Econ4620 Alexander W. Cappelen Welfare and justice Econ4620 Alexander W. Cappelen

Introduction Why do we levy taxes? Why do we dislike taxes? To improve the allocation or the distribution of resources Finance essential state functions Correct for externalities Stabilize the economy Finance public goods (or publicly provided private goods) Redistribute income Why do we dislike taxes? It creates distortions It reduces the income of some individuals

How do we determine the optimal tax level? In order to determine the optimal level of taxation we need to weigh the benefits of taxation against the costs of distortions In order to make such trade-offs we need to have a clearly formulated policy objective We need an ethical theory – a theory of distributive justice

Ethics and decision making Ethics – a tool for decision/policy makers. The design of institutions and policy decisions have consequences for a large number of different agents. These agents have different interests and will often disagree about what the best decision is. A decision maker has to balance conflicting demands from different groups. Almost all policy decisions will benefit some individuals and harm others. This is particularly the case for the design of the tax system.

The need for ethics We need ethics in order to handle these types of trade-offs. Ethical theories are well-founded answers to the question of what is good and what is bad. What is the best decision all things considered. Three fundamental questions: Towards who do we have obligations? What type of obligations do we have? How do we handle conflicting obligations?

Social welfare functions Economists traditionally formulate policy objectives as a social welfare function Describes total social welfare as a function of individual welfare or utility There exist a number of Pareto-efficient allocation, but they give different distributions of resources and welfare between individuals

Cont. A social welfare function ranks different Pareto-optimal allocations: Utility possibility frontier

Different welfare functions The fundamental question: how much weight should be placed on the welfare of different individuals? Should people with low welfare/income be given more weight than people with high welfare/income? Two important versions in the two person case: The utilitarian principle: The maximin criterion Intermediate positions place more weight on the individual with low welfare.

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Utilitarianism The dominating ethical theory the last 150 year. Jeremy Bentham (1748-1842) and John Stuart Mill (1806-1873). Ethical principle Choose the alternative that maximizes the sum of individual welfare A principle of vertical equity Justification: what would an ’impartial spectator’ choose? Corresponds to some important moral intuitions, e.g. about how to settle conflicts.

Utilitarianism An ethical theory that is well suited for decision makers Has been important for the development of the welfare state An argument for progressive taxation Diminishing marginal utility of income But can also justify income inequalities Has been very important for the development of economic theory Welfare economics The theory of optimal taxation Cost-benefit analysis

How does utilitarianism answer the three questions? Towards who do we have obligations? All human beings Animals? What type of obligations do we have? We are obliged to promote the good. We should only be concerned with the consequences of different alternatives A consequentialist theory Forward-looking It is only concerned with one type of consequences: Consequences for individual welfare. A welfareist theory How should we handle conflicting obligations? It gives equal weight to all individuals An egalitarian theory?

Different types of critique In the rest of the lecture we shall discuss some important types of critique and some alternative theories of justice The theory cannot be implemented Utility cannot be measured Interpersonal comparisons are impossible The theory does not describe the just distribution Gives too little weight to the worst off Justifies unacceptable actions Does not take account of individual desert and responsibility We should not only care about consequences

How do we measure utility What do we mean by utility? Pleasure or absence of pain? Satisfying peoples preferences? Should we base our calculations on people’s own evaluations? Do people know their own good? It is better to be a discontent Socrates than a happy idiot (Mill) The tamed housewife and the happy slave What do we do with ’anti-social’ preferences? Cardinal or ordinal measures? We can describe peoples preferences using a mathematical function, but how do we interpret these numbers? Endogenous preferences

Interpersonal comparison Even if we can measure individual utility we still need to compare individual utilities in order to make utilitarian comparisons. How is it possible to say that one person has twice as happy as someone else? The new welfare economics in the beginning of last century was concerned with what economists could say without making interpersonal comparisons. Partly explains the importance of the Pareto-criterion The new public economics, however, assumes cardinal utility and interpersonal comparisons.

Can anything be justified? Can we justify any act if the consequences are good? Utilitarianism can justify cruel acts if the benefits outweigh the costs It might be optimal to sacrifices an individual in order to promote the welfare of others Should we not attach any importance to the character of an act?

Desert and reward The concepts of desert and reward are fundamental ethical concepts. Many people see the questions of justice primarily as a questions of ’Who deserves what?’. The relationship between effort and reward has also been central to several economists and philosophers.

Cont. ’Every person, if possible, ought to enjoy the fruits of his labour…’ (Hume). ”Though the water running in the fountain be everyone’s, yet who can doubt that in the pitcher it is his only who drew it out?” (Locke) ”The produce of labour constitutes the natural recompense or wages of labour”(Smith). ”From each according to ability, to each according to effort” (Blanqui) The concepts of desert and reward have little role in public economics. The main reason: consequentialism (utilitarianism)

Consequentialism Always choose the distribution that gives the best consequences. Forward-looking. What are the effects on GDP/total welfare What are the effects on income distribution Has no room for individual desert The only reason to reward is related to incentive considerations. Violates the idea that a reward should be related to the effort exercised.

Non-consequentialist theories Tries to capture the idea that effort and historical information might be important in distributive justice. Backwards-looking. Who did what? What were peoples intentions? We can only evaluate a distribution if we know how it came about. We shall discuss to non-consequentialist theories Libertarianism Liberal Egalitarianism

Libertarianism John Lock and Robert Nozicks are the most prominent advocates of libertarianism According to Nozick any person is entitled to whatever: A. He or she legitimately acquires B. He or she receives as a gift or as a result of a voluntary exchange - ’From each as they choose, to each as they are chosen’ Liberalism gives a specific answer to the question of what people should be held responsible for. People should face the actual consequences of their actions. People should be rewarded with what they produce Ensures efficiency

Liberal egalitarians Liberal egalitarians (Rawls, Dworkin, Roemer, Arneson) argue that we should eliminate inequality that is a result of factors outside a persons control, but accept inequalities that are a result of factors under the agents control. Can be seen as a principle of horizontal equity Two questions: What are we responsible for? What does it mean to hold people responsible?

What are we responsible for? Raises fundamental questions that have important political as well as ethical implication. Can we choose our preferences? Can we affect our abilities? Are everyone able to exercise high effort? Differences between the left and the right (and between Europan and American politics) can be traced to different answers to these questions.

Inequality and tax policy Important to understand the sources of inequality. Is income inequality primarily a result of factors that are under the individuals control – such as hours worked – or of factors that are outside their control (gender, skin color or IQ). If inequality only was a result of one type of factor it would be easy to construct a just tax system.

Equal effort – different wages Inequality is a result only of differences in the wage rate. In this situation we want to redistribute as much as we can from the rich to the poor.

Equal Opportunities – unequal income In this situation all inequality is a result of differences in hours worked. Do we want to redistribute in this situation?

The ideal Income inequality in society would be a result of both different wage rates and different effort levels. Ideally we would want to eliminate inequalities due to the first, but not to the second factor.

The problem Income tax can only be levied on total income. The tax authorities do not have any information about hours worked or effort. Progressive taxation then has two effects: It takes from those with high hourly wage and gives to those with low hourly wage. It takes from those who work long hours and gives to those who work few hours.

The effect of a progressive tax A system with progressive taxes: Is an advantage for people with low wages and who work few hours. Might be a disadvantage for those with low wages who work long hours.

Conclusions We would want to give individuals the same income opportunities. In reality we are faced with a trade-off between the income opportunities of different groups. Can we use other instruments to achieve this goal?