Rawls, Cohen and the Laffer Hypothesis

I was in Sydney for a fascinating conference on Evidence, Science And Public Policy. It was worth the trip just to hear John Worrall on evidence-based medicine point out this paper on remote retroactive intercessory prayer [1]. Assuming, as appears to be the case, that the study was totally legit (no data mining etc), the obvious question for me was why anyone would think it worthwhile (ex ante) to test this out.

But that’s not the subject of this post.

In discussion at the conference, some reference was made to Rawls, Cohen and incentives, the subject of quite a bit of discussion at Crooked Timber. Rawls and Cohen (and those of us following them) spend a lot of time on the question of whether it is just/desirable to adopt policies that increase the income of the well-off relative to that of the poor, assuming that the result is a Pareto-improvement (everyone is better off, even if the rich gain more). That’s an important question if you want to think about an ideal social order, or to clarify concepts of justice, but there’s a big risk (evident in some of the discussion at the conference) of sliding into the assumption that this question is politically relevant right now. To put it another way, this question is politically relevant only if you accept something very clsoe the Laffer Hypothesis[2], that a reduction in tax rates will, under current circumstances, produce an increase in revenue. Chris Bertram made much the same point in relation to the banking crisis a while back. The term “trickle-down economics” describes the general form of the claim.

There’s very little reason to believe the Laffer hypothesis or equivalent claims about the banks. The reason tax rates aren’t higher and bankers are getting bailed out on hugely generous terms isn’t because Rawlsians have outvoted Cohenites behind the veil of ignorance, or even because lots of economists believe the Laffer hypothesis. It’s because the rich and powerful are, well, rich and powerful. Not only can they promote ideas, however dubious, that serve their cause, they can bring powerful force to bear against any government or political movement that threatens their interest. All of this is obvious enough, but after thirty years in which any mention of these facts has been shouted down as the “politics of envy” or “class hatred”, it may be necessary to restate the obvious.

Again, that’s not a reason not to talk about whether Pareto improvements are (necessarily) desirable and just. I only want to remind everyone to mention, from time to time, that we’ve got a long way to go before we need to worry about this in practice. At the moment, the relevant version of the question is how the left can regain some of the ground lost over the last thirty years, now that the trickle-down theory has failed so spectacularly and obviously.

fn1. Paywalled, sorry. The authors of the study took records of people who had been treated for blood infections some years previously, randomly assigned them to two groups and got a volunteer to read a brief, non-specific prayer for the recovery of the test group, while holding the list of names. It turned out that the prayed-for group had had significantly better outcomes. John Worrall presented it as an data point against believing in randomised trials as the gold standard of evidence based medicine. As I said, my main puzzle is, assuming that the results were just a 100-1 fluke, why the authors thought of doing this in the first place, given the low probability of a publishable result.

fn2. Laffer didn’t invent the curve to which his name is commonly attached, but he can reasonably claim responsibility for the hypothesis that the US in the 1980s was on the declining part of the curve.

74 thoughts on “Rawls, Cohen and the Laffer Hypothesis

  1. Alice, I meant to respond to your earlier point regarding tax cuts for high-income earners and the relationship to economic inequality.

    Regardless of what anyone thinks about claims of rising inequality, I believe that most economic modelling has shown that if income inequality has been increasing over the past two decades that inequality in market incomes (before taxes and transfer payments) has increased faster than income inequality after the tax/transfer system is taken into account. If this is true, it shows the net level of government redistribution is if anything greater than in the past.

    If your argument about tax cuts for high-income earners contributing to rising inequality was true, the exact opposite would be the case. That is, income inequality before taxes and transfers would not have risen as fast, but income inequality after taxes and transfers would have risen faster.

    I’d be interested if JQ has any economic modelling to disprove this.

  2. Monkey’s Uncle

    supposes that
    ” if income inequality has been increasing over the past two decades that inequality in market incomes (before taxes and transfer payments) has increased faster than income inequality after the tax/transfer system is taken into account. If this is true, it shows the net level of government redistribution is if anything greater than in the past.”

    Illogical Monkey’s Uncle. If before tax income and after tax income both show inequality rising, it matters little which is rising faster.

    Inequality is still rising.

    Redistribution policies are ineffectual if both the inequality of before tax and after tax incomes are both rising, regardless of which one is rising faster.

  3. # 33 Joseph Clark Says: March 31st, 2009 at 9:20 pm

    Having bizarre conspiracy theories about ‘elites’ is one thing.

    No elite conspiracy? Ever heard of “remuneration committees“?

    Corporate governance has become a shambles since financial free marketeers took over the board-room. Wikipedia summarises results:

    The results of previous research on the relationship between firm performance and executive compensation have failed to find consistent and significant relationships between executives’ remuneration and firm performance. The results suggest that increases in ownership above 20% cause management to become more entrenched, and less interested in the welfare of their shareholders.

