Tim Harford The Undercover Economist

Undercover EconomistUndercover Economist

My weekly column in the FT Magazine on Saturday’s, explaining the economic ideas around us every day. This column was inspired by my book and began in 2005.

Undercover Economist

The psychology of saving

‘There is one dramatic success for behavioural economics — the way it has shaped pensions’

“THERE ARE IDIOTS. Look around.” So began a famous economics paper by Larry Summers — a lauded academic before he became US Treasury secretary. It is perhaps the most concise expression of behavioural economics, the branch of economics that tries to take psychology seriously.

Behavioural economics is appealing not only because it is realistic but also because it is vastly more charming than the traditional variety. Championed by economists such as Richard Thaler (co-author of Nudge and author of a new book, Misbehaving ) and psychologists such as Nobel laureate Daniel Kahneman (author of Thinking, Fast and Slow), it has triumphed in the “smart thinking” section of the bookshop and exerted increasing influence in academia.

It can be hard to turn psychological insights into rigorous academic models, and even harder to turn them into good policy. But there is at least one dramatic success for behavioural economics — the way that it has shaped pensions. At a recent Financial Times event, Professor Thaler rightly celebrated this as the field’s greatest triumph.

Other than Thaler’s own evangelism, the reason for this success is twofold. First, when it comes to pensions there is a large gap between what we do and what we should do. Second, bridging that gap is fairly simple: we need to encourage people to save more, and in most cases those savings should flow into simple, low-cost equity tracker funds. The only comparable example that springs to mind is smoking: many smokers are making themselves unhappy and would be better off if they could find a way to stop. And as a classic research paper in behavioural economics concludes, taxes on cigarettes seem to make smokers and potential smokers happier by prompting them to quit, or never start.

Given the problem — people need to be nudged into saving more — the biggest pension policy breakthrough has been automatic enrolment, a cornerstone of modern UK pension policy and widely used in the US too. A typical defined contribution pension invites people to pay money into a pension pot, often enjoying tax advantages and matching contributions from an employer. Yet people procrastinate: money seems tight, retirement is a long way off, and who wants to fill in forms? Automatic enrolment reverses the default, deducting pension contributions from our payslips unless we take active steps to opt out. The process respects our autonomy — you can opt out if you wish — but makes it easy to do what we probably should be doing anyway.

A clever supplement to this approach is “Save More Tomorrow”, a scheme in the US whereby people make an advance commitment to redirect part of their pay rises into the pension. At a 50/50 ratio, for example, a 2 per cent pay rise becomes a 1 per cent pay rise and a 1 percentage point increase in pension contributions. It doesn’t take long for a 3 per cent contribution (which is inadequate but typical in the US) to become something more sensible, such as 10 or 15 per cent. Thaler has been a driving force behind both ideas.

Of course, these tactics do not work for everyone. I once spoke at a book festival in Australia and found that a slice of my modest fee had been automatically invested in an Australian pension for me. This benefited nobody except some administrators and the postman who delivered the letters from Australia, detailing the evaporation of my tiny pension pot.

A more serious difficulty is choosing the right level of default contribution. A default that is too aggressive — automatically deducting 25 per cent of salary — jolts most people into opting out. A default that is too low, such as 3 per cent of salary, could conceivably be worse than the old opt-in default of zero. Many people who might have taken an active choice to save 6 or 7 per cent rather than nothing end up settling instead for the default. As mentioned, 3 per cent is a common level for automatic enrolment in the US, for no good reason other than historical accident. Yet it is dangerously low.

There is also a painful conflict of interest at the heart of any corporate pension plan. From the perspective of classical economics, companies will offer generous pensions if they want to attract capable staff. It is expensive to subsidise a pension but staff value the subsidy, making it worthwhile.

From the more realistic perspective of behavioural economics, a tension emerges. A benevolent planner, armed with behavioural insights, would nudge people into a passive pension investment with almost no conscious thought. But a corporate human resources director would want to remind employees how generously their pensions are being subsidised. That means frequent reminders and ample opportunity to admire the pension pot — even if such admiration leads to anxiety about uncertain returns, or expensively trading shares within the pension.

There are approaches that might keep both the behavioural economist and the HR director happy. For example, a pension pot that is expressed in terms of daily or weekly income in retirement, adorned with photographs of cruise ships, seems more appealing than an abstract and rather meaningless lump sum.

We cannot blame behavioural economics for this tension but it is real. As automatic enrolment becomes the norm, it will be important to keep an eye on how corporations respond.

Written for and first published at ft.com.

Undercover Economist

Teamwork gives us added personbyte

‘Complex products require elaborate networks of teamwork, and only a few places manage the trick’

Is economic life getting more complicated? In some ways, no. It’s much easier to use a computer than it used to be, or to make an international phone call, or to buy avocados. But, in many ways, complexity is on the rise.

This is true for products. When once we used to buy simple chunks of matter, such as copper, tin or wheat, now we buy smart watches, movie downloads and ready meals — these are things whose structure is a vital part of their value. You can melt and cool copper, or scatter and then rebuild a pile of wheat, and no great harm will come to either. Put your phone into a blender and you’ll find it has changed in ways that matter a great deal.

