Sunday, 7 August 2016

An Invisible Inequality

     Yesterday I wrote and posted an essay about why the economics of bulk discounts provides some justification for progressive income tax rates, and a friend asked about how this seems to be the very opposite of the traditional justification cited, namely that it's less of a burden for a rich person to pay a 10% tax than it is for a poor person to pay 10%. The traditional argument is that a dollar is worth less to a rich person than to a poor person, and so we should prefer our government to take more of its tax dollars out of the pockets of rich people than the poor. So how can my argument, which is that marginal dollars are worth more to the rich, be consistent with this?
     It is confusing, to be sure, so confusing that I felt it necessary to write a whole new blog post to answer it, instead of simply replying to the original comment.

     The source of the confusion, though, is this: Although we naturally treat money and wealth as essentially interchangeable (because, hey, that's what money is for: to exchange for wealth), they are fundamentally different things. Money is ultimately a fiction, or to put it less subversively, a convention. It stands for value, but isn't itself intrinsically valuable; when you get a dollar in exchange for something, what you're really accepting is a promise to be able to exchange that dollar for something else of value later on. And that something of value, whatever it is, is what actual wealth is all about. To put it another way, money is potential wealth, not actual wealth.

     Now, let's look at the traditional argument for progressive income tax my friend was talking about. You can see that it is really about wealth, because it works just as well if we substitute, say, bread for money. For someone with a loaf of bread to give up half a loaf is much more of a burden than for someone with ten loaves to give up five loaves, because of the condition they're in afterwards. The first person will be pretty hungry with only half a loaf to eat, while the guy with five loaves will suffer only for a lack of variety.
     The argument still works pretty well if we talk about dollars instead of bread, because on an every day scale, we tend to think of prices as constant: 1 dollar buys one loaf, 5 dollars buys five loaves. And so on a practical level, this has been a pretty good argument for why progressive income tax is fairer than a flat tax. The error of equating money with wealth here does not create any immediate confusion, and so it goes unnoticed. But it is still an error, and it leads us into trouble when we move too far beyond the everyday scale, to consider the workings of the economy as a whole, which is what we have to do when we talk about tax policy.

     Remember what I said about money being a fiction? That becomes clearer when you look at the bigger picture. Money is a placeholder for credit/debt, a hydraulic fluid for trade. You trade your labour for food, clothing, shelter, entertainment, etc., but money lets you do it indirectly. So what's really happening in an economy is people making stuff (wealth) and trading it with each other. The wonderful thing about the free market is that, by allowing people to make their own decisions about what to buy and sell based on the prices that emerge from voluntary negotiations, we can collectively come up with extremely efficient allocations of resources, much more efficient than we could produce with some super-smart person deciding and directing everyone's efforts. If there isn't enough of some good being produced, the price will rise, and more people will start producing it. If there's too much, the price will drop.
     In theory,  you don't need money for a free market. In a barter economy, people would still be able to see that there's lots of demand for this and very little demand for that, and so people who chose to make something valuable would accumulate more wealth than those who didn't. Money just speeds up the process and makes it much easier to see where the demand lies. But it does something else, too: it introduces some dangerous distortions to the process.

     Thought experiment time. Imagine you have two identical workers, equally skilled and equally productive, and both commanding the same hourly rate for their work. The only difference is that one has worked very little this year, and the other has already earned a hundred thousand dollars. You need to hire one for an hour's work, and since you'll pay the same rate and get the same result whichever one you choose, you should be indifferent as to whom you hire. And that's sensible. Except remember my previous post on the economy of scale and bulk discounts. If you happen to hire the guy who's already earned a lot of money, you won't be paying any more, but he'll be getting a lot more buying power out of the dollars you give him. So, from a society-wide view, all of us collectively will be allocating more chocolate bars, more piano lessons, more whatever, to the already-rich guy than we would be if you gave the same money for the same work to the other guy.  In other words, they may be getting the same amount of money, but the richer worker will receive more wealth.
     Think about that for a moment. I mean, there's only so much wealth to go around at any given time, and as a society, we do want to make sure it's used efficiently. That's why we have a free market system, because it generally encourages people to invest resources in things that create more wealth rather than less. But here, in the thought experiment, the two workers are exactly equal in the amount of wealth they produce for the money they are paid, and yet they receive unequal distributions of wealth when they go to spend that money. That's inefficient, and it's an inefficiency that results entirely from our mistakenly equating money with wealth.

