Home > economics community, Fallacies, foundations of econ, inequality > Who’s in the echo chamber?

Who’s in the echo chamber?

Via Krugman, I see this post by Chris House talking about an efficiency-equity trade-off.  House, of course, is just writing from the standard, near consensus view within economics.   The thing is, though, there is no evidence or theory (not depending on modelling choices) within economics which supports the view that there is necessarily a trade-off.

Let me be clear.  I’m not saying that there is no trade-off, I’m saying that House and Sargent (whose speech to some Berkeley undergrads started this whole blog debate) are making a claim which, while commonly believed by many economists, has no other justification.

Sargent’s speech lists 12 principles of economics that everyone ought to know, the principle in question is his assertion that:

There are tradeoffs between equality and efficiency

Again, I’m not saying this is wrong, I’m saying there is no justification.

So, what is House’s case?   Basically this:

The truth is that if we want to really attack the problem of income inequality (promote equality and help the poor) then we are going to have to take stuff away from richer people and channel it to poorer people. This kind of action will most likely have consequences for markets and these consequences will be unsavory.

Taking stuff away from the rich and giving it to the poor equals unsavory consequences… and you can justify this generally, without invoking a model-specific result, right Chris?

I’ve written about this before, but this particular argument is one that I perhaps didn’t adequately deal with, so here goes.   House is saying that in order to correct for a… let’s call it a maldistribution… will require taxes and transfers.   Taxes and transfers have efficiency costs, ergo equality-efficiency tradeoff.   QED.

That’s not how it works, Chris.

The way it actually works in economics when we want to study efficiency is that we imagine a god-like social planner and ask ourselves “what would the social planner do”… so what would a social planner view as a maldistribution of wealth?   (I’m presuming that utility is weakly increasing in wealth, not income, btw)  You can view this in several ways, but the simplest intuition is just this:  GDP, which House is implicitly using as a measure of well-being (although it’s nothing of the sort), is “additive”, but all else equal, social welfare is “multiplicative” (as a result of convexity).    Maximizing a sum (or equivalently an arithmetic mean) would leave a social planner indifferent to distribution… there is no maldistribution in House’s world.   Social welfare on the other hand is maximized at the point of equality (or equivalently the geometric mean).

The reason that there would be any “optimal” inequality at all, then, is that there is an informational rent associated with figuring out which factors are most productive and encouraging those factors to be active.   This is the heart of Mirlees’ optimal taxation result.   So House has things backward: a sufficiently god-like social planner would make sure that everyone has equal wealth, ceteris paribus and any deviation from that result has to be justified on informational grounds.   Inequality can only be justified as constrained efficient, not to be confused as efficient.

More than that, though, is that its just not clear that taxes must necessarily cause inefficiency.  It’s not at all difficult to tell a story in which wealth taxes, for example, can encourage capital formation by, say, encouraging complementary human capital to accumulate or by encouraging productive capital over “frivolous” capital (by that I mean things like McMansions).   Taxing productive capital may increase its after-tax cost, but the redistribution it funds can also increase the value of its production stream.

So, are efficiency and equality free of any tradeoff?   Not necessarily, and certainly that’s not what I’m saying.    No, the point is that Sargent’s “principle” is not some immutable law of nature, but a model-dependent best-guess.   You might say that the sign of the tradeoff is ambiguous in theory… and it is at this point that I should mention that the only empirical evidence I know of which directly test the sign of that tradeoff are those IMF studies that suggest that equality and efficiency move together.

So, Chris, if you’re reading this, I leave you with the following wise words:

Talking in an echo chamber can be fun but public intellectuals like [House and Sargent] have a greater responsibility to self-censor than most because they have large audiences. They have a responsibility to the public and also a responsibility to their… readers who take their statements to heart

Just sayin’…

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  1. May 4, 2014 at 3:06 pm

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