Scientific ideas are also becoming more complex. Benjamin F Jones, an economist, has used large databases of academic articles and patents to show that researchers and inventors are getting older and have narrower specialisations. This seems to be because there is much more science to be known, and scientists must devote more time to mastering what is already known before they can contribute original research.

César Hidalgo, a physicist at Massachusetts Institute of Technology and author of Why Information Grows, coins the word “personbyte” to describe the amount of knowledge that one person can reasonably know. The personbyte isn’t getting any smaller but — relative to the knowledge that needs to be mustered to produce a modern scientific paper, or a computer, or a car — the personbyte looks ever more inadequate.

The way to escape the constraint of the personbyte is to work in larger teams, and this is exactly what Jones finds in academic and patent databases: research teams are bigger than they were 40 years ago. This is a natural consequence of the fact that a personbyte isn’t big enough to process the knowledge required for modern science or engineering. One person cannot hold all the necessary know-how in her head, so she must work together with others.

How easy is this collaboration? It depends. Some knowledge is easily copied. Once someone has invented the wheel, anyone else can simply copy the idea and no more elaborate teamwork is needed than that. Other knowledge can be embodied in a product and widely dispersed. I don’t know how to make a laptop computer but I know how to use one. In a sense, I am standing on the shoulders of Ada Lovelace, Alan Turing and Bill Gates. But I do not need to spend any time in meetings with these people, which is just as well. Better yet, my laptop is built from simpler standalone modules, such as the central processing unit, the keyboard, the operating system and the hard drive. Individuals — or teams, or firms — can work on these modules even if no organisation has mastered the skills necessary to build every part of the laptop from scratch. The modular nature of the computer makes it straightforward to use earlier knowledge.

But some knowledge requires far more challenging collaborations. This knowledge is tacit, hard or perhaps impossible to describe. It may be easy to send data around the world but data may not be enough. Knowledge may be weightless in principle but, as César Hidalgo points out, we find it easier to move heavy copper from mines in Chile to factories in Korea than to move manufacturing know-how from Korea to Chile.

Hidalgo argues persuasively that networks of people and companies with such tacit knowledge are an essential part of a modern economy. They form essential capabilities: how to make a plasma display, or champagne, or a financial derivative. Simpler products require simpler networks of collaboration, and can be produced almost anywhere. More complex products require elaborate networks of teamwork, and only a few places manage the trick.

More than 20 years ago, economist Michael Kremer published “The O-ring Theory of Economic Development”. His title refers to a simple seal whose failure destroyed the Challenger space shuttle and killed seven astronauts. Kremer wanted us to think about weak links. A string quartet is not much better than its worst player. A gourmet meal could be ruined by a clumsy chef, a faulty oven, a rude waiter, a decaying ingredient, or a rat scurrying across the dining room. These are O-ring products.

The logic of an O-ring world is that the most skilled workers end up collaborating with each other, using the best equipment. Chef Heston Blumenthal does not work at Burger King. It makes more sense for Joshua Bell to play a Stradivarius and for a street busker to play a worm-eaten fiddle than for the two musicians to swap.

Inequality soars in O-ring worlds because the more complex a product or service, the greater the value of someone who can avoid errors. And a weak link somewhere in your economy can spread like a cancer. Why should a young person in Nigeria study hard if her efforts will be dissipated by electrical blackouts, criminal gangs or corrupt officials?

The economic world is unlikely to become simpler. But we may rise to the challenge better if we think about both the social and institutional support that helps make complex collaborations possible — and the simple modular engineering that makes complex collaborations unnecessary.

Written for and first published at ft.com.

Undercover Economist

The truth about our norm core

‘Social pressure matters but it is not the only thing that matters. Facts can trump groupthink’

While not quite as infamous as Philip Zimbardo’s Stanford prison simulation, or Stanley Milgram’s obedience research, Solomon Asch’s conformity experiments remain among the most celebrated in psychology. In 1951, Asch’s research showed that our judgments about simple factual matters can be swayed by what people around us say. The finding echoed down the decades. Milgram found in 1961 that people were willing to administer apparently dangerous electric shocks when ordered to do so by an experimenter. In 1971, Zimbardo set up an imitation prison in a Stanford University basement with subjects given the role of guards and prisoners, then observed as the guards humiliated the prisoners.

Between them, the three academic psychologists taught us that in order to fit in with others, we are willing to do almost anything. That, at least, is what we are told. The truth, as so often, is more interesting.

Asch gave his subjects the following task: identify which of three different lines, A, B or C, was the same length as a “standard” line. The task was easy in its own right but there was a twist. Each individual was in a group of seven to nine people, and everyone else in the group was a confederate of Asch’s. For 12 out of 18 questions they had been told to choose, unanimously, a specific incorrect answer. Would the experimental subject respond by fitting in with the group or by contradicting them? Many of us know the answer: we are swayed by group pressure. Offered a choice between speaking the truth and saying something socially convenient, we opt for social convenience every time.

But wait — “every time”? In popular accounts of Asch’s work, conformity tends to be taken for granted. I often describe his research myself in speeches as an example of how easily groupthink can set in and silence dissent. And this is what students of psychology are themselves told by their own textbooks. A survey of these textbooks by three psychologists, Ronald Friend, Yvonne Rafferty and Dana Bramel, found that the texts typically emphasised Asch’s findings of conformity. That was in 1990 but when Friend recently updated his work, he found that today’s textbooks stressed conformity more than ever.