    Some argue that firm performance is positively associated with share option plans and that these plans direct managers’ energies and extend their decision horizons toward the long-term, rather than the short-term, performance of the company. However, that point of view came under substantial criticism circa in the wake of various security scandals including mutual fund timing episodes and, in particular, the backdating of option grants.

    Even big businessmen are questioning the value of these sweet-hearted contracts with “welcome aboard” teasers, dodgy stock-optioned bonuses and “golden parachutes”. It just encourages a short-term “pump and dump” attitude amongst management.

  4. #53 “No elite conspiracy? Ever heard of “remuneration committees“?”

    Exactly Jack. You can show them the elephant in the room but you still cant convince them its there…

  5. Jack – The Age only just archived one of your links after you posted it (the big businessmen link above) – but I know who it is. I think its David Murray? saying that exec remunerations have gotten ridiculous. I read it very recently.

  6. It seems to me that the statement that “pareto improvements are good by definition” is only true where the improvement is in our ends, and not necissarily true when the improvement is in a means, such as money.
    So whether a pareto improvement in income is always good becomes a question of indirect costs associated with inequality.

  7. Jack 53

    On this we are strongly agreed; BTW terminology aside I never disagreed with you or Alice on the nature of the powerful adn how they operate.

    Regarding remuneration committees, if anything that Wikipedia entry is not strong enough. John Shields did some work a few years ago that showed there WAS a clear relationship between exec pay and corporate performance. Unfortuantely, it was negative – the higher the pay, the worse the return. I suspect now you could establish a similar relationship with the risk of failure.

    Pesonalyl I think “Old Boys Club” is a more accurate term for elites. Either that or “oligarchs”. Anothe hudnred years at this rate adn they will be “overlords” and we their serfs.

  8. @ 57 “Anothe hudnred years at this rate adn they will be “overlords” and we their serfs.”

    I hope you are right Socrates – I’ve not been so optimistic.

  9. Jack & Alice,
    Remuneration in publicly listed companies is a matter for shareholders. If management have their snouts in the trough it’s shareholders who suffer and shareholders who need to become more active. It is not a public policy issue.

    This outrage over executive remuneration is truly bizarre. Why do you care? Do you just enjoy being outraged?

  10. Joseph, spot on. If someone owns a business and is paying a worker more than they are worth, why should I care or be outraged by it? Unless I have money invested in the business, or am being somehow forced to pay for it. Otherwise it’s none of my business?

    If taxpayer subsidies or bailouts are used to help fund excessive executive pay, then people have a right to be outraged. But that is the only situation.

    “This outrage over executive remuneration is truly bizarre. Why do you care? Do you just enjoy being outraged?”

    Yes, a lot of people enjoy being outraged.

  11. JC and Monkey

    the trouble is that, to continue the analogy most of us are forced to contribute funds into this business (via super legislation) and have no control over the wages set. Meanwhile those who run the businesses are now taking more out in fees than many of them are making in profits.

    If the Director/Executive relationship in large corporations really was owner/employer then you would be right. The trouble is, its nothing of the sort. You imagine as though votes on execuive remuneration at shareholder meetings are binding. But with 60% or more of shareholdings in the hands of institutions, which are not subject to the same legislation, even that change will not solve the problem.

  12. JC and Monleys Uncle

    Tell me, if you think there is no problem with exec pay, what do you personally think is a reasonable annual pay level for a CEO of an ASX 200 listed company earning average returns? How many hours a week would you expect the CEO to work for it?

    Bear in mind that the Prime Minister has a salary of $330,000 (more like $400,000 with alowances) and there is no shortage of applicants for that job, despite quite long hours.

    Look forward to your answer.

  13. Socrates,
    You can allocate your super to 100% cash or start up your own SMSF. You’ll sleep better at night.

    Minor shareholders who are unhappy with the behavior of major shareholders can take their money elsewhere.

    Executive pay is usually a small portion of a firm’s costs. Shareholders have many more important things to worry about (like the decisions being made) that have a larger impact on profits.

    There is no such thing as a fair wage in the same way that there is no such thing as a fair price. The fair price is the traded price. If you think of prices (and wages) in terms of fairness you will spend a lot of your time being unnecessarily outraged.

    If a painting sells for 50m or an actor gets paid 20m to appear in a movie I could prance around whining at the unfairness of it all. I could find people who work harder than the actor and get paid less or things that are more useful than the painting but sold for less. The fact is my view of value is entirely irrelevant to the parties who entered the trade. Things don’t have an objective monetary value: they are worth exactly as much as people are prepared to pay for them, not a penny more or less.

