Scott Sumner  

Economics is all about consumption

Carlos Ball, RIP... Free Market Virtues...

Or at least it should be. And it was when I studied economics in grad school. In recent posts I've complained that the Piketty debate has focused on the wrong variables, income and wealth. These variables do not measure what people assume they measure--economic well-being.

I have finally found an article that actually discusses the Piketty book from a consumption perspective, over at Free Exchange:

Income inequality is the most commonly cited measure, primarily because the data on it is the most comprehensive. However, for the purpose of measuring how inequality affects a community it is also probably the least interesting yardstick of the three.

Consumption inequality, though harder to measure, provides a better proxy of social welfare. This is because people's living standards depend on the amount of goods and services they consume, rather than the number of dollars in their wage packet.

. . .

Within countries however, all three measures of inequality have a positive correlation with each other. Wealth inequality begets income inequality, which in turn begets consumption inequality. So why should we care about which yardstick we use? The yardstick matters when deciding how policy should best respond. Consider, for example, the progressive wealth tax that Mr Piketty promotes in his book. Taxing large family fortunes would surely decrease wealth inequality. However, its impact on consumption inequality is far less clear. While the tax would reduce wealthy households' income, it would also increase their incentive to consume to avoid the burden of the tax. Thus it is possible the tax may actually increase consumption inequality, at least in the short run. Conversely, a progressive consumption tax, which is designed to reduce the level of consumption inequality, will exacerbate wealth inequality.

These policies will have very different, perhaps even diametrically opposite, effects on the two measures on inequality. Thus the way we measure inequality, and the choice as to which we wish to minimise, will have a critical impact on the optimal policy response.

The correct response to economic inequality (from utilitarian perspective) is to abolish all taxes on capital income, and institute a progressive consumption tax.

Unfortunately, most of the Piketty supporters seem to think it's better to have lower tax rates on a wealthy person who devotes his wealth to riotous living, as compared to a wealthy person who is thrifty, putting the money into capital formation, charity, and/or his children's welfare. I have yet to see a persuasive justification for this bizarre policy preference.

One false argument for taxing wealth is that wealth is correlated with excessive political influence. But political influence is more closely correlated with consumption, i.e. what people have to lose. That's why organizations representing groups like teachers, farmers, prison guards, small bankers, realtors, auto dealers, lawyers, etc., are so powerful. They represent a lot of consumption that could be lost if the economy were made more market-oriented. In contrast, America has the highest corporate tax rates in the developed world, and our top personal income tax rates in states with lots of rich people (New York, California, etc.) are unusually high for a "small" government country. No country goes after wealth hidden in overseas tax shelters more vigorously than the US. Never heard of FATCO? Talk to a banker from another country, you might be surprised to find out how hated we are overseas. The extremely wealthy in America are not as powerful as most people assume. Special interest groups (including the moderately wealthy) are extremely powerful.

Contrary to what you read in the press, the top federal rate on personal income is 43.4%. That's because the US has two personal income tax systems, and the wealthy must pay both income taxes. In many states the top combined rate is close to 50%, higher than in most of Europe.

Ironically, the extreme wealth of the ultra-rich weakens their political influence in one very important respect. Because they can't possibly spend all that wealth on consumption, they have no selfish reason not to be idealistic in policy advocacy. Thus they tend to split on issues like high tax rates for the rich, with Gates, Buffett, and Soros supportive, and the Koch brothers against. This weakens their message. In contrast, average (moderately wealthy) businessmen like auto dealers are much more unified in their opposition to free market policies. They don't want to lose that 6 bedroom McMansion.

When I point out that billionaires like Gates and Buffett plan to give away most of their wealth, one response is that the "public" should get to decide who benefits from charity. By "public" I presume they mean the government. The government (public?) may believe that giving money to dictators in Pakistan and Egypt so that they can buy military jets is a better use of foreign aid than inoculating poor kids in Africa.

You can probably guess what I think of that argument.

Comments and Sharing

COMMENTS (20 to date)
Ken from Ohio writes:

The policy solution that Piketty advocates is a wealth tax.

Did I miss something? I thought we already had a wealth tax. It's called inflation. The current tax rate is about 1.5%, with a policy goal of at least 2%.

That tax rate is currently about the same in the US and the Eurozone.

So I guess what Piketty really means is that he advocates a HIGHER wealth tax.

Scott Sumner writes:

Ken, One of the weaknesses of Piketty's book is that he doesn't seem to understand that inflation is a wealth tax.

simon writes:

Inflation is a tax on cash, sure, but how is it a tax on other forms of wealth?

Ghost of Christmas Past writes:

You say economics "should be" about consumption.