This is odd, because the experiments found something more subtle. It is true that most experimental subjects were somewhat swayed by the group. Fewer than a quarter of experimental subjects resolutely chose the correct line every time. (In a control group, unaffected by social pressure, errors were rare.) However, the experiment found that total conformity was scarcer than total independence. Only six out of 123 subjects conformed on all 12 occasions. More than half of the experimental subjects defied the group and gave the correct answer at least nine times out of 12. A conformity effect certainly existed but it was partial.

This surprised me, and it may surprise others who have read popular accounts of the so-called conformity studies. I doubt that it surprised Asch. Conformity was already a well-established finding by 1951, and his experiments were designed to contrast with earlier research on social norms. This previous research showed that people conformed to social pressure in situations where there was no clear correct answer — for instance, when asked to identify which of two ungrammatical sentences was the most ungrammatical. But Asch wanted to know if peer pressure would also wield influence when the crowd was unambiguously wrong. His research provided an answer: social pressure is persuasive but, for most people, the facts are more persuasive still.

Myths about famous experiments have always grown in the telling. It seems most unlikely that Archimedes ran naked through the streets of Syracuse yelling “Eureka!”, and an apple probably did not strike Newton’s head. But there seems to be something particularly attractive about these famous psychology experiments that paint us all as sheep — even when the experiments may have been flawed, impossible to replicate or (as with Asch’s work) have simply found something much more subtle than the myth would have us believe.

The psychologist Christian Jarrett comments, “the resistance to tyranny shown by many participants in Zimbardo’s prison study has largely been ignored, and so, too, has the disobedience shown by many participants in Milgram’s seminal work.”

Zimbardo’s Stanford prison experiment was shocking stuff, and raised serious questions about research ethics. But we should also ask questions about what Zimbardo really found. By his own admission he gave a strong steer to the guards, and cast himself as their ally in a quest to dehumanise the prisoners. “We’re going to take away their individuality in various ways,” he told them. Other psychologists have suggested that this was more a test of obedience to Zimbardo than a demonstration that sadism blooms given the opportunity.

Few textbook accounts of the study mention Zimbardo’s attempt to influence the guards; nor do they point out that two-thirds of the guards refrained from sadism.

Social pressure matters but it is not the only thing that matters. Solomon Asch showed that facts can trump groupthink. It would be ironic if our own biased recollections of his finding proved him wrong.

Written for and first published at ft.com.

Undercover Economist

Down with mathiness!

‘In the recent UK election campaign, a diet of numbers was stuffed into voters like feed into French ducks’

The American Economic Review isn’t usually the place for trash talk but a brief new article by Paul Romer is the closest academic economics is likely to come to a spat between boxers at a pre-fight weigh-in. Romer, a professor at New York University, is worried that a new trend in economics — “mathiness” — is polluting the discipline. And he names names — including Robert Lucas and Edward Prescott, both Nobel laureates, and inequality guru Thomas Piketty.

In a follow-up comment, “Protecting the Norms of Science in Economics”, Romer says: “I point to specific papers that deserve careful scrutiny because I think they provide objective, verifiable evidence that the authors are not committed to the norms of science.”

Romer adds that if his suspicions are confirmed, such people should be ostracised — suggesting that Nobel Prize winners should be ejected from academic discussion because of their intellectual bad faith. This is strong stuff.

Romer, though, has rarely stuck to the academic script. In the late 1980s he developed a new approach to thinking about economic growth that mathematically modelled the development and spread of ideas, an achievement that many regard as worthy of the Nobel memorial prize in economics. But Romer then drifted away from academia, first founding an online learning platform called Aplia, and then campaigning for a radical development idea, “charter cities”.

Does economics have a mathiness problem? Many casual observers would say, “of course”. Economics has a reputation for producing rigorous nonsense.

But Romer’s attack is much more focused. He doesn’t mean that economics uses too much mathematics but that some economic theorists are pushing an ideological agenda and using fancy mathematics to disguise their intentions. They can redefine familiar words to mean unfamiliar things. They can make unrealistic assumptions. They can take hypothetical conclusions and suggest they have practical significance. And they can do all these things with little fear of detection, behind a smokescreen of equations. If Romer is right, some economics papers are Orwellian Newspeak dressed up as calculus.

In his short essay “Politics and the English Language”, Orwell argued that there was a “special connection between politics and the debasement of language”. While some people wish to communicate clearly, the political writer prefers a rhetorical fog. And the fog can spread. Writers who should know better imitate sloppy writing habits. Readers become jaded and stop hoping that anyone will tell them the truth.

Romer fears a similar rot at the heart of economics. As some academics hide nonsense amid the maths, others will conclude that there is little reward in taking any of the mathematics seriously. It is hard work, after all, to understand a formal economic model. If the model turns out to be more of a party trick than a good-faith effort to clarify thought, then why bother?

Romer focuses his criticism on a small corner of academic economics, and professional economists differ over whether his targets truly deserve such scorn. Regardless, I am convinced that the malaise Romer and Orwell describe is infecting the way we use statistics in politics and public life.

