Economics 201

Case of the Day: Arthur Okun and the "Leaky Bucket"

Arthur Okun (OAK-un) was a prominent macroeconomist of the 1960s who served as chair of President Johnson's Council of Economic Advisors in 1968 and 1969. His main research was on the tradeoff between unemployment and inflation, which we shall study as the Phillips curve in macroeconomics. In 1975, a few years prior to his untimely death, he wrote a short book about another tradeoff that he considered to be even more important than the Phillips curve. He titled the book Equality and Efficiency: The Big Tradeoff. It is one of the few economics books of its era that is still just as important and, apart from the dated examples, just as current 40 years later.

In past years I have asked Econ 201 students to read Okun's book and write an essay about some aspect of it. But in 2016 there is so much current information and controversy about economic inequality that reading Okun's classic and also this more updated material would have been too much, even for highly motivated Reed students. So the former Okun reading and essay have become this case study, summarizing a few main points from his book and asking a few brief questions about your opinions about a fair income distribution.

Okun's book has four chapters:

1. Rights and Dollars
2. The Case for the Market
3. Equality of Income and Opportunity
4. Increasing Equality in an Efficient Economy

I will attempt to summarize these chapters in a concise way, bringing in the main points as much as possible in a short summary. Although it has disappeared from the reading list, I cannot encourage you strongly enough to read Okun's actual book. He is an excellent writer as well as an excellent economist (a combination not often found together). His prose and arguments are much richer than my summaries can reflect, both because of brevity and due to my own expressive limitations. I will try to let Okun speak through direct quotations as much as I can, injecting my own text to tie his arguments together.

1. Rights and Dollars

Okun begins his analysis by noting the America has a "domain of rights," in which inalienable entitlements are granted universally to all citizens (and, in some cases, to all residents) without regard to income or other consideration and not as a reward or incentive for anything else. Voting is obviously in the domain of rights, as are the freedoms enshrined in the Bill of Rights and access to publicly provided services such as public education. We occasional exceptions, denial of these rights is illegal (though it sometimes happens anyway).

The key feature of rights is that one cannot (legally) sell them. The purely voluntary sale of one's vote would, presumably, enhance the utility of both the buyer and the seller, so it would be Pareto improving. After all, if you truly do not care who wins the election, why not make a few dollars selling your vote to someone who cares enough to value having an extra vote more than the amount you are paid? He cites several further examples where Pareto efficiency seems to be violated by our system of political and social rights:

"The one-person, one-spouse rule could be altered to permit voluntary exchange by giving each person a marketable ticket to a spouse rather than a non-transferable right to marry one (and no more than one) person at a time. Since jury trials are expensive, society might offer any defendant who waived that right some portion of the savings. ... Even the obligation to obey the law might be made marketable, as it was, in a figurative sense, when the Church sold indulgences during the Middle Ages." (pp. 9-10)

In each of these cases, people are prevented by our definition of "rights" from undertaking transactions that, because both parties enter into them voluntarily, would seem to increase their utility if they were allowed.

Okun views the domain of rights as a part of the social system that overrides considerations of economic efficiency: "Everyone but an economist knows without asking why money shouldn't be able to buy some things. ... If votes were traded at the same price as toasters, they would be worth no more than toasters and would lose their social significance." (p. 13)

So where do rights end and tradable economic assets begin? Establishment, enforcement, and provision of rights cost economic resources; Okun argues that the more costly a right would be, the less likely it is to be universally granted. Some rights are relatively inexpensive to provide, such as voting rights and marriage rights. But other potential rights are very costly indeed.

A current example is the boundary between a universal right to health care and the treatment of health care as an economic commodity. European countries tend more toward the "universal right" side and the United States toward the "economic commodity" side. Health care is a massive expenditure that, if paid for solely by the government, quickly becomes a dominant part of public spending. Some kind of rationing is needed in order to keep costs under control. In the market setting care is rationing based on willingness and ability to pay; in publicly provided health-care systems it is often rationed by queues for non-emergency services and simply by refusal of services to those whose need is deemed insufficient. Surely a rich society should not allow anyone to starve. But imagine if everyone had a "right" to unlimited free food. How would farmers (or the tax system) keep up?

