Wednesday, January 25, 2012

Should wasteful competition for positional goods be taken into account in tax policy?

In my last post I began my review of Robert Frank’s ‘The Darwin Economy’, by outlining how Adam Smith viewed the strivings of people to better their condition as being motivated to a large extent by concerns about their relative position in society. I suggested that if there are negative externalities associated with strivings to improve relative position, these should be balanced against the positive externalities relating to technological progress identified by Smith.

The negative externalities that Robert Frank is most concerned about arise when people forgo something that they value (e.g. leisure or workplace safety) in order to engage in competition for positional goods. The basic idea is that while this competition makes sense from the perspective of each individual, it is socially wasteful because individuals are forgoing something they value in order to compete for positional goods.

There is an important definitional issue, which I will come to later, about whether the supply of positional goods is fixed. Let us assume initially, however, that there is only one positional good which is fixed in supply – housing land with views – and that humans have such a strong urge to obtain a house with a good view that, once their subsistence needs have been satisfied, all their efforts go into obtaining better views. If we now make the additional assumption that the government has to raise a certain amount of revenue to fund provision of public goods (e.g. defence, law enforcement) I think it would probably be reasonable to suppose that a tax on income above a certain level, which causes people to substitute leisure for income, would be an efficient tax to use in such circumstances. (This runs counter to my prior view which would have been in favour of a tax, or combination of taxes, with a neutral impact on income-leisure choices.)

Now, let us add some complications relating to the real world. Account should be taken of the fact that different people have different preferences and tastes. Some people are particularly interested in houses with views, some like to live near water, some are interested in living near good educational facilities and some like to live near their work. Then, there are the people who prefer to spend additional income on goods other than housing.

House sites in good locations are not the only good for which there is a relatively high income elasticity of demand. In the case of most high income elasticity goods, however, an increase in demand tends to result in a supply response and a reduction in price. Moreover, many studies suggest that there is a relatively high income elasticity of demand for leisure. Such considerations suggest to me that potential economic losses associated with competition for positional goods are likely to be quite small.

At this point I should introduce the further complication relating to the definition of positional goods. Frank adopts Fred Hirsch’s definition of positional goods ‘as ones whose evaluations are particularly sensitive to context’. House sites with views would be considered to be strongly sensitive to context if people would generally prefer to live in a location where they have better views than their neighbours, than to live in a location where the views are generally much better, but their neighbours have better views than they have.

On the basis of thought experiments he has asked students to undertake, Frank suggests that size of house is strongly sensitive to context, whereas workplace safety and time spent on vacation are not strongly sensitive to context. Frank argues that positional concerns are stronger for luxury goods than for necessities. He suggests that since ‘luxury is an inherently context-dependent phenomenon, it’s uncontroversial to say that the last dollars spent by those who spend most are most likely to be spent on luxuries’. This reasoning leads him to argue in favour of a steeply progressive consumption tax to replace personal income tax.

In the end, it seems to me that the view Frank is presenting boils down to an assertion that those fortunate (or silly) enough to have high levels of consumption spending impose an externality on the rest of the community who feel that their relative standing is diminished unless they make the sacrifices required to emulate this behaviour. The main problem I have with this this line of reasoning is that people can choose not to get involved in such emulation games, and many people have made such choices.

Furthermore, I don’t think relative income or consumption levels are nearly as important to life satisfaction as people might suggest in their responses to thought experiments. A rough calculation I reported on this blog a few years ago suggests that the probability of a poor person in a rich country being satisfied with life is about 60 percent higher than for a rich person in a poor country.

International migration patterns are also inconsistent with the view that relative position is of huge importance. Many people seem to be willing to migrate from poor countries, where they are relatively wealthy, to wealthy countries, where they are relatively poor, in order to give better opportunities to their children.

My bottom line is that while I think there may be a grain of truth in the idea that competition for some positional goods (goods which are fixed in supply) is wasteful, Robert Frank has not succeeded in establishing a case on efficiency grounds for a steeply progressive consumption tax.

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