What equality-efficiency trade-off?

Lorenz-curve-inequality-worsening

As my online debates with ‘well-trained’ economists continue with full force I will again use this blog as an outlet to expand on arguments that can’t be made in 140 characters or less, or those that simply attract religiously-held views via comment pages.

On Facebook an otherwise innocuous comment, that it is “undeniable there is an equity-efficiency tradeoff” really leapt off the screen at me. Why would a sophisticated economic analyst make such a strong statement that has little to no empirical support. Could it be that this little book has had such an enduring impact on the discipline?

What is rarely taught in the haste for economics departments across the Anglosphere to pump out energetic graduates are the numerous build-in assumptions of the core models that lead to this apparent trade-off. Nor are alternative models presented that parcel together different, and often more realistic assumptions, and arrive at far different conclusions.

In simple terms, the reason such a trade-off exists in economic models is because it is assumed that society is already at the production frontier and that any efficiency-increasing policy has already been undertaken. It’s a bit like saying once there are no win-win policies for equality and efficiency left, then there become a trade-off between them. Well, obviously. But that’s not real life, and we know that as soon as we leave this theoretical frontier almost anything goes (the theory of the second best).

To be more concrete, if there really is a real life equality-efficiency trade-off at a broad level, then there should be no single regulatory change that can increase both equality and efficiency, since if there exists such a reform, or set of reforms, it negates the entire aggregation to a macro level trade-off. Nor should you be able to simultaneous decrease efficiency and equality, as this leaves the door open for reversals of such policies.

An alternative, and my preferred, way to approach such problems is to consider the set of institutions that lead to the current level of equality as a whole. The evaluate the costs of these institutions against alternative institutions that result in greater of lesser equality.

Now one might interject at this point and say that the shifting nature of equality is a product of technology change, education or some other such thing. I’ll leave it to Matt Bruenig to address this point

When we talk about how economic changes, technological swings, and even education will affect the distribution of income in society, we always sort of assume away our government’s distributive policy as if it will or must remain static. But that’s not true at all. At any time we can change the huge set of policies that direct the distribution of income in society to something else.

The last few decades of median income stagnation didn’t have to happen. Even if you say it was caused by international competition or technological change or whatever else, the point is that if we had put a different set of distributive institutions into place, we could have avoided the maldistribution of income that we have seen. It is not like the median incomes stagnated because the economy as a whole stagnated. Quite the contrary: the economy is much larger on a per capita basis now than it used to be. If we had wanted to make sure median incomes continued to rise, we could have done that. We would have just needed different distribution policy.

Let us now consider a couple of important cases in the set of reforms that, by most estimates, would increase both equality and efficiency.

First is shifting the tax base to land (and other resource monopolies). This is probably the simplest in terms of administrative simplicity, and the one reform that would have the greatest efficiency boost and equality gains. Unfortunately it is also the one reform that, by virtue of its distributional impact, is the least palatable to the wealthy and therefore the least palatable politically.

The reason for the win-win nature of land taxes is that deadweight losses from taxation are reduced, increasing efficiency, while at the same time the tax will fall on those entities with the largest ownership claims to the natural wealth of a country.

The second case is actually any of a suite of investments that can be undertaken by government which would benefit the poor to at a higher proportion than their wealth. I’m thinking here of, say investment in a fibre optic communications network to all homes, or public investments in parks and community services in poorer neighbourhoods, or any number of things. These investments would then be provided free of charge or at token prices.

The policy space is vast, and economic thinking often limits it. Consider the case of gifts of land and accessible government-backed construction finance to households on low incomes. Such a scheme would provide the poorest in society an asset they can use to support themselves – to borrow against, to invest in, as a cushion in times of financial distress. We did it once before, with the soldier resettlement programs, for slightly different reasons.

In the case of Australia I might even suggest intervening in currency markets to keep the AUD low and foster local investment.

That’s a nice handful of policy ideas that appear to negate the apparent ubiquitous equality-efficiency trade-off.