Although he, as an economist, believes that market solutions are often the most effective, Okun argues that "the case for a right to survival is compelling. The assurance of dignity for every member of the society requires a right to a decent existence." (p.17)

While the support of this right has led to the establishment of many useful government "safety net" policies such as Social Security, Medicare and Medicaid, food stamps, unemployment insurance, and general welfare benefits, the United States has not enshrined the "right to survival" in the Constitution.

Okun concludes the first chapter by considering all of the ways in which money has transgressed on areas of society that were traditionally supposed to be equal rights. He cites as two prominent examples equality before the law (where talented and expensive lawyers can unjustly win cases for rich clients) and the use of money to buy political power (about which we need say nothing more in this era) through campaign financing and lobbying.

2. The Case for the Market

Okun begins his second chapter with a discussion of how markets can lead to efficiency and why capitalism allocates resources more efficiently than centrally planning. These arguments have dominated much of our class and need not be repeated here. Moreover, the collapse or reform of Communism in most of the world since he wrote in 1975 has vindicated his view that capitalism can be an effective mechanism for resource allocation—better than any modern alternatives.

He then goes on the discuss how the income distribution will be determined in a competitive (and presumably efficient) economy. Individuals derive income from selling productive services to the market, which are valued according to their marginal revenue products. "The productive contribution of the services I could sell in a hypothetical competitive market depends on four sets of elements: (1) the skills and assets that I have acquired through my lifetime; (2) the abilities and talents with which I was born; (3) the effort I am willing to expend; and (4) the supply and demand situations for other services related to the ones I can offer." (p. 42)

For each of these, he poses the question of whether the resulting income differences are "fair." For acquired assets and skills: "To the extent that my current supply of marketable services is augmented by effort (or thrift) that I have exercised previously, I am reaping the harvest from the seeds I planted in the past. But to the extent that my present position reflects heavily the advantages of family background, or privilege, or status, I am reaping what others have sown." (p. 43)

On difference in abilities and talents, he presents two sides to the argument. In defense of such inequality, he notes that such differences pervade all of life: "Should everyone ... stop running races? Obviously not. In real track meets, no official has ever disqualified a runner for having 'fast genes.'" (p. 43) But he goes on to argue: "... society should aim to ameliorate, and certainly not to compound, the flaws of the universe. It cannot stop rain, but it does manufacture umbrellas." (p. 44)

Differences in pecuniary income due to differences in effort are not only defensible—leisure is an alternative form of utility that some may choose in preference to the goods that higher income can buy—but also serves the essential role of motivating work in the market system. The real question, Okun argues, goes back to the idea of basic rights: to what level of survival should someone who simply refuses to work be entitled?

The final determinant is perhaps the most complex. Economists are in higher demand for historians and as a result (everywhere except Reed College) they earn higher salaries. Is this fair? Larry Page and Sergey Brin invented the Google search algorithm, which proved to be of enormous value to millions of people. Does this entitle them to a vastly higher income than, say, someone who writes an excellent poem or someone who paints an exceptional picture?

There is a strong efficiency basis for at least some degree of differential in compensation. Firms seem to believe that the services of economists contribute strongly to the production of commodities for which households are willing to pay; they do not as often seem to have that opinion about the services of historians. Higher salaries encourage students to study those disciplines that have more (apparent) value to society. Vast numbers of people gain from the effectiveness of Google searches every day, where only a few are likely to read a poem or view a painting. It is central to the market mechanism of efficiency that the prospect of high returns channels individuals to turn their efforts to enterprises that yield high benefits.

This argument gets at the central point of Okun's book: that there is a tradeoff between equality and efficiency. If all are guaranteed an identical income regardless of how much (or at what, or even whether) they work, would anything get produced? Efficiency in a market system (and all other economic systems ever tried have failed miserably at achieving efficiency) relies on incentives, and incentives involve the opportunity to earn rewards, and rewards inevitably lead to inequality of outcomes.

