives. Tax incentives
—also called “tax benefits”—are reductions in tax that the government
makes in order to encourage spending on certain items or activities. Tax
incentives are often cited as a great way to encourage economic development.
For example, a common individual tax exemption in the United States is the
mortgage interest deduction, which ensures money paid toward mortgage interest
isn’t counted as taxable income. This incentivizes people to buy property. An
example of a corporate tax incentive is a government giving major companies tax
breaks in exchange for them building an office or plant in their city. This
type of tax incentive stimulates the economy in that area by empowering the
company to provide jobs, as well as make goods or services available for
purchase.
Financial Incentives.
A financial incentive is a broader term that encompasses any monetary
benefit given to a consumer, employer, corporation, or organization in order to
incentivize them to do something they might not otherwise do. For employees, a
financial incentive might include stock options or commissions that encourage
certain types of work (think of salespeople, whose commission is considered a
sales incentive). For customers, an example of a financial incentive is a
discount, like a buy-one-get-one-free sale, which encourages more spending
under the guise of saving.
Subsidies.
Subsidies are government incentive programs that provide set
amounts of money to businesses in order to help them grow. Agricultural
subsidies are common in the United States, with the federal government giving
farmers billions of dollars both to farm more of certain products and to reduce
their outputs in times of surplus. Agricultural subsidies aren’t the only type
of U.S. government subsidy, of course. Other types of government subsidies
include oil, ethanol, export, environmental, housing, and health care.
Tax rebates.
Tax rebates are incentives to take certain actions, like investing in
solar energy, for example. In the case of renewable energy tax rebates, a state
or local government offers a certain amount of money to consumers to purchase
more environmentally-friendly methods to generate electricity. For instance, a
city might offer any homeowner who pays to install solar panels on their roof a
check for $1,000.
Negative incentives.
Negative economic incentives, or disincentives, punish people
financially for taking certain actions. This is a way of encouraging specific
actions without making them compulsory. For example, the Affordable Care Act
was designed with a built-in negative economic incentive called the “individual
mandate,” which penalizes anyone who doesn’t buy health insurance with a
monetary fine at tax time.