Archive for January, 2011

Principle, not principal

January 29, 2011 1 comment

There is much to be disgruntled with when it comes to the coalition government plan for university funding. I cannot better a number of criticisms made by Stefan Collini in the London Review of Books, which you should be able to read here.

But the one thing I am pretty unconcerned with is the increase in tuition fees. If a student loan was like a commercial loan, I would agree that this increase would be a bad thing. With a commercial loan, you are incurring a liability which you have to service no matter how onerous that may be. If you have a £200,000 mortgage and lose your job, payments still have to be made. You can’t say ‘give me six months and I’ll be able to get it to you’, it’s just tough luck. Debt can be frightening because it creates a predetermined nominal liability which you will have to pay no matter what. I am extremely fortunate to be completely debt-free, bringing with it considerable freedom when it comes to deciding what I want to do with my life.

However, I cannot emphasize enough that a student loan is not like normal commercial debt. It is repaid with a 9% tax over £15,000 (to rise to £21,000 with the new plan), which you pay until you have paid off the principal with any accrued interest. Any remaining debt is forgiven after 30 years. What this means is that high earners will pay significantly more money to the government in a short space of time, whereas low earners pay much less per year and will likely do so until the debt is forgiven. With the change, everyone will pay less per year and for slightly longer (unless you wouldn’t have paid off after 30 years anyway).

Now, to me this is probably not the fairest way fund universities. That 9% tax for graduates with fairly unspectacular earnings will take a big chunk out of the paychecks of those who do not initially earn very much but earn more as they get older. Those that come out of university with well-paying jobs will have already paid it off by that point. So I think it is safe to say the system isn’t fair. But I think the fear that potential students have that they ‘cannot afford’ university is the result of sloppy thinking and, frankly, terrible marketing. If you can’t afford the payment, you don’t have to make it! The financial liability you are assuming by going to university is a tax, and the role of the principal and interest is to determine how long you have to pay the tax for. That’s it.

To see how it is misleading to think about the liability as a loan, consider the recent rise in the top rate of tax from 40% to 50% for income over £150,000. Now, suppose actually what happened was the government said to everyone in the country you now have to pay a £100bn poll tax in order to stay in the country. But it’s OK, the government will lend you the money, with interest to be calculated at the RPI. But, instead of it being a normal commercial loan, we’ve decided that you just pay an additional 10% on income over £150,000 until you pay back the loan (which will be never).

This is functionally equivalent to increasing the top rate of tax by 10%.

So you see how irrelevant the principal is until you consider the actual payment profile. I simply cannot find it utterly beyond the pale to make what is effectively a tax cut (for a single year, at least) in exchange for having to pay that tax for more years of your life. Any unfairness in the payment profile positively pales in comparison to the other flaws in the proposal, as pointed out by Collini and numerous others. I submit that the outrage in the government’s plan be directed not to the principal of the loan, but towards the incoherence of the principles on which it is ostensibly based.

Categories: Policy

The Williamson Plan for Economic Prosperity

January 22, 2011 2 comments

Drum roll please…

Immediately reduce all government unemployment and retirement payments to zero, and then hire everyone who was receiving benefits to be a government employee with their wage being equal to the benefits previously received. Ta-da!

Ok, now let me show you why this ‘works’, taking the USA as an example. The latest Department of Labour statistics show the 4-week moving average of those collecting unemployment benefits in the US is about 4 million, at a cost of approximately $80bn a year. There are approximately 36m retirees claiming an average of $1,164 a month, which gets you to $502.9bn a year in social security payments for retirees.

First I’ll demonstrate the change this will bring to unemployment, currently standing at approximately 15m out of a labour force of 154m. The current unemployment rate is 15/154 which is 9.7%. My plan increases the number of employed persons by approximately 40m, and the labour force by approximately 36m. That gives us a new unemployment rate of 11/190 which is 5.8%. So I lied when I said it would halve the unemployment rate (mental arithmetic fail), but I have substantially reduced it.

But why would GDP change as well? Because government spending on unemployment insurance and retirement payments doesn’t count, but spending on wages of employees does. I’ll try to explain this as best I can, as it still sometimes does my head in. The point of GDP is to measure the total value of goods and services produced within a particular geographical area. This is why things like the sale of used cars don’t count towards GDP, and new cars do. Unemployment and retirement benefits are considered ‘transfer payments’, as the payment isn’t reflective of compensation for a good or service produced, and aren’t counted towards GDP.