There being more statistics around than ever, it has never been easier to make a statistical claim in service of a political argument.

In the recent election campaign in the UK, a diet of numbers was stuffed into voters like feed into French ducks. A fact-checking industry sprang up to scrutinise these numbers — I was part of it — but the truth is that most of the numbers were not false, unhelpful. Instead of simply verifying or debunking the latest number, fact checkers found themselves spending much effort attempting to purify muddied waters.

This is infuriating — for the public, for the fact checkers, and for the scientists and statisticians who take such pains to gather evidence. Imagine their dismay when the politicians seize that evidence and hold it up for protection like a human shield. Good statistics matter; without them it is almost impossible to understand the modern world. Yet when statistics are dragged into political arguments, it is not the reputation of politics that suffers but the reputation of statistics. The endgame isn’t pretty: it becomes too much trouble to check statistical claims, and so they are by default assumed to be empty, misleading or false.

Just as the antidote to Newspeak isn’t to stop using language, the antidote to mathiness isn’t to stop using mathematics. It is to use better maths. Orwell wanted language to be short, simple, active and direct. Romer wants economists to use maths with “clarity, precision and rigour”. Statistical claims should be robust, match everyday language as much as possible, and be transparent about methods.

Some critics believe that economics should conduct itself in plain English at all times. This is, I think, unreasonable. Mathematics offers precision that English cannot. But it also offers a cloak for the muddle-headed and the unscrupulous. There is a profound difference between good maths and bad maths, between careful statistics and junk statistics. Alas, on the surface, the good and the bad can look very much the same.

Written for and first published at ft.com.

Undercover Economist

Mind the fair trade gap

‘If fair trade does deliver higher incomes for farmers, it may prove too successful for its own good’

In 2001, the world price of coffee sank to its lowest ebb for decades, threatening dreadful hardship for the often-poor farmers who grow the sainted berry. It was also around that time that fair trade coffee seemed to come of age, with a common certification mark launched in 2002, and the product becoming a familiar sight in supermarkets and coffee chains.

The premise of fair trade is that the disparity between poor coffee farmers and prosperous drinkers presents both a problem and an opportunity. The problem is that farmers often live a precarious existence: geographically isolated and growing a crop with a volatile price. The opportunity is that many western consumers care about the earnings and conditions of the people who grow their coffee, and have some money to spare if only it might reach those people.

Unlike a taxi driver or a waiter, you can’t just tip the guy who grew your coffee. The fair trade answer to the conundrum is a labelling scheme: an inspector verifies that all is well on the farm, with good conditions and a higher price paid for coffee; this information is conveyed to consumers by way of a recognisable trademark, the most famous of which is the Fairtrade logo. It’s an appealing idea — a voluntary scheme that helps people who want to help people. (Or rather, several voluntary schemes: there is more than one fair trade label, alongside diverse certification schemes such as Organic or Rainforest Alliance.) Who wouldn’t want a better deal for farmers who are poor and work hard? But there are problems with the idea too.

The most obvious problem is that this labelling scheme costs money. Flocert, a certification body set up by the Fairtrade Labelling Organization, charges farmer co-operatives €538 merely to apply for certification, plus an initial audit fee of €1,466 even for a small co-op. Cynics might suspect bureaucratic bloat but the costs may well be real. It cannot be cheap to check pay and conditions in some remote Peruvian coffee plantation. But every euro spent on certification is a euro that the farmer cannot spend on his family. And larger co-operatives from richer, better-connected countries are more likely to find it worthwhile to pay for certification. For this reason, economist and fair trade critic Ndongo Sylla says that fair trade benefits “the rich”. That seems too strong; but it is certainly a challenge for the fair trade model to reach the poorest.

A second problem is that fair trade certification cannot guarantee fair trade sales. If coffee importers want to put the Fairtrade mark on their coffee, they must find a Fairtrade certified producer and pay the Fairtrade price, which reflects both a modest premium and a guaranteed minimum price. But importers are not obliged to buy fair trade coffee and may avoid it when it gets too expensive, exactly when the premium is most needed. A study by Christopher Bacon found that during the price slump of 2000 and 2001, Nicaraguan coffee farmers were earning twice as much per pound when selling fair trade coffee as when selling the uncertified stuff. But much of their coffee could not find a buyer at such rates and was sold at market rates instead; as a result, the average price premium, while substantial, was much lower at around a third.

Another study, by Tina Beuchelt and Manfred Zeller, found the fair trade certified farmers in Nicaragua started at a similar income level to conventional farmers and, if anything, slipped backwards. A recent survey by Raluca Dragusanu, Nathan Nunn, and Daniele Giovannucci was more upbeat but still found the evidence in favour of fair trade “mixed and incomplete”.

A final irony is that if fair trade does deliver higher incomes for farmers, it may prove too successful for its own good. If coffee farmers are able to sell more coffee at a premium price, more people will want to become coffee farmers. One possible result is that the market price for uncertified coffee falls and, on balance, coffee farmers are no better off.

As the development economist Paul Collier once wrote, fair trade certified farmers “get charity as long as they stay producing the crops that have locked them into poverty”. It is a telling point. For all the good I may wish the people who make my coffee, a globalised tip jar makes a precarious foundation for their future prosperity.

