What is Fair?

I recently read Thomas Piketty’s Capital in the 21st Century (my review of which will soon be published by National Review, for those interested). In reading the book, an implicit theme is that of fairness. Throughout the text, Piketty argues that his evidence on inequality suggests that there is a growing importance of inheritance in the determination of income and that this trend is likely to continue. It seems that Piketty sees this as problematic because it undermines meritocracy and even democracy. Nonetheless, when we start talking about there being too much inequality or too great of an importance of inheritance, this necessarily begs the question: How much is too much?

Economists have common ways of dealing with that question. There are vast literatures on optimal policies of all different types. The literature on optimal policy has a very consistent theme. First, the economist writes down a set of assumptions. Second, the economist solves for the efficient allocation given those assumptions. Third, the economist considers whether a decentralized system can produce the efficient allocation. If the decentralized allocation is inefficient, then there is a role for policy. The optimal policy is the one that produces the efficient allocation.

When Piketty and others talk about inequality and policy, however, they aren’t really talking about efficiency. Meritocracy-type arguments are about fairness. Economists, however, often shy away from discussing fairness. The reason is often simple. Who defines what is fair? Let’s consider an example. Suppose there are two workers, Adam and Steve, who are identical in every possible way and to this point have had the exact same economic outcomes. In addition, assume that we only observe what happens to these individuals at annual frequencies. Now suppose that this year, Adam receives an entirely random increase in pay, where random simply refers to something that was completely unanticipated by everyone. However, this year Steve loses his job for an entirely random reason (e.g. a clerical error removed Steve from the payroll and it cannot be fixed until next year). After this year, Adam and Steve go back to being identical (the clerical error is fixed!) and continue to experience the same outcomes the rest of their lives.

This is clearly a ridiculously stylized example. However, we can use this example to illustrate the difference between how economists evaluate policies. For someone concerned with a meritocratic view of fairness, the ideal policy in the ridiculous example above is quite clear. Adam, through no actions of his own, has received a windfall in income. Steve, through no fault of his own, has lost his income for an entire year. Someone only concerned with meritocracy would argue that the ideal policy is therefore to tax the extra income of Adam and give it to Steve.

Most economists, armed with the same example would not necessarily agree that the meritocratic policy is ideal. The most frequently used method of welfare analysis is the idea of Pareto optimality. According to Pareto optimality, a welfare improvement occurs when at least one person can be made better off without making another person worse off. In our example above, Pareto optimality implies that the optimal policy is to do nothing because taxing Adam and giving the money to Steve makes Adam worse off.

Advocates of meritocracy, however, are unlikely to be convinced by such an argument. And there is reason to believe that they shouldn’t be convinced. For example, if Adam and Steve both knew that there was some random probability of unemployment ex ante, they might have chosen to behave differently. For example, suppose that Adam and Steve each knew in advance that there was some probability that one of them would lose their job. They might have each purchased insurance against this risk. If we assume the third party insurer can costly issue insurance and earns zero economic profit, then when Steve became unemployed, he would receive his premium back plus what is effectively a transfer from Adam.

Of course, in this example, there still isn’t any role for policy. Private insurance, rather than policy, can solve the problem. Nonetheless, as I detail below, this does give us a potentially better starting place for discussing fairness, efficiency, and inequality.

Suppose that inequality is entirely driven by random idiosyncratic shocks to individuals and that these events are uninsurable (e.g. one cannot insure themselves against being born to poor parents, for example). There is a potential role for policy here that is both fair and efficient. In particular, the policy would correspond to what economists traditionally think of as ex ante efficiency. In other words, a fair policy would be the policy that individuals would choose before they knew the realization of these random shocks.

As it turns out there is a sizable literature in economics that examines these very issues and derives optimal policy. The conclusions of this literature are important because (1) they take the meritocratic view seriously, and (2) they arrive at policy conclusions that are often at odds with those proposed by advocates of meritocracy.

It is easy to make an argument for meritocracy. If people make deliberate decisions that improve their well-being, then it is easy to make the case that they are “deserving” of the spoils. However, if people’s well-being is entirely determined by sheer luck, then those who are worse off than others are simply worse off due to bad luck and a case can be made that this is unfair. Unfortunately, for advocates of meritocracy, all we observe in reality are equilibrium outcomes. In addition, individual success is often determined by both deliberate decision-making and luck. (No amount of anecdotes about Paris Hilton can prove otherwise.) I say this is unfortunate for advocates of meritocracy because it makes it difficult to determine what amount of success is due to luck and what is due to deliberate actions. (Of course, this is further muddled by the fact that when I say luck, I am referring to entirely random events, not the definition of the person who once told me that “luck is when preparation meets opportunity.”)

Nevertheless, our economic definition of fairness allows us to discuss issues of inequality and policy without having to disentangle the complex empirical relationships between luck, deliberate action, and success. Chris Phelan, for example, has made a number of contributions to this literature. One of his papers examines the equality of opportunity and the equality of outcome using a definition of fairness consistent with that described above. Rather than examining policy, he examines the equality of opportunity and outcome within contracting framework. What he shows is that inequality of both opportunity and outcome are both consistent with this notion of fairness in a dynamic context. In addition, even extreme inequality of result is consistent with this definition of fairness (such extreme inequality of opportunity, however, are not supported so long as people care about future generations).

Now, of course, this argument is not in any way the definitive word on the subject. However, the main point is that a high degree of inequality is not prima facie evidence of unfairness. In other words, it is not only difficult to disentangle the effects of luck and deliberate action in determining an individuals income and/or wealth, it is actually quite difficult to figure out whether a particular society is fair simply by looking at aggregate statistics on inequality.

This point is especially important when one thinks about what types of policies should be pursued. Advocates of a meritocracy, for example, often promote punitive policies — especially policies pertaining to wealth and inheritance. Piketty, for example, advocates a global, progressive tax on wealth. The idea behind the tax is to forestall the importance of inheritance in the determination of income and wealth. While this policy might be logically consistent with that aim, but it completely ignores the types of things that we care about when thinking about optimal policy.

For example, consider the Mirrlees approach to optimal taxation. The basic starting point in this type of analysis is to assume that skills are stochastic and the government levies taxes on income. The government therefore faces a trade-off. They could tax income highly and redistribute that income to those with lower skill realizations. This represents a type of insurance against having low skills. On the other hand, high taxes on income would discourage high skill workers from producing. The optimal policy is one that best balances this trade-off. As I note in my review of Piketty in National Review, this literature also considers optimal taxation with regards to inheritance. The trade-off here is that high taxes on inheritance discourage wealth accumulation, but provide insurance to those who are born to poor parents. The optimal policy is the one that best balances these incentives. As Farhi and Werning point out in their work on inheritance, it turns out that the optimal tax system for inheritance is a progressive system. However, the tax rates in the progressive system are negative (i.e. we subsidize inheritance with the subsidization getting smaller as the size of the inheritance gets larger). The intuition behind this is simple. This system provides insurance without reducing incentives regarding wealth accumulation.

Economists are often criticized as being unconcerned with fairness. This is at least partially untrue. Economists are typically accustomed to thinking about optimality in the context of Pareto efficiency. As a result, economists looking at two different outcomes will be hesitant to suggest that a particular policy might be better than another if neither represents a Pareto improvement. Nonetheless, this doesn’t mean that economists are unconcerned with the issue of fairness nor does it suggest that economists are incapable of thinking about fairness. In fact, economists are capable of producing a definition of fairness and the policy implications thereof. The problem for those most concerned with fairness is the economic outcomes and policy conclusions consistent with this definition might not reinforce their ideological priors.