Why do these ideas still hold so much sway? Why do we teach that the usual case is for a trade-off, when it is equally valid to teach that the usual case that there is no trade-off? Why constrain the thinking of graduates in this way?

I can’t provide a complete answer to these questions now. I can only do my part to expand the thinking of receptive readers of this blog.

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Comments

  1. “..The last few decades of median income stagnation didn’t have to happen… we could have avoided the maldistribution of income that we have seen. … We would have just needed different distribution policy.” Beautifully put; and the answer in part, is so obvious “..The reason for the win-win nature of land taxes is that deadweight losses from taxation are reduced..” But we have the barrier of “..economic thinking often limits it..”
    A good post, dampened by the notion that “..I might even suggest intervening in currency markets to keep the AUD low and foster local investment.” Forget the intervention bit! Get the macroeconomic settings right, and the currency will look after itself. That’s what December 1983 was all about….

    • Rumples and Janet are exactly right. Rebase taxation off wages and business onto land. There’s $70-80 billion recurring in removing deadweight losses (KPMG Econotec). I’d call that a 5 per cent boost to GDP, available tomorrow.

      Some cretins think bad tax bases confer advantage. Applied economy-wide they just create a mis-shapen and mal-formed future. We know Thalidomide is disastrous in pregnancy. Why do we drink it like water?

  2. Excellent points. Land taxes. Investments in infrastructure that everyone benefits from.

    Any increase in successful rent-seeking increases inequality and reduces economic efficiency at the same time. This is appallingly little understood by the great mass of both left and right wing opinion holders.

    One point about inequality and income redistribution. The point about broadband investment already applies to most government spending.

    Most poor people have already had tens of thousands of dollars worth of benefit paid for by “rich people”; their education, their health care, the roads they travel on, the national defence system, the police, etc etc.

    It is a bit OTT to expect “the rich” to kick in for a bit of “income equalisation” as well on top of what they are already doing.

  3. Curiously well-timed: via a tip in an email just received:

    “When is inequality harmful? When it’s caused by cronyism”
    BY TIMOTHY P. CARNEY | DECEMBER 6, 2013

    http://washingtonexaminer.com/when-is-inequality-harmful-when-its-caused-by-cronyism/article/2540338#.UqXUA2Zs7Tk.twitter

    “……Sutirtha Bagchi of the University of Michigan’s business school and Jan Svejnar of Columbia’s School of International and Public Affairs studied how inequality correlates with economic growth. In general, more inequality meant slower growth, and less inequality meant faster growth.

    But in many countries, over various time periods, growing inequality had no effect on economic growth. The new study suggests that an increase in inequality hurt the economy when the rich were getting rich through political connections.

    That is, inequality hurts the economy when “a large share of the national wealth is held by a small number of politically connected families,” as the authors put it.

    It’s a subjective distinction, but Bagchi and Svenjar took pains to classify political billionaires as narrowly as possible. Just being politically connected wasn’t enough to earn that label. Simply profiting from government policy didn’t trigger the designation. The political billionaires were only people who “would not have become a billionaire in the absence of political connections that resulted in favoritism and/or explicit government support.”

    For instance, Indonesian businessman Prajogo Pangestu is a political billionaire because the government-owned bank extends him loans on absurdly generous terms and the state erected tariffs to protect his business from competition.

    Or here’s a Wall Street Journal account of Russian Mikhail Fridman: “[Fridman was] among a handful of businessmen who helped to finance Boris Yeltsin’s re-election campaign in 1996. The Kremlin rewarded these men by selling them state-owned oil and metals companies at bargain-basement prices.”

    Contrast these men to America’s richest people. Bill Gates and Warren Buffett haven’t abstained from politics (Buffett is an Obama fundraiser), but they overwhelmingly made their money by inventing well and investing well.

    When a country’s wealthiest people got their wealth as Pangestu and Fridman did, inequality places a drag on the economy. When a country’s wealthiest got wealthy through market means, the resulting inequality has no negative effect on economic growth…..”

