Robert H. Frank is H.J. Louis Professor of Management and Professor of Economics Johnson Graduate School of Management, Cornell University
What are the practical consequences of the failure to recognize that we live in a Charles Darwin’s economy rather than in Adam Smith’s?
Smith's uncritically enthusiastic modern disciples think his invisible hand theory makes government unnecessary. Just turn selfish individuals loose, they say, and the magic of free markets will take care of everything. Smith himself believed no such thing, of course. With many modern social critics from the left, he thought government regulations were needed to protect workers and consumers from exploitation by powerful economic elites.
Conservatives respond, accurately, that markets are far more competitive now than they were in Smith's day. But as Charles Darwin saw clearly, individual and group interests don't always coincide, even in perfectly competitive environments. Success in such environments, he realized, depends much more on relative performance than on absolute performance. And when individuals jockey for position for scarce slots atop any hierarchy, many of their actions are mutually offsetting, and hence largely wasteful.
The massive antlers of the elk are a case in point. Because a small minority of bull elk sire a disproportionate share of all offspring, bulls fight bitterly with one another for access to females. Their primary weapons in these battles are their antlers, which span four feet and weigh more than 40 pounds. Natural selection fueled the arms race the led to such antlers, because at each stage bulls with larger antlers were more likely to win their battles, and hence more likely to pass their genes along. But the massive antlers of modern animals are a significant handicap for bull elk as a group, making them much more vulnerable to wolves in densely wooded areas. Bulls would have good reason to favor a proposal to scale each animal's antlers back by half. After all, that wouldn't affect the outcome of any fight, and it would make each animal less likely to be killed by wolves. But evolution favors individual interest, not group interest. Any individual bull with smaller antlers would never pass his genes into the next generation.
Similar individual-group conflicts play out in the marketplace. A parent, for example, might accept a riskier job at higher pay in order to be able to bid more aggressively for a house in a better school district. But when other parents make the same move, they succeed only in bidding up the prices of the houses served by the best schools. As in the familiar stadium metaphor, all stand to get a better view, only to discover that no one sees any better than if all had remained seated.
What is to be done, in order to make the economic pie larger?
One of the biggest sources of waste in modern economies is the waste associated with mutually offsetting spending patterns. In the US, and to a lesser but still significant extent in other industrial nations, most of the income gains in recent decades have gone to people at the top of the income ladder. Naturally, they have been spending more, and when they do, they shift the frame of reference that shapes the spending of others just below them, and so on, all the way down the income ladder. Without reference to these "expenditure cascades," there's no way to explain why wedding celebrations in the US now average $30,000, almost three times as much as they did 30 years ago. But the extra expenditures haven't really bought anything of value. Surely no one could argue with a straight face that the couples getting married today are happier because their weddings cost so much more. The extra spending has simply raised the bar that defines how people are expected to celebrate special occasions.
Much of the resulting waste could be curbed by abandoning the current progressive income tax in favor of a much more steeply progressive tax on each household's annual consumption expenditure. Families would report their incomes to the tax authorities as they now do, and they'd also report their annual savings, as many now do for tax-exempt retirement accounts. The difference between those two numbers--income minus savings--is the family's annual consumption. That amount minus a large standard deduction--say, $30,000 for a family of four--is the family's taxable consumption. Tax would be levied on that amount, with low rates at first. As taxable consumption rose, rates on the next dollar would also rise, and at very high levels of taxable consumption, rates would be substantially higher than under the current income tax.
Consider how this tax would alter the incentives confronting a wealthy family that had been considering a $2 million addition to its mansion. Even the rich respond to prices. (That's why they live in much smaller housing in New York City than in Seattle.) Because the after-tax cost of their planned addition would be sharply higher than before, they would scale back. And because others in similar circumstances would also scale back, the new smaller additions would serve them all just as well as the larger ones would have. Does anyone doubt that, beyond some point, it's relative mansion size that matters?
Because savings would be tax-exempt, the biggest spenders would save more and spend less not just on mansions, but also on weddings, coming-of-age parties for their kids, and other luxury items. They would save more, and the resulting investment would promote growth in productivity. Consumers just below the top, who are influenced by those at the top, would also spend less, and so on. In short, a progressive consumption tax would attenuate the expenditure cascades that have made life so much more expensive for the middle class.
Adopting a progressive consumption tax would be like creating wealth out of thin air. Its magical quality stems from the fact that luxury spending is strongly context-dependent, just like antlers are. If everyone spends less, someone will still have the biggest mansion or the most lavish party, or the most massive antlers, but it will be also be possible to achieve many other important goals.
Why did it take so long to get started with a movement like Occupy Wall Street?
One thing that's always been different about the US is that the middle class feels little resentment of the rich. Perhaps that's because the American dream is that everyone thinks he or she will be rich some day. Socio-economic mobility is actually much lower in the US than in other countries. If you're born poor here, you're more likely to stay poor than in most other places. But that's not the perception. In any event, the economic difficulties experienced by the middle class in the US are not a result of their trying to emulate the rich directly. They know that's impossible. The effect has been indirect, through the process of expenditure cascades described earlier.
But as the economist Herb Stein once said, "If something can't go on forever, it won't." Conditions of middle-class life in the US have grown steadily more difficult. As some point, people were bound to push back.
Thank you very much.
Robert H. Frank is Professor of Management and Professor of Economics Johnson Graduate School of Management at Cornell University. He contributes to the “Economic View” column, which appears every fifth Sunday in The New York Times. Prof. Frank is the author of the current book (2011) The Darwin Economy.