## Sunday, March 7, 2021

### Merit doesn't cause income

In a podcast interview with the terrific Joseph Walker, geneticist Robert Plomin said something that stuck in my mind—"in a meritocracy there will still be large deviations of income due to genetic variation in abilities."

I also stumbled onto an economics blog about capital taxation that relied on the idea that high capital incomes come from previous savers who therefore deserve that higher income (I can't seem to find it again, but I'm sure you've heard the idea before). To bring Plomin's comment into the mix, we could say that if genetics determines time-preferences or risk-taking attitudes, then capital incomes are also determined genetically. Taxing those capital incomes is therefore taxing the "merit" of saving.

Like much of the economic and political debate about poverty and inequality, these ideas rely on a flawed understanding of how income is distributed in human societies. That flaw is to pretend that there is something called "merit" or "value" (or "productivity" for that matter) that is independent of the ability to be rewarded via payments.

Think about it like this. We often look at the characteristics of people who earn more money—their education, their patience, their leadership skills, their attractiveness—and then label those attributes that correlate with incomes as "merit", or "value", or "productivity". This approach merely defines "merit" based on current income. If "merit" causes incomes, there must be a way to define and measure it independently before looking at any correlations.

Imagine LeBron James was born in 1784. His genetic gifts are identical—his athleticism, work ethic, and his overall intelligence on every dimension. His genetic "value" or "merit" assessed without reference to his income is identical to what it is now.

But society at that time would be structured in a way that his genetic gifts would make him a high-value slave. His personal reward would be the pleasure of working hard manual agricultural tasks for longer, and the slave owner would get the income for having the "merit", "value", and "skills" of cultivating high productivity slaves. (Do you see the parallel with capital owners generally? Their "skill" and "value" is choosing investments. In practice, that means choosing what tasks other people do when they work for their income.)

Here's another example. In-breeding of royal families historically led to genetic variation that made many of them useless in the productive activities of the day. Despite this, their incomes and power remained nearly identical to their genetically superior siblings. If our social structures mean that "merit" determines income, and "merit" is heavily genetically determined, this should not happen.

In fact, if you follow the logic that genetic variation causes merit variation, which causes income variation, then genetically diverse places should naturally have more inequality. That "homogenous Nordics" argument rears its head again. Compression of genetic variability or some other attribute we have labelled "merit", like education, is therefore seen as the best way to compress the income distribution.

But in reality, the Nordics compress their income distribution through welfare state policies. Their market income distribution is much the same as peer nations. They merely choose to create a social structure that keeps the income distribution more compressed regardless of any underlying variation in individual attributes, genetic or otherwise.

We also know that income and wealth inequality has grown tremendously in the past four decades. This has nothing to do with changing genetic variation. It has nothing to do with a changing distribution of an independently-assessable concept of "merit". School teachers make lower relative salaries today because we chose not to raise their salaries faster. Some countries didn't do this, and their school teachers make more money.

Some of you might be thinking that places with high-income school teachers have better teachers. But you are again failing at basic logic by reversing out "merit" from income.

We know that increasing incomes actually causes changes in personal attributes that are usually labelled as "merit" and assumed to be determined independently from income. Basic income experiments show that higher incomes cause people to become more confident, trusting, healthy, less depressed and more able to concentrate, for example.

It seems logical to me that if there is no such thing as an independent concept of "merit" or "value", then we should simply choose a more compressed income distribution in society rather than the unequal one we have chosen. That more compressed distribution will help avoid the pitfalls of high inequality by ensuring that regardless of variation in genetics or "merit", people can live comfortable lives and take opportunities that low incomes often prevent them from doing.

In practice, this comes about by setting an income range via the tax and transfer system. Very high marginal tax rates on high incomes, coupled with generous unconditional payments for low-income households, will compress incomes.

Perhaps the minimum income could be roughly $20,000 per person (with variation depending on household size and type), with a maximum of$2,000,000 per person. That leaves a 100x income range within which market-based incentives can operate. I see no reason why the range of variation should be any higher than that. Can individual merit, however defined, really explain a 1000x variation in income? Will some people not go to work because they earn $8,000 per day instead of$20,000 per day, even if there are no \$20,000/day options because of the tax system? I doubt it. People won't even see a change in their rank within the distribution.

Income compression should be the focus of policies for dealing with poverty and inequality. Ideas that rely on "merit", "value", or "productivity" are going to be failures as they implicitly (or explicitly) define merit by income.

1. Indeed, merit does not determine income. What does determine it ultimately is consumer preferences.

As you say, there's no independent "value", but your suggestion to cap incomes, or otherwise redistribute wealth doesn't follow from that fact.

A free market is a mechanism to optimize individual preferences, and wealth inequality is a byproduct.

The problem with redistribution is not that it fails to reward "merit", rather the problem is that it sabotages the mechanism to optimize for consumer demand. (There's also an ethical problem, summarized by "taxation is theft", but this is outside the sphere of economics).

1. "A free market is a mechanism to optimize individual preferences, and wealth inequality is a byproduct."

I disagree. In my view there is no such thing as a free market. Only a strict "big government" regulatory regimes can create the property and contract laws necessary for what we call a "free market". It is a regulation like any other that arguably steals land from the common pool for private beneficiaries, just like taxes.

