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Tuesday, July 13, 2010

Market Failures

A response to "The New Politics of Consumption" by Juliet Schor

by Robert H Frank

Boston Review (Summer 1999)

IS JULIET SCHOR RIGHT that American spending patterns have gone astray? At a quick glance, it would certainly appear so. Despite growing threats from E-coli, listeria, and other deadly organisms, we cite financial distress to explain why we've cut FDA inspections of meat-processing plants by more than 75 percent in the last decade-even as we've continued to build larger houses and buy heavier sport utility vehicles. And each year we postpone repairs on structurally unsound bridges and shut down cost-effective drug-treatment programs, even as our spending on luxury goods continues to grow four times as quickly as spending overall.

Behavioral science now provides additional grounds to question the wisdom of our current spending patterns. Scores of careful studies show that we would be happier and healthier if we spent less on luxury goods, saved more, and provided more support for basic public services.

But this raises an obvious question: If we'd be better off if we spent our money differently, why don't we? In her essay {1} and in her recent book, The Overspent American {2}, Juliet Schor surveys a variety of possible explanations. Communitarians cite a decline in social capital, noting that affluent Americans sequestered in gated communities are increasingly insulated from the consequences of our neglected public sphere. Social theorists emphasize the imperatives of class and identity, which drive many to proclaim their superiority over others through the purchase of costly goods. Other critics stress the influence of sophisticated marketing campaigns, which kindle demands for things we don't really need. Professor Schor especially favors this marketing explanation, and she argues forcefully on its behalf, as did John Kenneth Galbraith more than forty years ago in The Affluent Society {3}.

Despite its distinguished pedigree, however, the marketing explanation also has a drawback: although it can account for a bias toward luxury consumption spending, it does not seem to explain why things have gotten so much worse. Television advertising has been with us since the early 1950s, after all, and salesmanship in various other forms since before the dawn of the industrial age.

Why, then, are the apparent distortions so much larger today? In my recent book, Luxury Fever {4}, I suggested that one reason may lie in a simple change in the economic incentives we face. This change is rooted in a fundamental shift in the distributions of income and wealth in America that began in the early 1970s.

Whereas incomes grew at about three percent a year for families up and down the income ladder between 1945 and 1973, most earnings growth since 1973 has gone to families at the top. For example, the top one percent of earners have captured more than seventy percent of all earnings growth during the last two decades, a time during which median real family income has been stagnant and the incomes of the bottom fifth have declined about ten percent. Reinforcing these changes has been a parallel shift in the distribution of wealth, much of it driven by the spectacular run-up in stock prices.

Increasing inequality has caused real, unavoidable harm to families in the middle-class - even those who now earn a little more than they used to - by making it more difficult to achieve balance in their personal spending decisions. The problem stems from the fact that the things we need so often depend on what others have. As Nobel laureate Amartya Sen has pointed out, a middle-class Indian living in a remote mountain village has no need for a car, but a middle-class resident of Los Angeles cannot meet even the most minimal demands of social existence without one.

When those at the top spend more on interview suits, others just below them must spend more as well, or else face lower odds of being hired. When upper-middle-class professionals buy 6,000-pound Range Rovers, others with lower incomes must buy heavier vehicles as well, or else face greater risks of dying. Residents in a community in which the custom is to host dinners for twelve need bigger dining rooms than if the custom were dinners for eight.

So when top earners build larger houses - a perfectly normal response to their sharply higher incomes - others just below them will have greater reason to spend more as well, and so on all the way down. Because of the growing income gap, the size of the average American house built today is roughly 2,200 square feet, up from 1,500 square feet in 1970.

The middle-income family that buys this house must carry a significantly larger mortgage than the buyer of the average house in 1970. And because public school quality is closely linked to local real estate taxes, which in turn are closely linked to average house prices within each school district, families must buy an average-priced house or else send their children to below-average schools. So even the middle-income family that doesn't want a bigger house may feel it really has no choice but to buy one.

Yet because this family has no more real income than in 1970, it must now carry more debt and work longer hours to do so. Little wonder, then, that despite the longest economic expansion on record, with the unemployment rate at a 29-year low, one American family in 68 filed for bankruptcy last year, almost seven times the rate in 1980. Our national savings rate is now negative, which means that we are currently spending more each month than we earn.

MY CLAIM, in a nutshell, is that the imbalance in our current spending patterns may be viewed as a market failure caused by consumption externalities: by the fact that greater consumption by some people imposes costs on others. An important strategic advantage of this explanation is that it is grounded in the very same theoretical framework that animates the beliefs of the most ardent defenders of the status quo. Thus, as even conservative economists have long recognized, when one family's spending decisions impose negative consequences on others, Adam Smith's invisible hand simply cannot be expected to produce the best overall spending pattern.

The good news is that if consumption externalities are what lead us to work too hard, spend too much, and save too little, a relatively simple legislative fix is at hand. Just as we have persuaded legislators that effluent taxes and other economic incentives are better than regulation as a way to curb pollution and other environmental externalities, so too might we eventually persuade them that it is better to curb consumption externalities through the tax system than by trying to micromanage personal spending decisions.

In Luxury Fever, I suggested that we scrap our current progressive tax on income in favor of a far more steeply progressive tax on consumption. Because total consumption for each family can be measured as the simple difference between the amount it earns each year (as currently reported to the IRS) and the amount it saves, such a tax would be relatively easy to administer. And if the tax were coupled with a large standard deduction (say $7,500 per person) and had low marginal tax rates on low levels of consumption, it would be even less burdensome for the poor than our current income tax.

More important, it would provide top earners with strong incentives to save more and limit the rate at which they increase the size of their mansions. Their doing so would reinforce the incentives on those just below the top to do likewise, and so on all the way down. Phased in gradually, this tax would slowly reduce the share of national income devoted to consumption and increase the corresponding share devoted to investment. Total spending would continue at levels sufficient to maintain full employment, and greater investment would lead to more rapid growth in productivity.

The tax could be set up so that the revenue raised from each income class would be roughly the same as under the current system. But persuasive evidence suggests that if legislators were to set rates on top spenders high enough to raise greater revenue than under the current system, both rich and poor would benefit significantly. Since beyond some point it is relative, not absolute, consumption that matters, top earners would not really suffer if the tax led all of them to increase the size of their mansions at a slower rate. Yet they and others would reap large benefits from the restoration of long neglected public services.

PERSUADING LEGISLATORS to enact a steeply progressive consumption tax will not be easy. Its congressional sponsors could count on being pilloried by opponents as tax-and-spend liberals. Yet the progressive consumption tax is hardly a fringe idea. A bill proposing a tax with essentially the same features (the "Unlimited Savings Allowance Tax", or USA Tax) was introduced in the US Senate in 1995 by Pete Domenici (Republican, New Mexico) and Sam Nunn (Democrat, Georgia).

By suggesting that our current consumption imbalance is a result, in large measure, of consumption externalities, I do not mean that other explanations for the imbalance are wrong. Social capital has declined. Class also matters, and there is no denying the influence of commercial advertising.

If a political solution is what we seek, however, there may be considerable strategic advantage in focusing on externalities. It is difficult to imagine Congress approving legislation aimed at transforming class consciousness or eliminating commercial advertising. But we have a long tradition of collective action to control externalities - of discouraging some people from imposing uncompensated costs on others. And as Madison Avenue hucksters have known all along, it is a lot easier to sell with the grain than against it.







Originally published in the Summer 1999 issue of Boston Review

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Bill Totten


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