Is it better to tax consumption or to tax income? Is it better to tax carbon or to mandate fuel efficiency? Is it better to foster global competition or to protect local industries?
Today, I will attack none of these questions. Instead, I will attack the meta-question of how to attack such questions. For economists evaluating alternative policies, the industry standard is the efficiency criterion, also known as the welfare criterion. (I’ll illustrate what that means as I go along.) But now comes Princeton Professor Uwe Reinhardt with a piece in the New York Times that questions the orthodox approach found in virtually all modern textbooks (including one in particular).
Let’s first dispense with the straw man. I’ve never heard of an economist who believes that every efficient policy is good, and I’ve heard of very few who believe that every inefficient policy is bad. It’s true that most economists do seem to believe that any good policy analysis should start by considering efficiency. That doesn’t mean it should end there.
I think economists are right to emphasize efficiency, and I think so for (at least) two reasons. First, emphasizing efficiency forces us to concentrate on the most important problems. Second, emphasizing efficiency forces us to be honest about our goals.
I’ll illustrate the first advantage with a stylized example adapted from Chapter 17 of The Big Questions. Suppose you live next door to Bill Gates. Bill likes to play loud music at night. You’re a light sleeper. Should he be forced to turn down the volume?
An efficiency analysis would begin, in principle (though it might not be so easy in practice) by asking how much Bill’s music is worth to him (let’s say we somehow know that the answer is $10,000) and how much your sleep is worth to you (let’s say $25). It is important to realize from the outset that no economist thinks those numbers in any way measure Bill’s subjective enjoyment of his music or your subjective annoyance. Only a crazy person would think such a thing, and I’ve never met anybody who’s that crazy in that particular way. Instead, these numbers primarily reflect the fact that Bill is a whole lot richer than you are. Nevertheless, the economist will surely declare it inefficient to take $10,000 worth of enjoyment from Bill in order to give you $25 worth of sleep. We call that a $9,975 deadweight loss.
Why is that an important calculation? Here’s why: It reminds us that there might be a better solution to this problem, such as allowing Bill to crank up his speakers and forcing him to pay you, say, $5000 in compensation. Compared to shutting down the music, that’s better for Bill and better for you. Maybe that’s an alternative we should consider. In fact, whenever a policy is inefficient, there’s always an alternative policy that, in principle, is better for everyone. That’s what inefficiency means.
Now in this case the proposed alternative policy might not be such a good idea. It might, for example, encourage Bill to lie about the value of his music, and encourage you to lie about the value of your sleep. It might even encourage you to move a little closer to Bill just so you can find more things to complain about and get compensated for. Or it might have negative long-term consequences for the way we think about wealth and social status. So maybe we don’t want to pursue this alternative policy after all. But, says the economist, we ought at least to consider it.
And — here’s the point — the bigger the deadweight loss, the greater the potential gains from an alternative policy. Therefore, the bigger the deadweight loss, the more it’s worth at least attempting to devise a good alternative policy. We calculate the deadweight loss as a rough but useful guide to how much effort we should put into this problem. (Calculating deadweight losses is the same thing as worrying about efficiency.)
Take a more realistic example: Should we spend, say, a billion dollars a year to subsidize end-of-life health care for poor people? It would be, I think, a terrible mistake to settle this question without at least asking whether the recipients might prefer that we spend our billion dollars some other way — say by subsidizing their groceries or just giving them cash. If so, the difference in value between what they’re getting and what they could be getting (as measured by the recipients) is a deadweight loss. The bigger that deadweight loss, the more we should reconsider our spending priorities.
Now once again, efficiency is not the be-all and end-all of policy analysis. Even if poor people prefer subsidized groceries to subsidized health care, we might still choose to give them health care if, for example, we believe that they are less likely to make wise decisions about their own health care than about their own groceries, or if we’re afraid that subsidizing groceries (or handing out cash) is somehow more likely to invite fraud. But the bigger the deadweight loss, the more we should probably rethink those concerns, because the bigger the deadweight loss, the more opportunity there is to improve life for the recipients. That’s the first reason we should care about efficiency.
The second reason we should care about efficiency is that efficiency analysis strikes down political smokescreens. Like this:
Politician: Here’s my program to make the health care system work better by subsidizing health care for the poor.
Economist: Your program costs a billion dollars and delivers half a billion dollars worth of benefits. That’s inefficient.
Politician: So what?
Economist: Well, the “so what” is that maybe you could take that billion dollars and deliver a full billion dollars worth of benefits instead if you spent it a little differently. Why not just hand the cash out to poor people?
Politician: Because I don’t want to help all poor people. I only want to help sick poor people — and this is the only way I can think of to do that.
Economist: Ah. So your goal here is not to make the health care system work better after all. Instead it’s to transfer resources to sick poor people.
Politician: I guess so.
Economist: That’s fine. Now we can have a healthy debate about whether that’s what we want to do.
And now, you see, thanks to the economist’s insistence on thinking about efficiency, we end up having an honest debate about the politician’s real goal instead of a dishonest debate about the politician’s feigned goal. However the debate turns out, that’s a useful exercise.
It’s not just politicians who sometimes hide their true goals behind smokescreens. Suppose, for example, that one of Professor Reinhardt’s colleagues were to write a series of columns in the New York Times calling for more fiscal stimulus, including higher unemployment benefits. On some days, he argues that these policies will increase GDP. Other days, he argues that they will reduce unemployment. Other days, he tells you that it’s cruel to deny benefits to suffering jobseekers.
Those are of course all different (though intertwined) arguments. You might accept some but not others. Even if you accept them all, you still can’t draw a policy conclusion until you weigh these benefits against the policies’ offsetting costs (including the opportunity cost of the expenditures, the effect on long run growth, and so forth). The advantage of an efficiency analysis (along, say, the lines suggested here) is that it would force Professor Reinhardt’s colleague to be clear about his priorities. Is he, for example, concerned primarily about increasing current output or about redistributing current output? Either might be a worthy goal, but we can’t have a useful debate with someone who won’t tell us what his goals are.
Usually, when economists take policy stands, they start with an efficiency analysis precisly in order to clarify their goals and so make it easier for opponents to identify the locus of their disagreement. They say things like “I support this policy because it’s efficient” or “This policy is inefficient — I estimate the deadweight loss at $X — but I think that much deadweight loss is worth tolerating for the following reasons.” That’s called intellectual honesty. I think it’s a good thing.