    I don’t think there is a `reasonable’ salary for a CEO for the same reason that I don’t think there’s a reasonable price for a Rembrandt or a reasonable amount of prize money in a sporting competition.

  14. Nicely avoided JC; courageous answer.

    Actors and paintings are non-sequitors – their salaries are set in different ways. If actors don’t generate the ratings they are soon dropped. Rosne’s work on the economics of superstars explained their incomes 20 years ago. This does not explain CEO salaries.

    If you see Bebchuk’s research on this subject you would know that remuneration of the top five execs now averages over 10% of gross profits in top 500 corporations. Hardly a small cost.

  15. CEOs value compared to a Rembrandt painting by JC?
    Well we all know they have had had egos as big as the Nightwatch but Rembrandt created something grand, and didnt paint fakes with delusions of grandeur.

  16. Alice,

    And the titans of business never created anything grand?

    So IBM is not grand? Nor is Compaq? The PC you are using has impacted the world just as much a painting has – but you don’t think that the person who managers/owns the business is entitled to a good income?

  17. CEO salaries are set by company boards. Company boards are elected by shareholders. The system is an example of representative democracy. Not the finest.

  18. Sean G

    That is another popular non-sequiter argument used to falsely justify execuive pay.

    What does it mean to “create something grand”? If you are Bill Gates or Warren Buffett it may be true. However their wealth doesn’t derive from what they paid themselves as CEO; its from their share of ownership in what they started. But most (still highly paid) CEOs inherit positions of power over organisations that they did NOT create. So why pay them millions for just managing something that someone else built up?

    Even for those who do create “something grand” the main method is by mergers and acquisition, not creating a new product or building up a business from scratch. Does this represent a net icnrease in wealth for the society? Usually not; its mainly financed by borrowing, with many deals now unravelling. No credit for that. The evidence on the success rate of mergers is also very poor, with Citibank being a classic example of its folly.

    They shouldn’t get credit for creating “something grand”. That is an ego trip. They should get credit IF they create something profitable. The flip side of that is that they should be penalised if they destroy something that was previously profitable.

  19. Just to illustrate how much fans of high executive pay have forgotten their theory, here is what Adam Smith said about managerial pay in Wealth of Nations:
    ” “The profits of stock, it may perhaps be thought, are only a different name for the wages of a particular sort of labor, the labor of inspection and direction [leadership]. They are however altogether different, are regulated by quite different principles, and bear no proportion to the quantity, the hardship or the ingenuity of this supposed labor of inspection and direction.”

    I bet the Adam Smith society won’t quote that passage too often.

  20. Sean66# says
    “but you don’t think that the person who managers/owns the business is entitled to a good income?”

    Good yes – Im all for “good salaries for managers and owners”, but not ripping the guts out of the company and shareholders returns, just for their own personal use.

    Are you blind Sean? You think Alan Moss was worth 23 mill in one year????? You think any one person is worth that in salary Sean. Thats about 23 times a good salary Sean.

  21. Sean –

    what the CEOs of the grand financial institutions created was a grand catastrophe and they will do it again given half a chance if they dont get their hand slammed down by the cookie jar lid (regulators) and they dont get told what to do with their excessive greed in remuneration (listen here boys – you get two cookies after school not the whole jar). I was glad to see Merkel and Sarkovsky telling Obama to listen up. Someone needs to tell the US to listen up with its out of control financial sector and we in Australia need to drop the “we are U.S. grommets” approach to financial de-regulation.

  22. Terje says
    “CEO salaries are set by company boards. Company boards are elected by shareholders.”

    Terje forgot to say that massive blocks of shareholders are represented by one like minded institutional fund manager and for all we know he is probably getting a cut…

    No its not ideal.

  23. Or the institutional fund manager is probably getting a deal sweetener – how about a company sale of real estate and way below market values…..to one of the funds companies..

    Come now..it goes on all the time. Asset switches with a remunerative sweetener sachet attached.

  24. Re Joseph
    “Pareto improvements are defined in terms of preference not quantity. [True (thank you), but I was tacitly talking about goods and ignoring bads so that “more” necessarily would be preferred.] Unless people prefer less preferred commodity bundles Pareto improvements are just plain good. [“Preferred” is factual. “Good” is usually typically used as normative. Maybe one should stick to PI means “preferred”, given the preferences that are recognised by the analyst. Do analysts permit individual preferences about distribution to be included? Eg, your improvement makes me feel weaker, exploited, envious or resentful. Typically not. Perhaps you are commendably permitting people to have whatever preferences they like (including interdependent ones), but is this standard practice?] Pareto optimality is another matter.[Indeed, but PO is a choice among P Efficient points. If these PE points are ill-identified, choosing the most ‘equitable’ among these is an uninteresting exercise.]”

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