Written for and first published at ft.com.

Undercover Economist

Why democratic elections are always flawed

I sometimes wonder if we expect more than we should from democracy

Most Britons are unhappy with the result of the UK general election. That is the logical conclusion, given that 63 per cent of voters cast their vote for someone other than David Cameron’s Conservatives. Nevertheless, the Conservatives surprised even themselves by winning more seats than every other party put together.

From the point of view of the losers, this state of affairs seems outrageous. It is sometimes said that splits on the left of British politics have prevented what should have been a solid leftwing majority and allowed the rightwing views of a minority to prevail. Yet the right is also split: the Conservatives and the UK Independence Party attracted more than 50 per cent of the vote between them. Leftwingers frustrated by the election result should blame the voters before they blame the voting system.

Critics of the British voting system do have a point. An analysis by Jack Blumenau and Simon Hix of the London School of Economics suggests that the disparity between votes cast and seats won has been widening for many decades, the consequence of the large number of votes now cast for smaller parties.

Since each seat is decided separately, votes cast for losing candidates simply do not count. It is possible to stack up a hefty pile of such votes while winning only a single seat — just ask Ukip’s Nigel Farage, who failed to be elected despite leading a party that attracted 3.9 million votes. The Conservatives earned about 34,000 votes per seat won, and Labour about 40,000 votes. The Scottish Nationalists needed just 26,000 votes per seat. Nick Clegg’s derided Liberal Democrats required more than 300,000 votes for each of their eight seats. Supporters of both Ukip and the Liberal Democrats might well feel disenfranchised, as might the Greens and the many Scots who voted for parties other than the SNP. Still, rules are rules and everyone knew the rules before they started to play the game.

Yet rules can be changed. And perhaps they should be. But to what? Clever schemes abound: the D’Hondt method offers something close to proportional representation while maintaining a link to local constituencies; the Borda count attempts to measure the strength of preferences; the alternative vote, AV, is designed to allow people to cast a conditional vote for whichever of several parties might find itself with a chance of winning.

AV was decisively rejected by the British in a referendum in 2011. But perhaps referendums themselves need looking at. Consider a referendum on an issue such as gay marriage. A small number of people — gay people who might wish to get married — have a tremendous interest in liberalisation. But no matter how strongly they feel, they get just a single vote each and so they have had to wait while the weakly held views of the majority slowly move in a tolerant direction.

Glen Weyl, an economist, argues that in such cases we might want to hold a referendum that allows people to express their strongly held beliefs by buying multiple votes at increasing cost: one vote costs $1; two votes cost $4; 1,000 votes cost $1m. Weyl calls this idea “quadratic voting”. It has some appealing theoretical properties but to the layperson it looks alarming. Expect to see it used in TV talent shows.

I am all in favour of improving institutions when we can but I sometimes wonder if we expect more than we should from democracy. There are two deep reasons why democratic elections are always flawed.

The first is that voters are, quite rationally, rather ignorant about politics. Sensible people vote to express themselves or out of a sense of duty, not because they harbour the illusion that it might be their vote that swings the entire election. Quite sensibly, then, people who devote hours to researching a new phone will not waste time researching which party to support.

The second reason is Nobel laureate Ken Arrow’s “impossibility theorem”, one of the most celebrated and misunderstood results in economics. Arrow’s theorem is often described as showing that there is no voting system that will reflect what society truly prefers. Arrow actually showed something more profound: that it makes little sense to speak of what “society truly prefers”. That very idea is incoherent. And those who expect that a democratic election will ever give society what it “truly prefers” will have to get used to disappointment.

Written for and first published at ft.com.

Undercover Economist

Tax: a Scandinavian solution

‘With tax, our politicians seem determined to make the process as clumsy and painful as possible’

If a politician was a surgeon, faced with the task of amputating your leg, we can well imagine how it would go. First he’d deny that he planned to amputate the leg. Then he’d pass a law making it illegal to amputate the leg. Then he’d say that he’d amputate an investment banker’s leg instead. Finally, he would blame the mess handed to him by the previous surgeon and would begin to rub away at your toes with a cheese grater.

So it is with taxes. It’s no fun paying them but public spending must be paid for somehow. Yet our politicians seem determined to make the process as clumsy, painful and disingenuous as possible.

This may be because politicians see taxes purely in political terms. They believe that the deep problem with taxes is that people do not like paying them, which is why they say, instead, that the taxes will be levied only on multinational corporations, investment bankers and tax dodgers of all stripes. Politicians placate angry voters with tax exemptions and deductions. All this is politically understandable but has the effect of making the taxes much more damaging than they need to be.

The true problem with taxes is quite different. It is that in an effort to pay less tax, people do some extraordinary things. Most obviously and controversially, they’ll adopt odd legal labels that have the effect of reducing their tax bill. Some are fiendishly complex international schemes, playing different tax treaties off against each other and generating corporate profit that each tax authority deems is someone else’s problem. Others are quite simple. All of them are unfair, and all of them generate paperwork.

A second problem, less fussed-about but probably more serious, is that people will change their behaviour rather than just the legal description of that behaviour. For example, some new mothers who want to work will stay at home rather than hire childcare out of heavily taxed income. The mother doesn’t get the career she wanted, and the taxman doesn’t get the tax revenue. Nobody wins.