I suggest economics "should be" about human action. Human action is driven not just by consumption, but by status-seeking, and things cannot be otherwise because natural selection operates on relative rather than absolute differences between people.

Consider the policy-driven growth of status inequality. Instead of general price inflation due to the Fed's money-printing over the past few years, we have seen much greater inequality of wealth and therefore status. Middle-class people can still afford to eat, but an upper-middle-class lawyer, say, no longer commands 10% of the purchasing power of the bank CEO he works for, but more like 1%. The inflation has mostly been directed into pumping up the nominal wealth of the few at the top so they are much, much wealthier (in current dollars) than the next tier down. Effects on burger prices have been moderate, but the relative prices of goods with inelastic supply or positional value such as Ivy tuition or Manhattan co-ops have grown dramatically.

Note that inequality doesn't depend on actual spending for consumption. If I have $100,000,000 in "investments" and you have, say, $500,000 including your home equity, I don't have to spend 200 times as much as you to have 200 times your status. I can spend, oh, five times what you do. I'll ride in a private jet while you wait in the TSA line and all the pretty girls are gonna want to fly with me, not you. The Federal Reserve will guarantee my investments (TBTF, systemic risk, yada-yada) but your pension will be cut 70% upon transfer to the PBGC and you will be offered 0.5% on a CD to encourage you to gamble your pathetic savings in the stock market, where the modal small investor loses consistently because the market is rigged.

Also, your analysis of US taxation is weak. US taxes, financial regulations, and so-forth, including the behaviors of institutions like the Federal Reserve, are calibrated to minimize competition for the richest by discouraging capital accumulation among the middle classes.

For example, marginal tax rates are highest on the upper-middle-class and low on plutocrats (thanks to policies such as FICA and deductibility "phase-outs," favorable rates on "capital gains," etc.*). It is literally unlawful to offer the best investments to most citizens because they lack the legal minimum wealth to be "qualified investors." The Federal Reserve bails out large investors and their corporate vehicles by directly transferring the wealth of smallholders to plutocrats with ZIRP, interest on reserves, concessionary loans, QE, money-printing, etc.

Right now the Fed gives banks and other large firms money in the form of bail-out loans at low rates which they lend at higher rates to everyone else, a policy financed by pure money-printing which results in plutocrats gaining hugely while non-plutocrats' savings melt like a snow cone spilled on the asphalt in Houston in August.

The goals of FATCA (which is, indeed, evil) and so-forth are controlling and harassing the mid- and upper-middle class, not the "private jet rich" who don't have to worry about keeping a few thousand bucks in a European bank account.

*There is no principled distinction between capital gains and ordinary income in the US tax code, which allows businesses to distribute profits to investors in whichever form is least taxed, e.g., by substituting stock buy-backs ("capital gains") for dividends. By contrast, returns on "human capital" instead of financial capital are termed "wages" and taxed at the highest rate.

Scott Sumner writes:

Dave, I doubt whether inflation helps the rich or poor, unless of course an economy is deeply depressed, and more AD is needed. In that case it helps the rich and the poor.

Warren, That's great.

Simon, Most tax systems (including the US) tax nominal capital income, not real capital income. Thus inflation increases the real tax rate on capital income.

CMA (@CmaMonetary) writes:

Wealth inequality is inevitable. We need to work to ensure that wealth is earned fairly and that an even playing field exists so all can accummulate wealth. Not work on redistributing wealth.

Alot of wealth isnt earned fairly thats the problem.

simon writes:

OK, I would be inclined to frame it as current capital gains and income taxes in effect taxing wealth to some degree due to not being corrected for inflation, as opposed to inflation being a wealth tax as such.

A writes:

CMA, the notion of determining fairness as a criteria for the right to be wealthy opens up a can of worms. Being part of that group that judges fairness is a kind of wealth, in that you hold a claim on the assets of others, albeit perhaps limited by fiduciary "liabilities". So that right of judgement also needs to allocated fairly. And the people who get to select the people who select people like you must also be chosen in a fair process. It's fairness committees all the way down!

Wouldn't it be clearer to just say that you have a preference for the world you would like to live in, and that you want to convince enough of the right type of people so that you can manipulate the world to that state?

A writes:

Maybe instead of searching for the "best" measure of inequality, it would be useful to have measures for different types of inequalities. It seems that different parties have different motivations for investigating inequalities. For example, if improving social stability is a goal, then income and consumption might be less relevant than some direct measure of public outrage diffusion. A person enjoying white asparagus and caviar in a truffle broth might experience the same joy as a person eating entrails with Tabasco sauce. But then, if you have them eat in front of each other, it can stir feelings of envy and hopelessness.