But how much inequality can we tolerate before we judge the outcome to be "unfair"? Ultimately, each of us has his or her own definition of "fairness," conditioned by our background and training. These are opinions, not facts. None of us can claim to be "correct." That's why there will always be healthy disagreement about issues of economic inequality. (And why there is no right or wrong answer to the questions at the end of this case.)

3. Equality of Income and Opportunity

One of the major questions we should consider is whether we seek equality of incomes/outcomes or equality of opportunity. If two people have the same opportunities and face the same choices, but one chooses a path of wealth and the other a path of poverty, then it is difficult (for me) to see anything unfair in this outcome. In his third chapter, Okun talks about some of the pitfalls in interpreting inequality statistics, to which I'll add a few of my own.

Inequality statistics are often cited in (at least) three dimensions, which sound kind of alike but which are vastly different. Earnings inequality refers solely to labor income, either before-tax or after-tax. It is usually the measure that exhibits the least inequality, especially if measured after taxes and transfers are considered. Income inequality includes inequality arising from labor earnings, but also includes income from other resources such as capital and land. Because holdings of real and financial assets are strongly concentrated among people with high labor earnings, income is more unequal than earnings. Finally, wealth inequality is usually the greatest of all. Earnings and income are annual flows, whereas wealth is an accumulated stock. Bill Gates could earn nothing next year and he would still be much wealthier than you or me because of the value of the assets he has accumulated through his past income. Moreover, measures of wealth inequality count physical and financial capital, but ignore human capital. So one's measured wealth almost always grows dramatically through one's working life as one's uncounted human capital depreciates and one's counted financial capital accumulates. Measured wealth typically peaks at retirement and then dissipates as one spends down one's accrued retirement assets.

It is important to measure inequality over the life cycle. Most people at age 20 rank lower in all of the inequality distributions than they will at age 50. They will rank higher at 50 in terms of earnings, income, and especially wealth. The part of measured inequality that is driven by differences in age is probably less important than the part driven by differences across people over their lifetimes.

When measuring inequality it is also important to adjust for differences in households' needs. How much should we adjust for family size? Okun argues that "[p]arents in large families may not sacrifice their welfare if they consciously choose to have lots of kids because they get more fun from children than from vacations or cars; but the children of big families unambiguously attain a lower level of economic welfare than those in small ones with the same incomes. Whether or not they enjoy siblings, the kids rarely get a vote on family size." (p. 70) So should we measure inequality of income at the level of the family (because parents choose how thinly to divide the available resources) or per person (because the kids' well-being depends on per-capita income and the choice was inflicted upon them)?

What about "voluntary nonmonetary sacrifices"? "Some families earn higher incomes than others because their members work more by moonlighting or seizing opportunities for overtime, or because a larger number of family members work. A hard-working family may achieve its extra income by sacrificing leisure that other families with the same opportunities regard as indispensable." (p. 71) Equality in opportunity or equality in income?

As we discussed in the labor economics segment, differences in earnings sometimes result from differences in the work environment that the laborer endures. Workers in strenuous, dangerous, or unpleasant jobs usually earn higher wages (otherwise they would not be willing to do that job) than others with similar qualifications. This is a source of inequality of income, but not necessarily of opportunity or utility.

Okun asks to what extent we should think of income inequality as "cafeterias," where individuals choose their occupations and corresponding levels of income, or "casinos," where some are lucky enough to be endowed with more valuable resources through genetics, environment, or inheritance. This really gets at the fundamental question of this chapter, in which he argues that equality of opportunity should often take precedence over equality of outcome. He goes on to describe the kinds of policies that would enhance equality of opportunity, including elimination of discrimination of any kind in access to education, jobs, or capital.

