Monday, 27 April 2009

Fairness and the Budget

It seems like someone in the Treasury has been reading Shiller and Akerlof's Animal Spirits. This Budget has a strong unstated theme of 'fairness' in the sense that the authors use it - as one of the fundamental psychological phenomena that they believe contribute to economic performance.

Two behavioural experiments are useful in understanding the Budget and the reaction to it.

The first is the ultimatum game. This has two players, Mary and John. Mary is offered £10 to share with John as she wishes. The catch is that whatever share she offers to John, he has the chance to accept or reject it. If he rejects it, neither player gets anything.

In a perfectly rational world, Mary would offer John a penny and keep £9.99 for herself. He would accept the penny - it's better than nothing, after all - and both would get their money. But in practice, John never behaves like this. If Mary offers him less than about a third of the money, he normally rejects it - so both players lose out. In other words, John would rather have no money at all than accept what he sees as an unfair share. Mary is usually aware of this and makes a fair offer - averaging about £4.40, with many people offering an exact 50-50 split.

The results occasionally differ by culture - Henrich (2000) found a much weaker tendency towards fairness in the Machiguenga tribe in Peru - but nearly every experiment finds similar results.

The other relevant experiment is a simple question about which world you would rather live in. A world where everyone else's salary is $50,000 and yours is $75,000 - or a world where everyone else earns $125,000 and you earn $100,000 (assuming each dollar has the same buying power). There is a strong preference towards the 50/75 scenario - that is, people will accept a lower income in order to be the top dog in a poorer world (details of this and various similar experiments in Alpizar et al (2001)).

So what relevance does this have for the Budget? The most spectacular figure, the 50% tax rate, is all about fairness, as is the reaction to it.

Although it will raise a little money, it's clear that this change will have almost no direct impact on the expected deficits over the next ten years. Instead, it's intended to show the 99% of the population that are not subject to it that the other 1% are "paying their fair share". From a (somewhat) left-wing government's point of view, this is the perfect time to do it - the popular outcry at the supposed responsibility of investment bankers for the recession gives ideal political cover for the change. And if Shiller and Akerlof are right, a greater perception of fairness will provide more satisfaction for the majority of people and offer an extra incentive for them to participate in the economy. Indeed, initial poll results show majority support for this change - though it's too early to say whether the support will survive until the election.

Of course, that's not how it looks to the people who are hit by the change. Lots of complaints from them - claims from tax specialists that they'll be able to avoid the increase, threats to move abroad or stop working so hard - the usual stuff. Is this rational? Not very. The likelihood is that anyone leaving London is going to earn much less elsewhere - more than enough to outweigh any tax saving. Equally anyone who reduces their amount of work will gain nothing materially - only a sense of justification - or spite - at reducing the taxman's share of their income.

That doesn't mean nobody will act on it - we often see people acting against their own interests for the sake of pride or anger - or a sense of fairness. So we can expect to see a small outflow of people who would rather earn £200,000 and pay 30% tax than earn £400,000 and pay 50% tax - because they simply see the 50% rate as unfair. This would accord with the results of the ultimatum game.

Fundamentally, however, what is it that makes people perceive 50% as unfair? It's just a number. What if, instead of raising the income tax rate, the arbitrary ceiling on national insurance contributions had been removed - which would have an identical fiscal effect but in a much less obvious way? I suspect that far fewer high earners would have the same feeling of unfairness - of being punished - but also, the rest of the population would not have felt the same kind of justice which I think they perceive in this tax hike.

More rationally, there may be a few people who are close to the margin of benefits versus costs of living in London now, and for whom this is just enough to push them over. But moving costs and inertia make the margin effect weak in this direction - in fact a stronger effect may be to discourage people who might have otherwise moved to the UK. Those people, of course, will never show up in any statistics, but it may be possible to look at immigration figures in a few years and try to decipher an effect.

If doing a conventional macroeconomic analysis we would look at other counterfactuals. If the Government had not spent as much over the last ten years, or if it were to reduce spending over the next ten, what would happen? Higher-rate taxpayers might pay less in the short term, but aggregate demand would be greatly reduced, and - if you think that the economy will be stuck in a low-activity Keynesian equilibrium for a few years - GDP might be about 10% less by 2017. On average, everyone's income would be lower - so we might even end up paying a higher tax rate, but on a smaller income. Net income would be lower, not higher.

Of course this can't be proved - it is far from certain that the size of the economy would be reduced by lower public spending. Laffer advocates would say the converse, that the economy will thrive if government spending (and taxes) are reduced - but the reality is that nobody has a demonstrably reliable model which can answer the question either way.

Looking at a more monetary analysis, you could argue that this tax increase signals the government's willingness to increase future taxes to close the fiscal gap - which should reduce financing costs for UK debt. Or you could say that this tokenism shows the deficits are too large for the government to credibly close, and the cost of funding will instead go up.

In other words, the macroeconomic effects are extremely hard to predict - but the cultural and psychological effects are quite easy. Somewhere in between is the puzzle of evaluating the medium-term economic impact of this change in psychology. On balance, I expect that the effect on economic activity is more likely to be positive - but if the Government doesn't have a good model for projecting this outcome, it is playing with fire.

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