Pajser writes:
Scott Sumner: Ironically, the extreme wealth of the ultra-rich weakens their political influence in one very important respect. Because they can't possibly spend all that wealth on consumption, they have no selfish reason not to be idealistic in policy advocacy.
So, for ultra-rich, the wealth is some value beyond consumption. We don't need to guess that value. It is enough to assume that it is value for other people. If there is utilitarian argument for equalization of consumption, the same utilitarian argument holds for equalization of other values of wealth.
ThomasH writes:

Yes, we should have a progressive consumption tax to compensate the regressive effects of a carbon tax and to raise revenue. Criticizing Pinketty for not advocating that tax is sort of besides the point.

Fonzy Shazam writes:

Great post. To wit: my children are remarkably poor. Their wealth and income are astonishingly low. Sadly, when I was their age, I had a very similar income and wealth situation. It appears no progress has been made in the last 20-30 years. And 15 years ago when I was in college my income was actually much LOWER than my father's income when he was in college at the same university 20 years prior. That's 40+ years of stagnation/decline...

Funny, I can't remember what games I played at the age of 5 on my iPad. My son loves his . . . I traveled to Europe three times while in college. I'll have to ask my dad about his travels there . . . can't seem to remember him talking about it...

Ken from Ohio writes:

It is interesting that certain pundits seem to equate income inequality with poverty. So that a criticism of income inequality carries the same righteous validity as a criticism of poverty.

As Prof Sumner points out, income inequality is not the same as poverty. Consumption is the true measure of standard of living.

The GINI coefficient is a common metric to measure income inequality within groups. The GINI has its problems, but it is a reasonable starting point.

The GINI of the United States is about 0.37
The GINI of Rowanda is also about 0.37
The GINI of the Miami Heat is also about 0.37.

Obviously members of these three different groups vary widely in their degree wealth and poverty

So it is clear that income inequality says nothing about absolute wealth or poverty, only relative differences within the measured group.

We should stop focusing on income inequality and instead focus on the real issue. Poverty

Ken from Ohio writes:

Dave Hamilton has an interesting point

inflation erodes the value of savings (deferred consumption).

But one could make the case that inflation increases the value of current consumption - because current consumption is worth more today than tomorrow.

In Piketty's r>g analysis he never (as far as I could see) considers the value eroding effect of inflation on r. Or the enhancement of inflation on g

So maybe there is an inflation equilibrium point at which r=g

Anand writes:

A few points

a) Is anyone in political life in the US seriously proposing a progressive consumption tax? If not, is it really so bad to have a bit more progressive income taxation or wealth tax, on purely utilitarian grounds? Even if it is somewhat of a blunt instrument compared to consumption, surely the correlation is better than nothing?

b) I find the Free Exchange argument unpersuasive. In reality, it notes that there is a positive correlation between the three, and that is much more persuasive than any argument with "may", "might", "perhaps", "at least in the short run", with pure thought experiments backing it up.

c) For the top rates you mention, I wonder how many people pay those rates, and aren't there loopholes for that sort of thing? I don't really know much about "effective" corporate and income tax rates in US compared to OECD, say.

d) You seem to dismiss the argument too easily that the wealthy might get their way too much. You point to associations for teachers/doctors etc., which no doubt have an effect. But what is your measure when you say that the wealthy don't have that kind of clout? And how does one say what is enough? How much of a clout should a teacher's union with many thousands of members really have? Also, what do you think of Gilens/Page research exploring this?

RPLong writes:

I was going to point out that consumption taxes are complicated, but but EconLib actually has a great article on the subject, which convinced me otherwise.

Mark V Anderson writes:

Very good post. Leftists ignore consumption probably because it undermines their argument of inequality. Ghost makes a good point that wealth has benefits other than consumption, but that is only a mitigation. Consumption is still a much better measure of well being than wealth or income.

Anand - The US tax system is already greatly progressive. Not that you'd know that reading the mass media. That only 53% pay income tax has been somewhat publicized. But did you know that the highest earners average over 20% federal tax (not counting state tax, and prior to the new 4% investment tax)? Contrary to Buffet's essay. And those that bring up FICA forget that it is a forced pension payment, not really a tax.

I do agree that Sumner's posting understated the political benefits of wealth, but it certainly is true that the rich don't have a unified agenda. But I don't see why we don't have a larger inheritance tax, which only takes money from heirs that haven't earned it.

Alan Reynolds writes:

Piketty and Saez don't focus on income and wealth, they focus on (1) pretax, pretransfer income as reported on individual tax returns, and (2) wealth as estimated from a creative mixture of estate tax returns and surveys or inferred from capital income reported on indivdiual tax returns.

Their measure of income might reflect relative well-being only in a world with no taxes and transfers.

As for their measures of wealth see

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