Two articles in last year’s Journal of Economic Perspectives explore how governments might get more serious about raising taxes. One, by Gabriel Zucman, emphasises that the complexity and inconsistency of different tax systems allow wealthy individuals and multinational companies to exploit cross-border loopholes and avoid tax. Zucman’s calculations suggest that US companies are increasingly booking their profits in what he calls “the main tax havens”, jurisdictions that housed about 2 per cent of US corporate profits in 1984 but 18 per cent in 2013.

But one way to look at the problem of levying high taxes is to ask who has solved it. The answer: Denmark, Norway and Sweden. US tax revenue is about 25 per cent of GDP, the UK and Germany at about 35 per cent, and the Scandinavians at about 45 per cent, according to economist Henrik Jacobsen Kleven. Somehow the Scandinavians have managed to raise large sums from their citizens without destroying their economies. How?

That’s the question that Kleven sets out to answer and, of course, the answer is partly cultural. It is also partly about the comprehensive tax reporting in Scandinavia, which makes outright evasion very difficult. Norwegian tax returns are published for all to examine. (No wonder Gabriel Zucman dreams — perhaps implausibly — of a global financial registry to help track down tax dodgers.)

Not everyone will feel delighted about an all-seeing government determined to invade privacy in the name of higher taxes. But there are other elements of Scandinavian taxation that any government might want to emulate: Scandinavian countries minimise the distortions of their tax system by avoiding the bad habits of politicians in other countries.

Chief among these habits is targeting a narrow tax base. The US tax system is full of ad hoc deductions and exemptions. The UK system needlessly excludes swaths of the economy from tax. Rather than charge a 10 per cent rate of VAT on everything, the UK government charges a 20 per cent rate of VAT on roughly half of what consumers spend. The Danes have a much broader VAT base, and a higher rate too.

The simplest way to broaden the tax base is to dismantle barriers to getting a job. Scandinavian governments subsidise education, transport and care for children and the elderly, all of which help people to work who might otherwise find themselves stuck at home. As a result, even high taxes do not keep them out of the labour market.

That makes sense. If the surgeon really is going to amputate your leg, having a prosthetic replacement would be wise.

Written for and first published at ft.com.

Solve this puzzle and win a Dom Reilly bag

Tim Harford will be interviewing University of Chicago economist Richard Thaler about his new book Misbehaving on stage in London on June 10. Please visit live.ft.com/richard-thaler for more details.

In anticipation of this event, Professor Thaler is setting FT readers a challenge, revisiting a puzzle he set them once before, in 1997.

The task is simple: choose a number between 0 and 100, and supply a short justification for your choice. The winner is the person whose number is closest to two-thirds of the average of all the entries. For example, three entries are submitted: 20, 30 and 40. The average is then 30 and the winning entry is 20, being exactly two-thirds of the average.

In the event of a tie, the prize will go to the person who submits the best justification. Prof Thaler’s decision is final.

The prize for the winning entry is a luxurious weekend bag designed for the FT by Dom Reilly — lightweight, elegant and exquisitely handcrafted in brown full-grain leather with subtle FT branding.

Please send your guess and your justification to: email hidden; JavaScript is required

Competition ends May 31. T&Cs apply. ft.com/thalerconditions

Undercover Economist

The problem with sexed-up statistics

‘Statistics tell us nothing until we understand what is being counted in the first place’

Men think about sex every seven seconds. Eighty-four per cent of women are emotionally unsatisfied with their relationships. Single people in the United States have more sex than married people do. Sixty-nine per cent of people over the age of 35 have had extramarital affairs. People have 40 per cent less sex now than they did 20 years ago. Truth, or myth?

A new book by statistician David Spiegelhalter, Sex by Numbers, runs a statistical comb through our collective sex lives. His book is largely designed to teach us about sexual behaviour — who is doing what with whom and how often — but along the way he manages to impart some important statistical lessons too.

Lesson one is that statistics tell us nothing until we understand what is being counted in the first place. To ask how old people are when they start having sex, or when they stop having sex, or how many sexual partners people typically have, we need a generally agreed definition of “having sex”.

We should not take for granted that we all mean the same thing when we talk about sex. Just ask Bill Clinton, who notoriously declared “I did not have sexual relations with that woman, Miss Lewinsky.” When it later became clear that he had received oral sex from her, he apologised for giving a misleading impression but maintained that “my answers were legally accurate.”

Clinton’s carefully chosen words were in tune with the way most people used language. A survey of US college students conducted in 1991 found that only 40 per cent of them reckoned that oral sex counted as “sex”. (The US Senate implicitly reached a similar conclusion in clearing President Clinton of perjury.)

While Clinton exploited ambiguity, modern scientific surveys of sexual behaviour try to eliminate it. According to definitions used by the UK’s well-regarded National Survey of Sexual Attitudes and Lifestyles, Natsal, Clinton did have sexual relations with Miss Lewinsky.

