How does income inequality affect happiness?

Early yesterday the thought occurred to me that it might be a good idea to write something about the effects of inequality on happiness levels. I have been thinking that the judgements people make about inequality are more like judgements about the characteristics of a good society than judgements about the effects of inequality on aggregate happiness (whatever that means). I thought I would spend an hour or so bringing myself up to date with the literature and then another hour or so writing something - and the rest of the day in the garden. However, the process has taken longer than I thought it would (and this post might also take longer to read than some people might think appropriate).

The issues involved are fairly complex. There are at least three different aspects of the relationship between income inequality and happiness that might be relevant – the effects of relative income levels on happiness, the more general effects of income inequality on happiness and the effects of income inequality on happiness inequality.

How do relative income levels affect life satisfaction? As discussed here some time ago, this is not always about envy and status-seeking. The findings of a study by Guy Mayraz et al, based on German panel data, are consistent with the more conventional view that income comparisons tend to have negative effects on life satisfaction of people with relatively low incomes. However, some of the authors’ findings shed further light on the issues:

• ·         Life satisfaction of men is more affected by relative income than that of women.
• ·          Comparisons with friends and neighbours are less important than broader comparisons with the whole population.
• ·          Those who perceive income comparisons to be important tend to have lower life satisfaction.
• ·         The negative effect of relative income comparisons for those with below average incomes is balanced (from a Benthamite perspective) by the positive effect for those with above average income.

Does inequality have an effect on life satisfaction over and above the relative income effect? Studies which have attempted to answer this question have often reached different conclusions. A recent study by Paolo Verme, which seems to be technically superior to previous studies, has found that income inequality tends to have a significantly negative effect on life satisfaction, after controlling for relative income effects etc. The results seem to apply in western countries as well as non-western countries and to rich people as well as to poor people.

This raises the question of why income inequality might have these effects. One possibility is that people feel more comfortable in societies where opportunities are relatively equal. Another possibility is that they are more concerned about equality of outcomes. If so, it seems reasonable to suppose that they are concerned about income inequality because they think it results in happiness inequality.

Is there strong correlation between income inequality and happiness inequality? In a post a couple of years ago I suggested that there was not much evidence of correlation between income inequality and happiness inequality - on the basis of a paper by Jan Ott and some research of my own. Since there were not many countries included in these studies, it seemed like a good idea to produce the scatter diagram below showing measures of income and happiness dispersion for a larger number of countries. (I used World Bank and CIA data on the income/consumption gini and data on standard deviation of life satisfaction from Veenhoven’s latest IAH paper. Both series are based on information for various years during the last decade.)

I can’t see any relationship between the variables in the chart, but statistical analysis suggests that a weak positive relationship might exist.  (The correlation between the variables is 0.13. The estimated coefficient relating inequality of happiness to inequality of income in a linear regression is positive, but the standard error is not much smaller than the estimate. The ‘t’ statistic is 1.38.)

The absence of a strong relationship between inequality of income and happiness at an international level is consistent with the observation of Betsey Stevenson and Justin Wolfers that there has not been a close link between trends in happiness inequality and income inequality in the United States. It is also consistent with the findings of a paper by Leonardo Becchetti et al, based on panel data, that the increase in income inequality has not been one of the drivers of the increase in happiness inequality in Germany.

So, how did this information enlighten me on the question of whether the judgements people make about inequality are more like judgements about the characteristics of a good society than judgements about the effects of inequality on aggregate happiness? The effects of relative income on life satisfaction do not seem relevant to this question. The relationship between income inequality and individual happiness does seem relevant, but I suspect it has more to do with empathy with compatriots and a desire to alleviate suffering of people near the bottom of the income scale rather than a more general concern about distributional equity.

Happiness inequality also seems relevant. When Ruut Veenhoven argues that the quality of a society should be judged by the disparity of happiness among its citizens as well by average happiness levels, he is clearly making a judgement about the characteristics of a good society. The weakness of the relationship between income inequality and happiness inequality certainly suggests that caution is required in basing judgements about the relative quality of different societies on income distribution data. The question I am left with, however, is to what extent disparities of happiness can be attributed to government policies and societal institutions (the rules of the game) rather than individual and group behaviour. It seems to me that to the extent that we introduce distributional considerations into our consideration of the quality of different societies, we are on safer ground in basing our judgements on the distribution of opportunities that are offered, rather than on the distribution of happiness outcomes.

Where is Ross Gittins coming from?

A few days ago, Evan, a person who comments on Jim Belshaw’s blog, wrote: ‘I think Ross Gittins is a good model for how to write on economics’. That was in response to a discussion Jim and I were having about Robert Frank’s ‘The Darwin Economy’ and the difficulty that we were experiencing in communicating on the issue of whether the ideology of the market is having too much influence in modern society. At least, that is my take on what the discussion was about. Jim and I agreed with Evan that Ross does write well.