He ends this chapter by focusing on a difference in philosophy between the mindset of market economists and a more egalitarian, cooperative mindset that I have found to be common among Reed students. From his section on "Races or Dances":

"Efforts to promote equality of opportunity accept an individualistic, achievement-oriented, and essentially competitive economy in which prizes will be given and a variety of hierarchies will continue to exist. On the other hand, some see the contests of modern society as dehumanizing rat races, and their objective is not to make them fairer but to eliminate them. They want fewer races, and more dances that feature cooperation and fraternity. It may will be desirable to effect some shift in the mixture of competition and cooperation. But a major deemphasis of competition means forgoing individualistic incentives; and that, in turn, involves either a tremendous sacrifice of efficiency or else the creation of alternative incentive systems. Perhaps people will work and produce in order to serve humanity, guided by a love for all [hu]mankind as brothers and sisters. Properly indoctrinated, people can be induced to work for the greater glory of the state or of the leader of the state. Reflecting traditional values, however, most Americans would rather run races for their own prizes than run errands for their leader's glory." (pp. 85-86)

4. Increasing Equality in an Efficient Economy

In his final chapter, Okun brings his analysis to what has become his signature metaphor: the "leaky bucket." In essence, he is saying that because policies that increase equality involve taxing high incomes and subsidizing low incomes, they dull the incentives that the market provides for production and will reduce output overall. There are deadweight losses involved in any practical system of taxes and income transfers: In transferring more of the pie to those with smaller pieces, the overall size of the pie is made smaller. Or, to use his metaphor, it is like transferring water in a leaky bucket. More is put into the bucket than is taken out at the other end. He illustrates the leaky bucket with the following hypothetical example (with numbers that are obviously far out of date):

"First, consider the American families who make up the bottom 20 percent of the income distribution. Their after-tax incomes in 1974 were less than $7,000, averaging about $5,000. Now consider the top 5 percent of families in the income pyramid; they had after-tax incomes ranging upward from about $28,000, and averaging $45,000. A proposal is made to levy an added tax averaging $4,000 (about 9 percent) on the income of the affluent families in an effort to aid the low-income families. Since the low-income group I selected has four times as many families as the affluent group, that should, in principle, finance a $1,000 grant for the average low-income family. However, the program has an unsolved technological problem: the money must be carried from the rich to the poor in a leaky bucket. Some of it will simply disappear in transit, so the poor will not receive all the money that is taken from the rich." (p. 91)

He goes on to ask the reader to "[s]uppose 10 percent leaks out; that would leave $900 for the average poor family instead of the potential $1,000. Should society still make the switch? If 50 percent leaks out? 75 percent? Even if 99 percent leaks out, the poor get a little benefit; the $4,000 taken from the rich family will yield $10 for each poor family. Where would you draw the line?" (pp. 91-92)

From where do these leakages come? Okun cites a number of causes of inefficiency in the process of transferring income from rich to poor:

• Administrative costs of the government programs to collect the taxes, distribute the transfers, and determine tax liability and benefit eligibility.
• Reductions in work effort both by the rich who have lower after-tax wages due to the tax and by the poor who now have additional non-labor income and who may be dissuaded from work if earning more disqualifies them from the transfer program.
• Saving and investment may be discouraged by high tax rates on income both because the incentives to accumulate wealth are reduced and because the wealthy typically save more of their income than the poor.
• Socio-economic leakages due to the possible stigmatization of wealth accumulation, which may cause individuals to try less hard to be productive and get rich.

He concludes the book with a discussion of policies in 1975 America that attempt to effect this income transfer: income taxes and various transfer programs.

After attempting, highly imperfectly, to summarize its content, I can only reiterate how much I think you will enjoy and gain from actually reading this book. Much richness, detail, and nuance are inevitably sacrificed in the attempt to reduce it to a few short pages. It's kind of like a leaky bucket.

Question for analysis

Suppose that you are the economic dictator of an economy with five equal-sized groups of people, A, B, C, D, and E. You must choose between two policies that affect the income distribution for these groups. For each policy choice, explain which you would choose (Plan #1 or Plan #2) and explain why.

1.

2.

3.

4.

Answer the questions in Moodle