A second lesson is that we should pay attention to whether statistical work has been done carefully or casually. Consider Time Out magazine’s finding that people have sex 10 times a month if they are in a relationship, though only five times a month if they are married. This is twice as much as more credible surveys have found. As Spiegelhalter observes, Time Out’s method can only tell us about the sexual claims of people who go out of their way to fill in sex surveys. Spiegelhalter is similarly dismissive of the “Trojan US Sex Census”, which announced that Los Angeles was the most sexually active city in America with 135 sex acts per person per year. While a great source of publicity for a manufacturer of condoms, the people who fill in Trojan’s survey don’t represent the rest of us.

Some of the most famous sex researchers are also limited by a lack of representative sampling. Alfred Kinsey found that 37 per cent of men had a homosexual experience resulting in orgasm; Shere Hite reported that 95 per cent of women experienced “emotional and psychological harassment” from their male partners. The underlying research here was politically groundbreaking but we cannot have too much confidence that these numbers are correct.

Hite, for example, distributed questionnaires through university women’s centres, abortion rights groups and other women’s groups; the response rates were less than 5 per cent, making it unclear whether respondents were typical of women as a whole. Kinsey was on the lookout for interesting sexual case histories and so sent his researchers to prisons and to bars famous for being gay meeting places. He may well have captured a broader range of sexual behaviour as a result but at the cost of a representative sample. As the great mathematician John Tukey once told Kinsey, “I would trade all your 18,000 case histories for 400 in a probability sample.” If the aim is to judge what is going on in the population as a whole, Tukey was right.

To revisit the factoids in the first paragraph: most are unproven, the results of unrepresentative surveys. The “seven seconds” claim is an urban myth and provably nonsense. But the final discovery — that we are having 40 per cent less sex — is true. According to the rigorously collected Natsal survey, heterosexually active people aged 16-44 typically had sex five times in the past month back in 1990. By 2010, the number had fallen steadily to three times. Perhaps the next Natsal survey will be able to figure out why.

Written for and first published at ft.com.

Undercover Economist

What a radical Conservative government could do

‘Scrap all mainstream benefit payments — jobseeker’s allowance, child benefit, housing benefit and even the state pension’

Last week I described Anthony Atkinson’s proposals for reducing inequality. Atkinson — a professor of economics at Nuffield College, Oxford — proposes substantially higher income tax rates for everyone earning more than £65,000, a much higher minimum wage, guaranteed public employment, an expansion of universal benefits and much else. It is the agenda one would expect of a courageous Labour party, which of course places it a long way from the agenda that the actual Labour party is proposing.

It seems only fair, then, to offer the same service to the Conservatives: on the off chance that we ever see an economically radical Tory party, what policies might I suggest they embrace?

Step one is to replace the benefit system with a more libertarian form of redistribution. Scrap all the mainstream benefit payments — for example, child benefit, jobseeker’s allowance, housing benefit, winter fuel allowance and even the state pension. Scrap the income tax allowance too. Give all long-term UK residents a taxable basic income of £8,000 a year and charge a flat 40 per cent income tax rate on every penny. The basic income can be phased in on a residency basis over 10 years, ensuring that recent immigrants pay a larger net contribution to the exchequer.

This policy targets poverty rather than inequality. It abolishes much of the bureaucracy that surrounds benefit eligibility, promotes individual responsibility and reduces the stigma of collecting money from the state. It gives everyone, rich and poor, a clear incentive to work. Compared to the current system, it redistributes to the working poor and to the highest earners — both groups of people who are likely to produce more taxable income in response. It is simple, discouraging tax avoidance. And, despite the flat headline rate, the average income tax contribution is progressive: negative for those on low incomes, 10-25 per cent for those on average incomes and approaching 40 per cent for the rich.

People with unusual needs — the severely disabled, for instance — would be helped by a multibillion-pound fund with considerable discretion to make direct cash payments or commission assistance from charities.
A second policy is to privatise the entire school system. Children would receive a £10,000 basic income in a tax-sheltered educational account controlled by parents but usable only for childcare, school or university fees. Compulsory schooling would end at the age of 14 and educational institutions would be competing to attract these pots of tax-free cash with engaging and practical training courses. Any unspent money would be taxed and handed over to the child at the age of 21.

Third, scrap the personal pension system. Both the logic for and the reputation of the existing system is in tatters. With the new flat tax and universal basic income it would also be superfluous. People can save for their retirement in more flexible Isa-style savings accounts and could be nudged into doing so by a default payroll deduction.

A fourth policy must involve the housing market. The current cluster of housing policies (“cluster” is a polite abbreviation for a more appropriate term) ensures slow growth, resentment of immigrants, a crippling housing-benefit bill, inequality growing through luck rather than hard work and innovation, and the direction of potentially productive savings into accumulating unproductive housing wealth. This is a multifunctional policy indeed.

Given that housing benefit is to be abolished by this radical government, there is an urgent need to build large numbers of houses. This would boost the economy and reduce the price of new homes. One possibility, proposed by the Centre for Policy Studies, is the establishment of “pink zones” with lighter planning regulation (the colour represents a dilution of red tape). In these zones, substantial increases in housing could be achieved by a coalition of local authorities, community groups and developers.

However the trick is pulled off, the government must create the conditions for a housing boom — 400,000 new homes a year for five years would do to begin with. It’s ambitious, but necessary after decades of insufficient building.