It occurred to me soon afterwards that I have been ignoring Ross Gittins’ views on happiness for too long. Ross is the economics editor of the Sydney Morning Herald (SMH) and the leading economic journalist in Australia writing about happiness. When people have asked me what I think of Ross’s views on happiness I have refrained from saying much on the grounds that I rarely buy the SMH and haven’t read many of Ross’s columns in recent years.  I can’t use the excuse any longer, however, because I have discovered that Ross has a web site on which he posts his columns. (I have recenly included a link to the site on this blog to encourage myself to read his columns more regularly.)

When I looked at Ross’s site it was clear that, as well as the happiness theme, he is sometimes still playing an old tune that I like about the benefits of free trade. For example, one of the articles I read warns of the dangers to the rest of the economy from attempts to shield manufacturing industries from the consequences of the boom in the resources sector. This is consistent with the contribution Ross has made throughout his journalistic career in bringing good sense to public discussion of many economic issues.  I have a particularly high regard for the contribution that Ross made in earlier years in helping to improve public understanding of the costs of high trade barriers that were supporting inefficient resources use and unproductive work practices in this country. He deserves a medal!

But, what about Ross’s views on happiness? It wasn’t hard to find his review of ‘The Darwin Economy’. While well written and informative, the review is totally uncritical. In concluding his review, Ross gives the author, Robert Frank, the last word: ‘Frank concludes that the real reason we regulate markets is to protect ourselves from the consequences of excessive competition’. I was left with the impression that Ross concurs with that view.

How does Ross reconcile the view that regulation is desirable to protect against competition with his knowledge of how regulation has worked in the past in Australia to protect privileged interests at the expense of the rest of the community? How does Ross reconcile his opposition to economic growth, with his apparent ongoing support for productivity growth? I decided to buy Ross’s book, ‘The Happy Economist’ to see whether I could understand where he is coming from. (Since Ross is a strong supporter of international competition I’m sure he will not mind if I let readers of this blog know that I purchased the Kindle edition from Amazon for $9.99, rather than paying Allen and Unwin $26.99.)

I enjoyed reading Part I of the book, which is a discussion about such things as the nature of happiness, the evolutionary purpose of happiness, who is happy, whether wealth makes people happy, whether work makes them happy. This part of the book ends with a discussion of 10 hints about how to be happy. Perhaps it is strange for an economic journalist to be offering such advice, but from my (fairly extensive) reading in this field I get the impression that the advice Ross offers is based on the best research available.

Part II is comprised largely of an attack on mainstream economics and a sermon on ecological economics, mixed up with a strong dose of paternalism and proposals for increased government regulation. Despite all that, Ross manages somehow to convey the impression that he is more concerned about adulation of ‘the market’ than the actual existence of markets and competition.

Ross seems to be particularly concerned about the tendency of humans to over-indulge. He notes that many of us are tempted ‘to eat too much, get too little exercise, smoke, drink too much, shop too much, save too little, put too much on our credit cards, and work too much at the expense of our family and other relationships’.  He suggests that ‘individuals know they have trouble controlling themselves and would appreciate government taking temptation out of their way’.

This reminds me of a comment by the late Roger Kerr, executive director of the New Zealand Business Roundtable, in a speech aboutthe concept of progress that he made in 2009. Roger suggested that one consequence of the ‘fashionable academic preoccupation with happiness’ might be for more people to adopt the view: “I’m bald, fat and grumpy. What’s the government going to do about it?” I don’t think that is a necessary consequence of happiness research, but it seems to me that Ross is encouraging that kind of attitude in his paternalistic proposals. Among other things, Ross apparently wants governments to re-regulate shopping hours, limit advertising and take action to discourage spending on positional goods.

Ross’s presentation of his views on productivity, economic efficiency, market preferences and regulation involve as many twists and turns as the road from Thimphu to Punakha. At the risk of making this post excessively long, an appropriate place to begin might be with Ross’s claim that the regard mainstream economists have for ‘revealed preference’ – the idea that the choices people make reveals their preferences - has somehow led them to become ‘the great facilitators and advocators of economic growth – the high priests in the temple of Mammon’ (p 164). Economists who respect revealed preference actually have a long tradition of opposition to proposals by economic planners to lift savings and investment rates or give people incentives to work longer and harder in order to raise economic growth rates. My attitude has always been that if individuals prefer to spend rather than save or to enjoy leisure rather that to work long hours, their choices should be respected. A substantial component of my work involved providing advice about how governments could facilitate economic growth, but facilitating is about removing obstacles rather than pushing people around.

Ross makes it clear that he doesn’t see economic growth as being able to continue indefinitely – and in this regard he sees himself as one of history’s hastening agents (if I may borrow a phrase much used by a former work colleague). His discussion about ecological limits to growth and the desirability of the stationary state had me wondering how he was proposing to stop technological progress – a major source of economic growth. Ross eventually acknowledges that improvements in the efficiency with which resources are used are desirable. He suggests: ‘its growth in the throughput of natural resources we should forswear, not the rise in gross domestic product that comes from the continued pursuit of productivity improvement’ (p 221).

However, a few pages on Ross tried to convince me that I shouldn’t fear the end of economic growth. He states:

‘Many of the things that reduce our happiness stem from the search for greater efficiency so as to contribute to economic growth. Easing the efficiency imperative would be hugely liberating’ (p 229).

