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Welfare and justice

Econ4620

Alexander W. Cappelen

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Introduction

• Why do we levy 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

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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

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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.

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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?

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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

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Cont.

• A social welfare function ranks different Pareto-optimal allocations:

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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:(1) The utilitarian principle:

(2) The maximin criterion

• Intermediate positions place more weight on the individual with low welfare.

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Illustration

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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.

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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

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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?

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Different types of critique

• In the rest of the lecture we shall discuss some important types of critique and some alternative theories of justice

(1) The theory cannot be implemented- Utility cannot be measured

- Interpersonal comparisons are impossible

(2) 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

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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

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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.

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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?

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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.

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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)

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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.

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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

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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 acquiresB. 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

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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?

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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.

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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.

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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.

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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?

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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.

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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.

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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.

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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?