  4. A glaring example of successful economic rent-seeking and reduced economic growth, is in the consequences of urban planning policies.

    Excellent sources of analysis on this are:

    the McKinsey Institute report, “Driving Productivity and Growth in the UK Economy” (1998);

    Alan W. Evans’ “Economics and Land Use Planning” (2004);

    Evans’ “The Best Laid Plans” (2007);

    and a whole series of papers from the London School of Economics “Spatial Economics Research Institute”; Paul Cheshire, Henry Overman, Chris Hilber, and colleagues. The SERC Blogspot is worth following. A useful (but now out of date) LSE summary paper is “What we Know (And Don’t Know) About the Links Between Planning and Economic Performance”.

    There are a few obvious reasons for this erosion of productivity by growth-containment urban planning, even as the rentier class creams it, with the price of urban land increasing some hundreds of times per square foot.

    1) increased congestion

    2) businesses inability to afford “space” for efficient processes (eg workers crowding each other, stock on shelves being less accessible, aisles narrower, production lines too cramped)

    3) “anti-competitive” effects: including a reduction in new business start-ups

    4) reduced agglomeration economies via sub-optimal average city size (more, smaller cities are less efficient than fewer, larger ones)

    5) reduced agglomeration economies via spatial “clustering” of the Silicon Valley type; potential new participants are excluded even before such a cluster has even started to form; there is either no spare land at the location, or it is far too expensive.

    6(a) loss of the efficiency inherent in “splatter” growth patterns, where the best use of land via infill development is better discerned after some development has already occurred in the vicinity, and where infrastructure provision is cheaper and more efficient due to the low cost of land and the availability of space as growth occurs.

    6(b) the cost of disruption and the cost of land acquisition and the cost of legal processes in already-dense built areas, leading inevitably to a serious infrastructure deficit.

    7) “pricing out” effect leading to reduced efficiencies of co-location of households with jobs and amenities

    8) productive physical capital starved of investment finance

    9) interest rates higher than otherwise; exchange rate higher than otherwise

    10) social pathologies, workforce dissatisfaction, increased local pollution, low housing quality effects on health.

    Australia! You have been warned!

  5. “10) social pathologies, workforce dissatisfaction, increased local pollution, low housing quality effects on health.”

    Great article and yes on no. 10. PhilBest, not sure if you have a useful literature source?

    One thing though is that equality and equity are often used interchagably but they’re two different things (don’t want to sound like I’m teaching anyone to suck eggs). Pareto efficiency is where you get as much efficiency as possible without making anyone else worse off (equity in a way).

    Any inequitable policy is giong to pi$s people off. Pis$ed off populace are not going to be inclined to play by the rules, make productive contributions to society etc. etc. Why is that so underappreciated? It is normally a footnote or a ‘qualitative’ factor in a CBA.

    Transfers to get Kaldor–Hicks efficiency are hard to do in practice.

    I’m not looking forward to Australia becoming the next US. Well, we’ve always got the option of moving the family to NZ.

    • NZ is heading the same way.

      Southern and heartland USA is becoming the only part of western civ still worth moving to or investing in.

  6. Morning Rumple…

    This is a good reminder that economics is a social science with models that only roughly approximate what happens in the real world.

    I think melbourneguy has touched on a couple of very valid points. Firstly, equality is different to equity. However, due to difficulties in how equity is treated in cost benefit models, the approach normally taken is to ignore equity (the underlying assumption then becoming that benefit equality equates to equity).

    I’ve always found it fascinating how equity considerations are driven by cultural factors. To take the very obvious example of ‘value of a statistical life’ from the health economics field, you’ll find that different countries will have different values for a life – largely dependent on cultural factors (though not ignoring income and wealth factors). See the difference that exists between two similar-ish countries such as Australia and the US let alone differences between say India and Sweden.

    So long way round but brings me back to your example of land tax. Does it necessarily increase equity? Or does it increase equality of benefits? The second can only apply if there is an actual redistribution of tax revenue such that low income landowners are not slugged a disproportionately higher proportion of their total disposable income.