2. If taxation is theft, then property is theft and for exactly the same reason (it is ultimately supported by the threat of law - which is backed by violent enforcement).

2. I don't think redistribution necessarily sabotages the mechanism that optimises for consumer demand. Redistribution from the top to the bottom can at least reveal more consumer preferences by providing choices that were previously denied - which looks more like optimisation of consumer demand.

3. @unknown, what you say sounds like the broken window fallacy.
Yes, you can shift what preferences get fulfilled, but in the process you'll be creating dead weight loss and disincentives.

1. In a redistribution, the opportunity costs would be spending by the top. Given the lack of any evidence that trickle down exists to any material extent, do we currently need more spending, or even the existing spending by the top?

Given also the existing low interest rate environment, there are dead weight losses and disincentives. We're seeing/have seen significant asset inflation in the share market and in property - driven by low interest rates. How many times do the same houses/shares have to be sold (and I note that the top end of the market is rocketing up again) before anything worthwhile is produced?

Low interest rates benefit the wealthy and higher income earners disproportionately when compared with others further down the feeding chain, ***at the same time misallocating economic resources*** away from worthwhile pursuits and towards shares and property. Redistribution is a way of addressing this misallocation, increasing future demand to provide businesses incentive to invest, and making things fairer. How long it would need to continue for is a discussion for another day.

4. Can you explain why low interest rates benefit the wealthy?
Doesn't it mean the return on capital is lower, as compared to the return on labour. (Sure, asset prices increase when interest rates go down, but the coupon e.g. on bonds or rents doesn't change, and the return on capital is now lower for new investments).

Regarding trickle down, I'd say we live in a world with massive redistribution, and under laizzes-faire the poor will enjoy greater prosperity, primarily via stronger growth, not from trickle down of spending.

1. Consider your bond example. The coupon stay constant, but low interest rates increase the value of the bond. So your income stream is identical, but the value of your asset is higher. Your economic return (change in asset value plus income) is higher. Same with housing. Rental flows are the same, but asset prices increases. In an economic sense, but changes in asset value and income flows are equivalent.

Does that make sense to you?

2. That explains the increase in asset prices during the transition, I noted that in my previous comment.
The thing is, the new income will be reinvested at a lower yield.

In the long run this means labour has higher return than capital.

In the short run labour will be disadvantaged only in so far as inflation kicks in.

Consider a case where interest rates fall, price level stays on trend (including e.g. rents), and asset prices rise. From the labourer pov not much changed, from the capitalist pov the value on paper increased, cash flow stays the same, and yields on new investment falls.

3. "Regarding trickle down, I'd say we live in a world with massive redistribution, and under laizzes-faire the poor will enjoy greater prosperity, primarily via stronger growth, not from trickle down of spending."

The USA is an example of something approaching a laissez faire economy. Unfortunately, after allowing for inflation, the wages of US men without college degrees have fallen for 50 years (see Deaton and Case, Feb 2020), so no, we cannot assume that the poor will enjoy greater prosperity due to economic growth.

What appears to matter is the degree to which institutions have been captured by vested interests. Cameron's Game Of Mates is mandatory reading on this subject as it applies to Australia.

4. The US by no means approaches laissez faire. Government share of GDP is about one third.
Indeed, institutions are captured by vested interests, corporate welfare is widespread. This is by no means a free market.

Also, whether wages really fallen strongly depends on how price levels are being calculated (see the boskin commission report).

5. I think that this is a reasonable argument. There's probably a case for some natural variation, and definitely a need for a band of variation for market variability and incentives to function. However we do now seem to live in a world where this balance has gone way over a cliff.

There is a certain segment of society which now has such a high level of income and assets, that it has arguably become counter productive to social progress. Once these people have so much, they run out of things to consume. So they endlessly buy financial assets off each other. In essence it's peak capitalism in developed countries, as even with 0% interest rates people still will save/invest because there is little left for them to consume except buy another investment property etc. But we don't actually need these people to do this for our economic system to function well. And arguably Cameron's point on work incentives is somewhat supported in literature. Work and investment incentives of high income individuals (particularly primary household breadwinners) are far less sensitive to marginal rates.

Taxes are needed to curtail excess demand and prevent overheating of the economy. Savings (abstaining from consuming), serves a similar function. But if some people's marginal propensity to consume is approaching zero, then taxing them wouldn't have much impact on the real economy. It would merely take the inflationary heat out of financial and asset markets where all that endless demand seems to currently go. If anything re-distributional policies are needed to curtail the extremely unequal distribution of power high wealth/income segments of societies hold, which they use to distort democracy and the market in their favour.

That said, not really sure I would support a maximum income in practice. The real issue with high marginal income tax rates is whether it's effective in actually taking money off those people. At some point the cost of tax avoidance/evasion, migration etc. becomes lower and makes those marginal rates drives that money into making enforcement impractical. But in general the case for increasing progressive taxation through both broadening and increasing income tax, and utilising other progressive rent based taxes is highly valid. There's plenty of literature (e.g. Stiglitz) to suggest that we are at a point where redistribution aimed at reducing inequality would increase growth, rather than become a tradeoff. We are definitely not facing an incentives and growth problem from deficient market incentives - except for perhaps extremely high and regressive EMTRs on households and second income earners, which again is product of cutting those top marginal tax rates on individuals and heavily means testing welfare.

6. On QE: