Extending tax cuts for the well-off?

There are economic reasons against that, but the issue goes deeper than that, way deeper. Why do the rich work at all?

That’s way less of a stupid question than you might think at first hand. It’s part of the cultural folklore in America (as well as being a central tenet in traditional economics) that we work for the money, even if we’re rich. But it’s a pretty doubtful proposition that gets even renowned economist (like Greg Mankiw) in a twist…

It has always puzzled us why the rich would work at all after having made a couple of millions. Standard economic theory has it that we are naturally lazy and the incentive to work is to earn money.

The last couple of decades has seen a burgeoning ‘incentives’ literature based on this. It describes the art to tease out more effort on workers, to align management with the interest of shareholders, to subtly change behaviour, and much, much more.

We’re not questioning the usefulness of this approach (absolutely central to economics), but like everything, it has it’s limits. We’ll just give a couple of examples:

  • Incentivicing individual workers can damage cooperation, knowledge sharing, as it leads to organizations that can best be described as organized distrust (or, in economic terms, the much more neutral sounding ‘agency problem’)
  • How to measure effort (or results, or the often tenuous link between the two), using proxy’s opens the situation up to gaming the system (managers rigging accounting to get share prices up as the latter serve as proxy’s for management effort, etc.)
  • Heavy use on monetary incentives can damage intrinsic motivation and professional standards (the whole bureaucracy that has grown in order to ‘manage’ and measure the performance of professionals in education, health-care, etc.).

Diminishing returns
So as with most frameworks, the users should be aware of some limitations. Perhaps the most important limitation is that money, like almost everything else, suffers from the law of diminishing returns. The more we have it, the less useful additional units become.

So the richer we become, the less we would want to work, right? Having to chose between an hour of extra work yielding extra reward and an extra hour of free time when we have so little (and so much money to indulge spending) should be a no-brainer.

Actually, no. If anything, the opposite is generally true. The more money people make, the more hours they tend to put in. Corporate executives generally put in far more hours than factory workers or clerks. Economist would answer that the income effect outweighs the substitution effect here, that is, the more one earns, the more attractive working becomes. But surely the diminishing returns must set in at some time.

Money as a proxy for power and status
This little annoying factoid supports the picture emerging from psychology and behavioural economics, which is that after we reach a certain amount of comfort, money is at best an indirect proxy of motivation. Apart from money, two other motives are increasingly important if we get more comfortable:

  • Intrinsic motivation, the work itself (unlike what you might think, or hope, lying on the beach also suffers from the same law of diminishing returns)
  • Our social standing, we work to get recognition and improve our social standing

Since we are profoundly social animals, it turns out the latter increasingly matters. You really don’t think that billion dollar scoring hedgefund managers just work for the money, do you? They will not even be able to spend a fraction of it.

The point we’re making is that money is but a proxy of power and status, it’s a positional good. The essence of a positional good is that it’s enjoyment is relative, depending on how the others do (your ‘reference group’, that is, your neighbour, sister’s husband, etc.).

Economists of the traditional mold have a very hard time explaining why most people prefer to earn $50K whilst the others earn $30K, instead of earning $100K whilst others earn $150K, a result that has been reproduced many times over in experiments.

There has hardly been a more disastrous decision as to ‘name and shame’ corporate officials by making their salaries public. The rationale behind this decision (for instance in the Netherlands) was that it would have a moderate effect on executive pay (which was becoming a hot topic politically as the then prime minister Wim Kok had a few disparaging words to say about escalating executive pay).

In fact, it had exactly the opposite effect. Corporate executives started to compare their pay packages to others (invariably those better rewarded) and now had a new argument in escalating remuneration demands, like “why is that guy X at company Y making so much more than I do?”

That’s how it works, money (after a certain level of affluence), rather than a means of spending, has become a measure of social standing.

Collective action problem
So, people generally putting in more hours in high-status jobs might be related to the status and power they derive from the job (but would that diminish if they put in less hours?), to intrinsic motivation (these jobs are generally more ‘interesting’) or it might be related to the greater remuneration (as traditional economics has it).

On the other hand, it might just be a social convention. Surveys show that the latter is a distinct possibility, with working less and spending more time with the family invariably high up the wish list. This looks like a classic collective action problem. Individually, many high-earning, high-status people would prefer to work less, but they can’t because it would endanger their position, and hence their status, so they all end up working way beyond what they would prefer.

