Finding new opportunities among the economic wreckage

I am reprising this blog entry from a year ago partly because Robert Frank is one of my teaching heroes. But also because his idea of a steeply progressive consumption tax continues to have such resonance today as we seek to find ways of re-balancing our economic systems away from excessive and often wasteful consumption towards saving and productive investment. Read on and you will find out about positional goods, status races and the case for taxing consumption more and saving less.

The media is obsessed with finding examples of public sector waste (our elected representatives have given us enough material to last a lifetime). But much less attention is focused on the waste of scarce resources and energy that comes from the private sector. We could all adapt fairly quickly to a general fall in income and consumption and actually be no worse off than we were a few years ago – but this reduction in status-driven consumption can free up resources that might be much better spent elsewhere.

Today Bob Frank’s talk at the Royal Society for the Arts brought back memories of two other concepts and theories that were once an essential part of the teaching for A level economics – the relative income hypothesis (associated with James Duesenberry - whose work on this was published sixty years ago) and positional goods (often credited with the work of Fred Hirsch).

Citing Darwin as perhaps the father of modern economics (!) Bob Frank reminded his audience that there are many examples drawn from Biology and Economics where traits that benefit individuals often work to the disadvantage of groups.

One stark example of this is the huge rise in spending on positional goods by private sector consumers and businesses. This is a good whose consumption denotes a certain position or status within society or within smaller communities. The utility or satisfaction from consumption comes not just from the product itself but also from being seen to be able to afford it. Call it what you may – oneupmanship, keeping up with the Jones’, or playground name-dropping about the acceleration speed of your Mother’s sports car on the way home from school!

I suspect all of us have enjoyed consuming positional or status-related goods and services at one time or another. Teaching at perhaps one of the most exclusive private schools on the planet I am acutely aware of private wealth and waste! It is a useful reminder that most of the truly valuable things we consume are free!

But as average living standards have risen, so too has the demand for status products. A single rose is often insufficient on Valentine’s Day. Swimming pools need to be larger, end of term gifts for teachers more lavish with each succeeding year, coming of age parties more spectacular and lingerie and perfumery for birthdays carrying an ever-increasing price tag.

In a world driven so much by relative consumption there is a huge amount of private sector waste accentuated by over-charging from monopolistic suppliers who successfully manipulate our preferences and persuade us of the need to pay premium prices for a niche designer product.

But society as a whole is no better off. Indeed there are powerful cascade effects are more people are influenced by this and drawn into debt to pay for it. Parents fork out bigger sums for housing close to good schools, children’s parties and outdoor barbecues that often defy belief! If only we could find an effective pathway out of this status goods arms race? The cold war eventually reached a stable equilibrium with binding contracts to limit spending. Can a progressive consumption tax offer a policy option for private sector consumers?

Progressive consumption tax

This was the ‘central idea’ that Bob Frank put forward in his RSA address. The concept is simple. Income can be spent or saved. So consumption = income – saving. Saving represents a residual between income and spending, so it would be fairly straightforward for people to send in information when completing tax returns about how much they have saved in a given year. Taxable consumption would be based on income – saving – a standard deduction, and Frank argued that taxable consumption would be progressive. Low rates for lower spending families rising to very high rates (perhaps close to 100%) on marginal consumption above a very high threshold.

Frank’s argument is that shifting the burden of taxation towards spending is a much needed tax reform. At present many taxes (including income tax, national insurance contributions for employers and employees) penalise saving and job creation. Yet these are two of the things we need more of in the medium term if an economic recovery is going to be sustainable.

Taxing consumption – and in particular taxing items of consumption that create harm to others – would improve the incentive to earn income and save and it might just cause people to think about whether their latest extravagance is really worth the money.

He advocates taxing luxury consumption, heavy passenger vehicles such as SUV’s, carbon emissions, traffic congestion and even financial transactions. One side effect of the latter might be a reduction in the waves of speculative activity that have dominated financial and commodity markets in recent years creating deeply damaging poverty for millions around the world.

His argument – and it is one with both Keynesian and supply-side foundations – is that the extra revenue can be directed into productive uses (repairing and rebuilding bridges and other items of infrastructure) which in turn will increase incomes, raise a nation’s GDP and allow the majority of people to be better off both in absolute and relative terms. In a depression-ridden economy, the government is probably the only actor on the scene with the capacity to make a difference to the near-term outlook – it should use the macroeconomic wreckage to engage in bold spending and tax reforms to shape the upturn – when it finally arrives.

This was an hour spent in the company of a master craftsman. Bob Frank is simply a superb teacher of Economics and the success of his first book (The Economic Naturalist) is testimony to the impact he has had on his students many of whose creative and inspired questions were stimulated by his teaching approach. Core economics is best taught by frequent reference to a small cluster of essential ideas – the cost benefit principle being at the forefront of all of them! A progressive consumption tax will make students think about the canons of a good tax system. And it might just get millions of consumers to pause and think about the value of their next dollar.

The RSA holds a large number of free public lectures every year – the venue is just a short stroll away from Covent Garden and I find it tremendously accessible from Waterloo – less than 10 minutes over Waterloo Bridge. You can access podcasts and video recordings of the lectures; these are available on the RSA web site one or two days after each event. For ambitious students the RSA lectures are highly recommended.

The audio recording of the Robert Frank talk is available here

And here is a link to another of his articles on the idea of a progressive consumption tax