     Now, you as an employer cannot be expected to distinguish between the two workers here, and it's not your responsibility to decide what's best for society; you just need someone to do the work, and you'll pay whatever you are willing to pay whoever is willing to accept that price. You're in no position to figure out what real wealth that pay will buy for each of your prospective job applicants. And yet society does have a legitimate concern here; we want an efficient allocation of resources.
     A properly calibrated progressive income tax, however, can fix this. If we impose a tax that keeps the buying power of each earned dollar constant, then the dollars earned by rich and poor alike will be a more accurate reflection of the wealth that the market should allocate them for whatever it is they contribute.

     In other words, I'm proposing that free market capitalism can be made more efficient at producing wealth if we use taxes to correct for the distortions that money introduces into the system.


  1. So at the end we still need this "some super-smart person deciding and directing everyone's efforts" in a from of tax legislator to keep the free market from driving itself out of balance? Which makes free market no so free anymore, and brings us closer to a welfare state (without all the negative connotations attached to the term)?

    1. Well, they probably don't need to be super smart. Economists make workable estimates of things like the cost of living all the time, and they have methods that could probably be used to come up with a decent approximation of how the marginal buying power of a dollar grows with income. It wouldn't need to be a perfect value to work, either; even a very rough value could improve overall economic efficience by reducing SOME of the error.

      Actually, it occurs to me that there might be another way to generate a viable function, based on something like, I dunno, interest rates and maybe some index of income inequality.

      In any event, all I'm really proposing is a rationale for how we assign the marginal tax rates for each bracket, something we already do without thereby becoming a welfare state. We already HAVE progressive taxation; I'm just arguing why this is a good idea, and maybe how we can make it better.

    2. It doesn't really matter how smart the smart person is in this example, the important part is that it seems like his/her presence is necessary. My understanding of "free-marketeers" point of view is that left on its own, free market will lead the world to prosperity. As in free markets should not be regulated and left alone and this is how we fix economy. Yet in your example or in some real life implementations that we have observed during last several decades this postulate seems to be proven just as wrong as that pure large government socialist models are the be all and end all.
      Your rationale is by all means reasonable and useful especially in a sense that it doesn't have to appeal to emotions to be true, as in it is not based purely on the notion of common good. I think that it also works for my point against uncontrollable free markets, that is why I spoke up.

    3. Yes, but the unregulated free market is an impossibility. For it to have any meaning at all, contracts must be binding, there must be some sort of enforceable convention on what property rights there are, and so on. Most free marketeers either ignore these (they don't count, I suppose) or draw the line on them as the only justifiable intervention in an otherwise free market. But they have a very large effect on the actual play of the game. (Consider our intellectual property regime, for example, which artificially makes and enforces a kind of property right over creative works. There are many different ways we could have configured a patch for the scarcity problem, and each might favour very different economic strategies. Patent trolls might not exist in a different system, but there would be other ways to game those systems.)

  2. I think that what you actually want to set the tax rate here with is less income and more liquidity. Most people don't have sufficient cash reserves to cause an easily noticeable difference but the outliers can be extreme enough that it might be worth tracking that way.

    Fun new thought: What about purchasing co-ops and other collective actions organized by groups? Does anything need to be done with them?

    1. (Sorry, somehow I didn't get a notification to this comment, or I would have answered sooner.)

      It's a good question, about purchasing co-ops and the like. Does the availability of such opportunities undermine my argument for progressive taxation, by allowing lower-income members to enjoy bulk discount advantages without paying higher income taxes?

      I would argue that it does not, for two reasons. First, setting up and managing a co-op requires some kind of expense in time, money and effort, and that's going to be reflected in the end results. Yes, members WILL be able to get things cheaper than they would going it alone, but they won't get ALL of the savings for the bulk discount; some of it will necessarily go to support the overhead of the organization in some way (or will be effectively subsidized by the selfless volunteer board donating their time, or whatever).

      But more importantly, it's important to realize that such co-ops do not and cannot put their members on an equal footing with the very wealthy. For one thing, co-ops are only cost-effective for certain kinds of goods and services, and need a critical mass of members even for those to become worthwhile. There will always be SOME buying-power advantages enjoyed by the very rich that no co-op could ever provide. Meanwhile, the very nature of the co-op is such that they depend on having as many members as practical, and thus have an incentive to welcome the very rich themselves as members.

      In other words, all of the advantages of bulk buying through co-ops are going to be available to the very rich anyway. There will never be a situation in which the lucky poor folks have special discounts that the rich can't also enjoy, and if you introduce some sort of means-test to try to make that happen, well, you're adding an expense that lowers the net value of the poor folk's benefit.

      So I don't think it'd make any difference. The market already factors all of that into an equilibrium. Net result: rich people STILL enjoy greater buying power per dollar.