Positional goods: it’s all relative
However, the most important thing to take away from this is that social status is a positional good, that is, it’s relative. This is something that is mostly overlooked by many economist.

It means for instance that nobody’s position will essentially be hurt if salaries are cut in half all-around without affecting people’s social standing. If you have doubts, consider the following (apart from the outcome of the choice above):

  • The ratio of Japanese executive pay to median factory worker pay is a fraction of that in the US, do we really think this has any significant adverse affect on Japanese executive effort? Are they working any less hard than their US counterparts?
  • That ratio in the US has ballooned out of all proportion in the last couple of decades, do we really think that executives were putting in considerable less effort in previous decades?

The point is, people above a certain welfare level are not merely working for the money but for the intrinsic reward work brings and the power and status (for which money is but a proxy) the job confers (an not inconsiderable benefit seems that women prefer high status males). But power and status are positional goods, they are relative to others.

The costs of inequality
So above a certain welfare/income level, money matters mostly as a social marker. This line of reasoning goes a long way to explaining the ‘happiness paradox.’ This is the phenomenon that the level of happiness (as measured by social surveys) in advanced economies seem to have reached a plateau (or have even peaked) decades ago, when most people were a lot poorer.

Beyond a certain level, additional money has little effect on happiness. What we do see is the increase of all kinds of pathologies like depression, addictions, loneliness, etc. (if you really interested in this kind of stuff one can do worse than reading Robert Lane’s “The Loss of Happiness in Market Democracies”, one of the most authoritative works on this topic).

More recent work has painted an even more alarming picture, large and growing inequality is behind most social ills. It’s something of a race to the bottom (in economic speak, a collective action problem). Individually, we strife hard to improve our social position, mistakenly thinking it’s the money and consumption itself that will make us happier. This, however is not the case, the thing that would make us happier is our increased social status, but since most are trying to do that, the end result is most are worse off (we can’t all be winners, obviously).

The end result is a very competitive society that does create a lot of wealth, but it is terribly unequally distributed and it makes few happy, as those that enjoy the wealth don’t really enjoy it all that much for the wealth itself (lottery winners can testify about that as well, after a year they’re completely used to their new wealth and are no happier than before) but as a marker of status and power. Those at the bottom remain envious nevertheless.

Nordic countries (Sweden, Denmark, Finland, Norway, to a certain extent Germany and the Netherlands) have shown that such an outcome is not inevitable, although even they can’t escape some of the forces at work. For instance, the inevitable argument in the discourse of runaway executive pay and banker bonuses is that without these incentives, the best and the brightest would move elsewhere where no such inhibitions on their pay exist.

Although this danger is greatly overplayed (and one can to a certain extent question whether someone who is so motivated by money is the best candidate for responsible positions anyway), it shows that Anglo-Saxon capititalism has negative spill-over effects for other societies.

Although these countries also have taken steps in the last couple of decades to correct their often highly progressive tax systems by bringing top rates down, they continue to show that higher taxes in general and a more equalitarian tax system are not necessarily obstacles to thriving economies, whilst escaping the worst social effects of much more rampant, unequal Anglo-Saxon capitalism.

Economic disadvantages of inequality
We suspected for some time that the ever greater part of income and wealth by an ever smaller part of the population has played a significant role in the crisis. In essence, this is a rather straightforward proposition. The richer people are, the lower their marginal rate of consumption tends to be.

What is so striking in the economic history of the US in the last three to four decades is that the median family has (apart from a brief respite in the late 1990s) made very little progress in real purchasing power. Rising aspirations led to increased spending, reduced saving and increased borrowing, leading to over-leveraging, a crucial ingredient in the financial crisis.

Although we haven’t actually read the book, but it very much seems that this is the line of reasoning in Robert Reich’s “Aftershock” (see here for a review)

The rich should pay a little more
The simple truth is, since they proportionally consume much less than families on lower income, giving them tax breaks is the most inefficient way to stimulate the economy. (Krugman explains, herehere, and here). At a time when the public sector can borrow at extremely low interest rates, investments (with much higher returns than those interest rates) in infrastructure and big projects (like this one, or this one) is the cheapest and most effective way to revive the economy, not only in the short run, but it will address some of the structural problems that improve the capacity to grow in the longer-term.

As Soros noted, the rich themselves suffer from the societal effects of extreme inequality in wealth and income, and there are political disadvantages of inequality; elites buying democracy (see here as well).