So, we will have productivity growth without the ‘efficiency imperative’ of market disciplines?

Ross agonizes further about efficiency a few pages later:

‘My fear is that, were the goal of increased efficiency to be abandoned, the motive of rolling back areas of privilege would be lost. It would then be a matter of first in, best dressed. Workers in unprotected industries would be obliged to continue propping up protected industries in perpetuity, with a great likelihood that, should further difficult times emerge, the privileged industries would be first in line for additional assistance in the name of preserving the status quo’ (p 233).

Well put! I am glad that Ross is troubled by that thought.

The closing sentence of Ross’s book reads: ‘In the end we are what we feel’. I think that might contain the key to the problem Ross has in reconciling his belief that because individual humans are inherently fallible they can’t be trusted to pursue happiness as they wish, with his admiration for the efficiency of markets and his understanding that governments are neither angelic nor infallible .

Our feelings are important. We obviously make ourselves unhappy when we make bad choices. But they are our choices. The nature of humans is such that we cannot flourish unless we have responsibility for our own lives.  

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.

What did Adam Smith think of externalities associated with the efforts of individuals to improve their relative position?

I have enjoyed reading Robert Frank’s new book, ‘The Darwin Economy: Liberty, Competition and the Common Good’, more than I thought I would. This may be because I felt that the book had been written for people like me - the author seems to want people who have a strong regard for individual liberty to give serious consideration to his views.

I had expected Frank to argue that competition for positional goods involves a negative externality because those who are most successful are envied by many of those who are less successful. However, the view he presents of the nature of externalities associated with competition for positional goods is more subtle and less easily dismissed.

The starting point of Frank’s analysis is the ‘invisible hand’ of the market, which Adam Smith had suggested in ‘Wealth of Nations’ leads self-interested individuals to promote the greater good of society, without intending to do so. Frank describes Smith’s invisible hand as ‘a genuinely groundbreaking insight’, even though, as Smith recognized, the invisible hand ‘breaks down’ to some extent in the presence of externalities, public goods, and so forth. The particular negative externality that Frank is most concerned about in this book is associated with circumstances where individual rewards depend on relative performance and result from the strivings of individuals to improve their relative position. He contrasts this striving to improve relative position (which he describes as Darwinian competition) with the benign competitive forces associated with Adam Smith’s invisible hand.

Frank’s discussion of the different views of competition that he attributes to Darwin and Smith reminded me that Adam Smith had actually written about the strivings of individuals to improve their relative positions in ‘The Theory of Moral Sentiments’ (TMS). Smith suggested in TMS that what people hope to achieve by bettering their condition is not ‘ease’ or ‘pleasure’ but ‘to be taken notice of with sympathy, complacency and approbation’ (p 50-51, Liberty Fund edition, 1982). Later in the book, Smith suggests, however, that ‘the poor man’s son, whom heaven in its anger has visited with ambition’ imagines that if he attained wealth and greatness ‘he would sit still contentedly, and be quiet, enjoying himself in the thought of the happiness and tranquillity of his situation’. According to the story, this ambitious man endures a great deal of misery striving to better his position. By the time he achieves his goal, however, he is near the end of his life ‘his body wasted with toil and diseases, his mind galled and ruffled by the memory of a thousand injuries and disappointments …’. At this point he begins to think that ‘wealth and greatness are mere trinkets of frivolous utility’ offering little ‘ease of body or tranquillity of mind’ (p 181).

In my view, Smith’s story understates the benefits that people obtain from wealth because it doesn’t take account of the greater autonomy wealth enables them to enjoy. (I have discussed the link between wealth and autonomy previously on this blog.)

Smith was suggesting that people tend to make cognitive errors of the kind discussed by Daniel Gilbert in his book, ‘Stumbling on Happiness’. This view of strivings to improve relative position differs from that of Robert Frank, who does not rely on departures from the individual rationality assumptions normally used in neo-classical economics.

The similarity between the views of Adam Smith and Robert Frank in relation to strivings to improve relative position lies in the fact that both seem to see this as more or less a zero sum game, with externalities involved. Adam Smith wrote as follows about the externalities associated with the strivings of individuals to better their condition:

‘The pleasures of wealth and greatness … strike the imagination as something grand and beautiful and noble, of which the attainment is well worth all the toil and anxiety which we are apt to bestow upon it.

And it is well that nature imposes upon us in this manner. It is this deception which arouses and keeps in continual motion the industry of mankind. It is this which first prompted them to cultivate the ground, to build houses, to found cities and commonwealths, and to invent and improve all the sciences and the arts, which ennoble and embellish human life; which have entirely changed the whole face of the globe, have turned the rude forests of nature into agreeable and fertile plains, and made the trackless and barren ocean a new fund of subsistence, and the great high road of communication to the different nations of the earth’ (p 183).

These days many people would be less inclined to count as a benefit some of the ways in which the face of the globe is being changed by the motion of industry. But Smith’s insight that strivings of individuals to improve relative position can encourage technological progress is still relevant. If such strivings also result in negative externalities, those need to be balanced against the positive externalities that Adam Smith identified.

I promise to write about Robert Frank’s views in my next post.