In the private sector, the value of what is produced is determined by the price at which it is sold, and this is what counts for the purposes of GDP. But this clearly cannot work with government, as the government doesn’t (for the most part) sell goods and services. The value of what the government produces is instead booked at the cost of its production. This gives a huge advantage to the government in the argument over who can best ‘stimulate the economy’, as it doesn’t matter to the GDP figures how that money is spent. The private sector only ‘stimulates the economy’ when it puts resources to good use in the production of goods and services that people are willing to actually pay for. If the government pays 10 people to dig holes and 10 more to fill them, it ‘stimulates the economy’ in terms of boosting GDP, more so than if we gave those same 20 people unemployment benefits, but it doesn’t create any value1. That the former counts towards GDP and the latter does not is completely arbitrary from a standpoint of how well-off we may or may not be2.

I get so frustrated by the ease with which we bandy about numbers with precious little thought as to what they actually mean. I hope to have shown in this post how the government’s contribution to GDP is not necessarily representative at all of the value created by its spending decisions.

1This is not strictly speaking true, paying people to do something is usually preferable to paying people to do nothing – if only psychologically for those concerned

2This is why I am a little bit sceptical of one part of Felix Salmon’s praise of the Nordic economic model. Sure unemployment at Norway is at 3.5%, but what would it be if the government fired all the workers with zero marginal product and instead paid their salaries as unemployment benefit? That being said, the piece Felix cites is very much well worth reading about what is actually the best policy for fostering entrepeneurship. Also read Scott Sumner on Scandinavian socialism.

Categories: Economics, Policy

My foolproof plan to halve the unemployment rate and boost GDP by 4%

January 20, 2011 Leave a comment

Can any of you guess what it is?

I’ll post the plan in the next couple of days. I’m gunning for the Nobel, but the John Bates Clark Medal will do just fine.

Categories: Economics, Policy

Declining marginal utility of income and the utilitarian argument for income redistribution

January 17, 2011 3 comments

Update: A number of the arguments I have made in this post are highly problematic (I always publish too hastily). However, I still consider the basic point to be correct and will hopefully publish a follow-up soon.


What do economists mean when they are talking about the phenomenon of declining marginal utility of income? It’s pretty simple, really. If you earn £10k a year, an extra £1,000 is worth a lot more to you than if you earn £100k a year. Another way of putting it is: the world is better off ‘happiness-wise’ (ceteris paribus) if the extra £1,000 goes to the less well-off[1]. I used to believe that this generates a simple argument from utilitarian premises for widespread income redistribution.

But a few months ago, I had a thought that actually this isn’t so obviously the case. Declining marginal utility of income has an interesting corollary, namely that those who work jobs that require long hours should be paid more per hour in order to maintain the same level of happiness. I have made this point to a number of people in discussion and I don’t feel I have made myself clear, so I thought I would have a stab in written form.

Imagine a prime specimen of homo economicus whom I shall gender-neutrally term ‘Alex’. Now, let us first suppose that for Alex, the marginal utility of income is constant. Alex is deciding whether to take a job for £20k that requires 40 hours per week, or £30k that requires 60 hours per week. Alex would be indifferent to these two options, for if we understand the decision on how much he/she wishes to work as a trade-off between income and leisure[2], then as he/she is being equally compensated for his foregone leisure in each case, Alex would be neither better nor worse off with either job.

However, we know that marginal utility of income is not constant. The first 20k is more important, and of the first 20k the first few thousand is even more important as this is what will feed and clothe our imaginary prospective employee. The things we buy with our extra income as we get richer are less important than the things we would buy first. That’s the declining marginal utility of income. There is also a second effect, which is the declining marginal utility of leisure. In this example, the marginal hours Alex works (say he/she works 9-9 rather than 9-5) are more valuable than the marginal hours worked by the 9-5 employee. This is because if you get out of work at 5, you still have time in the day to do things like have hobbies and go and see friends. Getting out at 4 rather than 5 doesn’t make much of a difference to your ability to have extensive hobbies outside of work or to your social life, but the difference between getting out at 8 and 9 makes a very large difference – not only in terms of the time you have, but in how much energy you have to spend that time fruitfully. Therefore, in order to be compensated for all that Alex loses by working longer hours, Alex gets paid more for that time. In fact, declining marginal utility is everywhere. Working is (at least in one way) like cheesecake: the next slice is never as good as the previous one, and there would come a point where I would actually pay to not have an extra slice.

So, we have Alex working a 60 hour a week job for (say) £40k p.a., and suppose we have Casey[3] working a 40 hour a week job for (say) £20k p.a. It is entirely plausible that, in terms of their actual welfare, Alex and Casey are equally well off. Alex may be able to buy box seats at the theatre, but Casey has the time to do amateur theatre. So if we were considering what justice would require in terms of redistribution of the income of Alex and Casey towards someone else, ‘Morgan’[4] who cannot earn income due to disability or illness, it would be may well be inegalitarian to require Alex to give more a higher proportion of income[5] to Morgan than Casey. People who choose to work longer hours should not automatically be considered better off just because they have more income, and when you combine the two effects of working more and being compensated more highly for those marginal hours due to the declining marginal utility of income the amount of extra income required to equalize their well being could be considerable[6].

Let me make one thing perfectly clear: for income in excess of that required to compensate workers with long hours I think the redistribution argument holds – but with the ceteris paribus assumption. And there are lots of things that matter (from a utilitarian perspective) that would need to be taken into account such as the effect of high marginal taxes on work incentives. If you don’t think that work incentives matter, think about this: an economy is fundamentally about exchange – trades made between two or more parties for their mutual benefit. If I buy a sandwich at M&S for £3, what is basically happening is that I would rather have the sandwich than the £3, and M&S would rather have the £3 than the sandwich. Everyone is better off. Now, the people who run M&S are much richer than I am. But I want them to make the sandwich and trade with me rather than not. It is too easy to think of those who earn more as being parasitic on society’s resources – but a crucial part of society’s resources is labour itself, people taking resources and turning them into something more useful, desirable and, indeed, valuable.

The economist Tyler Cowen recently wrote an excellent essay in The American Interest entitled ‘The Inequality That Matters’, in which he makes the following point:

“The funny thing is this: For years, many cultural critics in and of the United States have been telling us that Americans should behave more like threshold earners. We should be less harried, more interested in nurturing friendships, and more interested in the non-commercial sphere of life. That may well be good advice. Many studies suggest that above a certain level more money brings only marginal increments of happiness. What isn’t so widely advertised is that those same critics have basically been telling us, without realizing it, that we should be acting in such a manner as to increase measured income inequality. Not only is high inequality an inevitable concomitant of human diversity, but growing income inequality may be, too, if lots of us take the kind of advice that will make us happier.”

If it is the case that much of what is really valuable is that which cannot be priced and exchanged in a market, then this makes a considerable difference to optimal public policy from the perspective of an egalitarian – let alone a utilitarian.

Update: if you are of an egalitarian mindset, and have not read Elizabeth Anderson’s fantastic ‘What is the Point of Equality?’ paper, please do. You are missing out on both a superb critique and impassioned defence

Update 2: That Alex and Casey should be taxed in direct proportion to their income does not at all follow, as has been pointed out to me. Strictly speaking what should happen from an egalitarian perspective is that each should be taxed in such a way that their welfare loss is equal. It is a completely open question as to what this would actually look like, because it depends on the exact way in which the marginal utility of income varies with income. If I was attempting to argue against progressive taxation/redistribution this would be a problem, but I’m not. I’m just attempting to show that arguing for progressive taxation/redistribution merely on the basis of declining marginal utility of income doesn’t do the necessary work. I have therefore adjusted the strength of my claim accordingly.

[1] File under ‘totally fucking obvious to everyone who isn’t an economist’

[2] Again, only an economist would call everything that isn’t gainful employment ‘leisure’, but I’ll stick to the convention here

[3] I’m going to start running out of gender-neutral names soon…

[4] Still going strong

[5] My original point was incorrect, as the declining marginal utility of income means that any given £1 taken from Alex is worth less to Alex than £1 from Casey is worth to Casey. However, if you take £1 from Alex and not from Casey, then Casey is better off than Alex since I assumed they are equally well off. The tax should therefore be proportionate, and proportion of income is as good a proxy as any for how to keep their welfare constant, even if it isn’t perfect

[6] There is also a third substantial effect, which is cost of living and relative rates of inflation. I would point the reader in the direction of two excellent essays from a couple of American conservative writers whom I enjoy reading (it’s not an extensive list) – the first is from Reihan Salam at the NRO, on variations in income and cost of living across the US, and the second is from Will Wilkinson, a.k.a. the sole redeeming feature of the CATO institute. Also very much worth reading is Steve Waldman’s response to Wilkinson, which can be found here. I link, you decide.

Categories: Economics, Philosophy, Policy