    The first question? Well, that’s a question where there is no right answer. PhilBest above provides a case in point where even though s/he supports assistance for low income people, there are limits to that. Where these limits should exist are not questions that economic theory (as it currently stands) can answer.

  7. In my crazy world only one quality is rewarded and that is excellence.
    Excellence is the corner stone of any great company and its the hallmark of all successful individuals, yet at some point in the development of economic theory excellence was averaged out of the equation, the perverse effect that averages have on outliers is embodied in the phrase
    “Lies, damn lies and statistics”

    It’s a true fact (thanks GWB) that the top 1% of any society punches well above its weight, resulting in absurdly skewed income and opportunity distributions, Averages only function to further distort the complex picture of how individual or corporate excellence truly rewards the greater society.

    Truth is:
    Excellence attracts Excellence,
    Mediocrity appeals to the mediocre,
    Serial Failure is the domain of the Serial #$%^-ups.

    As a globally competitive society, we collectively need to decide which of the three groups we will back with our limited capital(emotional, organizational, monetary….). If we invest poorly we will be rewarded accordingly.

  8. There is no economics in reality, but only political economics. This is the main problem. Once we start looking at the economy through political interests we suddenly will be able to see the true meaning of any policy and to understand the real world, which is ruled by human group interests, not by faceless useless models.

  9. To answer your broader questions:
    “Why would a sophisticated economic analyst make such a strong statement that has little to no empirical support.

    Why do these ideas still hold so much sway?

    Why constrain the thinking of graduates in this way?”

    Let Prof Quiggin answer this for you (present company on MB excluded of course):

    Well, I think it’s clear we can’t be too subtle. We need to speak in plain English, to everyone, and get straight to the point. Economists don’t know what they’re talking about. We should remove economists from positions of power and influence. Get them out of treasuries, central banks, media, universities, where ever they spread their baleful ignorance.

    Economists don’t know how businesses work, they don’t know how financial markets work, they can’t begin to do elementary accounting, they don’t know where money comes from nor how banks work, they think private debt has no effect on the economy, their favourite theory is a laughably irrelevant abstraction and they never learnt that mathematics on its own is not science. They ignore well-known evidence that clearly contradicts their theories.

    Let’s face it – economics is largely a fraud, spun by compliant fools of the 1%, who want the ‘trickle up’ to become a flood.

    Most of the policies of the last 30 years have simply been a failure – hence the deflationary depression that they are trying to forestall with trillions in QE and other radical measures.

    The problem is debt, privatization, outsourcing, captured politicians and regulators, law written by the 1% for the 1% (TPP comes to mind), fraudulent Profs and think tanks bankrolled by vested interests, a compliant media, and a generally self-interested populous that dreams of joining the rentier gravy train i.e. getting rich for nothing.

    PS China Bob, you are naive if you really believe the 1%ers are the smartest, most innovative etc to get where they are. They are simply the most corrupt and willing to grease their way to the top via lax regulation, shifting of taxes off capital and economic rents etc.

    • …..you are naive if you really believe the 1%ers are the smartest,…..
      That’s one heck of a statement coming from anyone with the handle “Magnus Carlsen”.

      As for the observation that the 1%ers are corrupt and exploitative, I’d only say that they’re for the most part also limited to working within the system. Maybe the Aussie economic system is too blame. Fortunately this is an area where the 99%ers can have much more influence then the 1%ers, Unfortunately get this wrong and the 1%ers might just get up and leave

      Hmmm decisions decisions decisions…

  10. paulparkerMEMBER

    “Consider the case of gifts of land and accessible government-backed construction finance to households on low incomes. Such a scheme would provide the poorest in society an asset they can use to support themselves – to borrow against, to invest in, as a cushion in times of financial distress. ”

    IF true why are the Commonwealth’s Aboriginal Land Rights (NT) Act communities so poor ?

    Thousands of square kilometres of land, billion$ spent supposedly towards improving things, with so little to show ?