A final idea: look to broaden the tax base and lower tax rates. Abolishing all VAT exemptions would be a good start, and would provide substantial revenue. A carbon tax would also be well worth introducing, as would more proportionate taxation of housing wealth. The proceeds of these taxes would be needed at first to pay for the universal basic income but the aim would be to reduce universal income tax rate too. A future leftwing government could redistribute within the same framework by increasing the basic income.

That should do the trick for the first term but a Conservative government should also commit to staying in the European Union, which stands in favour of trade, business and hard money; and to leaving the National Health Service alone for a few years just to see how it performs when not being incessantly prodded by politicians.

There you have it: a smaller, less bureaucratic state, innovation in education, redistribution to the poorest, a lower but more transparent income tax to attract the rich, an economic boom on the back of much-needed home-building and affordable housing for all.

Conservative Central Office can thank me later.

Written for and first published at ft.com.

5th of May, 2015Undercover EconomistComments off
Undercover Economist

The truth about inequality

‘One myth is that inequality in the UK has risen since the financial crisis. In fact it has fallen quite sharply’

How serious a problem is inequality? And if it is serious, what can be done about it?

Myths abound. Many people seem to believe that Thomas Piketty’s Capital in the Twenty-First Century showed that wealth inequality is at an all-time high; instead, his data show that wealth inequality has risen only slowly since the 1970s, after falling during the 20th century. In Europe we are thankfully nowhere near the wealth inequality of the past.

Another common belief is that the richest 1 per cent of the world’s population own half the world’s wealth (almost true) and that their share is inexorably increasing (not true). The richest 1 per cent had 48.2 per cent of the world’s wealth in the year 2014, according to widely cited research from Credit Suisse, but that share has fallen and risen over the past 15 years. It is lower now than in 2000 and 2001.

Neither is it clear that global inequality is rising. Average incomes in China and India have risen much faster than those in richer countries; this is a powerful push towards equality of income. But inequality within many countries is rising. Research from Branko Milanović, author of The Haves and the Have-Nots, suggests that the two forces have tended to balance out roughly over the past generation.

One final myth is that inequality in the UK has risen since the financial crisis. In fact, it has fallen quite sharply. “Inequality remains significantly lower than in 2007-08,” said the Institute for Fiscal Studies last summer. That conclusion is based on data through April 2013. The IFS did add, though, that “there is good reason to think that the falls in income inequality since 2007-08 are currently being reversed.”

Given all this, why the sudden anxiety about inequality? The answer is partly political: incomes fell and then stagnated after the financial crisis, and the crisis also made it seem risible to claim that the entrepreneurial activities of the rich would indirectly help the poor. None of this is directly connected to rising inequality but it certainly changes the conversation.

Yet there is more going on than a change in the political wind. By most reasonable measures, inequality of incomes has risen substantially over the past 40 years in both the US and the UK, with a particular surge in the 1980s. That should clarify the issue: the problem is most clearly seen within boundaries of nation states rather than globally; in income rather than wealth; and over the past few decades rather than the past few years. And it is stark enough to need no exaggeration.

I recently attended the launch of Inequality: What Can Be Done?, a book by Anthony Atkinson. Professor Atkinson is the economist who set the stage for younger stars such as Piketty and Emmanuel Saez; his first major paper on the subject of inequality was published in 1970, before either of them was born.

One thing that can be done, says Atkinson, is to use the same old redistributive tools with more vigour. The UK already redistributes income extensively. As Gabriel Zucman of the London School of Economics points out, the UK’s richest fifth had 15 times the pre-tax income of the poorest fifth, but after taxes and benefits they had just four times as much.

For some people that will seem more than enough redistribution. Others will disagree, and Atkinson is one of them. He would like to see the current 45 per cent top rate of tax levied at a much lower level (about £65,000), a new 65 per cent top rate for those earning more than £200,000, a substantially higher minimum wage, a “minimum inheritance” paid to every 18-year-old, guaranteed public employment, more comprehensive taxation of inheritance and property and an expansion of universal benefits.

Like it or loathe it, this is ambitious stuff. I don’t know if a 65 per cent top rate of tax is likely to be counterproductively high and neither does Tony Atkinson. I suspect that it is, and the available evidence provides some support for that suspicion. However, there is a wide margin of uncertainty so Atkinson is right to say that the evidence doesn’t conclusively rule it out.

Atkinson also wants to make market incomes themselves more egalitarian, leaving the welfare state with less to do. Ed Miliband, the Labour leader, once talked of “pre-distribution”, which is an ugly word for the same idea. But neither Miliband nor Atkinson is entirely persuasive about how this might work. Atkinson suggests that competition policy, vetting mergers and breaking up or regulating monopolies, should be used to reduce inequality. Or possibly the state’s support for science and innovation — always important — could favour innovations that complement labour rather than replacing it? In theory all this is possible. But my imagination is not up to the task of figuring out what these labour-complementing innovations might be, nor how the government might help produce them.

The UK general election on May 7 might well produce a Labour-led government but it will be astonishing if that government embraces a redistributive agenda half as ambitious as Atkinson’s. The conversation about inequality has changed quickly — but what mainstream politicians are willing to countenance has not.

Written for and first published at ft.com.

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