Meritocracy, mobility, and optimal taxation

What would a perfect meritocracy look like?

Suppose we could all agree on a definition of "merit" as "ability to contribute to the common good".

Suppose that each individual was born with a certain quantity of "merit", and that we could observe and measure each individual's "merit" perfectly. It's indelibly stamped on their foreheads.

Suppose that we had an economic system where each individual's income was strictly and perfectly proportional to that individual's "merit".

That perfect meritocracy is not a good economic system. Not in my eyes, anyway. Because, for example, it would mean that an individual who was unlucky enough to be born with zero "merit" would get zero income.

Standard Optimal Tax Theory says that if we lived in such a world we should put a tax on "merit", and only on "merit". And we should put the tax rate high enough to ensure that all individuals earn exactly the same after-tax income, regardless of "merit". Because doing so would maximise total utility of the population (assuming diminishing marginal utility of income).

The only difference between the imaginary world I have described above and the world described in (the simplest) models in standard optimal tax theory (Mirlees?) is that the latter assume that "merit" is not observable by the tax authorities. The tax authorities can only observe income, which equals "merit" times hours worked. So they can't tax "merit" and can only tax income. So unlike my imaginary world, the standard optimal tax theory model says that the marginal tax rate should be less than 100%. It balances the gains from equalising individuals' incomes through high marginal tax rates against the losses of the disincentive effects and lower total incomes. So differences in after-tax income would still exist. (Did I get that roughly right, Frances?)

How much mobility would there be in such a world, from one generation to the next? That would depend on the extent to which "merit" is inherited (either through nature or nurture) from one's parents. If parents' and their children's "merit" were perfectly correlated, there would be zero mobility in a perfect meritocracy. If the correlation were zero, there would be perfect mobility.

But I'm not sure why mobility matters.

Now let me change my imaginary world slightly. Suppose individuals differ both by "merit" and by "rent extraction skill", where "rent extraction skill" means "ability to transfer income from others to themselves". So an individual's income depends on his "total ability", which is the sum of "merit" plus "rent extraction skill".

If the tax authorities could observe each individual's "total ability", it wouldn't change the results in any way. Total utility of the population would still be maximised by taxing "total ability" to eliminate all differences in after-tax income.

If the tax authorities could not observe ability, and could only observe income, it would change the results. High marginal tax rates would discourage socially productive effort, which is bad, but would also discourage rent-seeking effort, which is good. So marginal tax rates should be higher than in a pure meritocracy where income depended only on merit.

Would intergenerational mobility be higher or lower than in a pure meritocracy where income depended only on merit? That depends. If the degree of heritability were exactly the same for "merit" as for "rent extraction skills", the amount of intergenerational mobility would be exactly the same as in a world of pure meritocracy. There is no obvious relationship between mobility and meritocracy.

But I'm still not sure why mobility matters.

Comments

[anon]

"If the tax authorities could observe each individual's "total ability", it wouldn't change the results in any way. Total utility of the population would still be maximised by taxing "total ability" to eliminate all differences in after-tax income."

Actually, I'm not sure of that. Suppose that an individual had 1% "merit" and 99% "rent extraction skill". Then we'd still want to tax her realized income, as opposed to her ex-ante ability, in order to incent her to take more leisure at the margin. The key is that government (by assumption) can do costless transfers, but individuals cannot. And the leisure is preferable to the extra output she could actually generate.

[Nick Rowe]

anon: I think you are right. If we assume the tax authorities could observe both merit and rent extraction skills (rather than just the sum of the two, which is what I am implicitly assuming there), and could observe income too, they would put very high marginal tax rates on the incomes of those with high rent extraction skills and low merit.

[Frances Woolley]

Nick, marking (still) - will reply shortly.

[A.A.]

If current merit ≤ potential merit, and potential merit have to be realized in a process that already depends on your current merit, I guess mobility would matter, no?

[Philo]

A great post (one of many). "But I'm not sure why mobility matters." It doesn't. Richard Herrnstein long ago (1973, I believe) predicted that mobility would decrease as we approached nearer to meritocracy. Since liberals were used to favoring mobility as compared with the ancien regime--"La carrière ouverte aux talents," etc.--they received this prediction negatively; but they really had (and still have) no good reason for their reaction against a background of meritocracy rather than hereditary privilege--that is, of true as opposed to false aristocracy.

[primedprimate]

My guess is that mobility would matter if future 'rent-seeking ability' is a function of current after-tax income.

Or, in the inter-generational case, if the next generation's 'rent-seeking ability' is an increasing function of the current generation's after-tax income.

I think that is the implicit reason behind the fear of the wealthy 'rigging' the system, e.g. by lobbying to extend copyright/patent protection for socially sub-optimal durations.

[PeterN]

Merit is even more problematic than value, and economics never got anywhere with that. How would you compare the merit of Justin Bieber with that of Maria Callas or Hockney with Carl Barks?

We can measure incomes. We can use citation indices as a proxy for scientific importance, but we can't reward people according to their merit any more than we can reward them according to the color of their auras. Nor will appealing to value creation or marginal product help much, since these are to a large extent contextual.

You can, in fact, argue that mobility is important because we can't define merit. We have to create opportunities for it to emerge and recognize it after the fact (sometimes long after).

There's no reason to believe a meritocracy would be more immune to regulatory capture than any other system, and a captured meritocracy would be particularly unpleasant.

[Frances Woolley]

Nick: "But I'm still not sure why mobility matters."

I think mobility matters, first, because it tells us whether or not we're living in a meritocracy.

Suppose we don't know whether we're living in a meritocracy or not, but we have some idea about the correlation between parents and children's ability, and can observe the amount of mobility. People care about mobility because, by comparing the actual amount of mobility to what would be expected given the correlation, we can work out whether or not our world is meritocratic. Take, for example, acting/actors. The fact that so many actors have parents who were also in the business, e.g. Kate Hudson suggests that the acting profession is less than 100% meritocratic. (Though you might say "no, this simply proves acting skills are highly heritable").

Second, people care about mobility because they reject the basic assumption of the model, i.e. that merit is something innate, unalterable; something that people are born with. They prefer the self-help view of the world - that by eating quinoa, running, doing yoga, practicing mindfulness, organizing your email, or whatever - one can become a better person, a more meritorious person, and thus achieve a better life.

Mobility = hope.

By the way, Nick, these lines of yours are absolutely brilliant: Suppose individuals differ both by "merit" and by "rent extraction skill", where "rent extraction skill" means "ability to transfer income from others to themselves". So an individual's income depends on his "total ability", which is the sum of "merit" plus "rent extraction skill".

I don't know if anyone has ever formally modelled that, but someone should. It's lovely.

[Kevin Donoghue]

Nick, if you want to explore why mobility matters, aren't you going to have to turn to political theory? of course I'm not saying that you shouldn't, if it interests you.

[PeterN]

Am I interpreting you correctly in defining merit as earnings in an efficient market with perfect competition and equal access to resources?

That would make rent a bit of a catchall.

If pure meritocracy is open to objections similar of those to direct democracy, should there be constitutional meritocracy, and how would it work?

[primedprimate]

Frances, I couldn't agree more - Nick's succinct and clear distinction between merit and rent-extracting skill immediately clarified my own thinking right away. In my admittedly uninformed view, the former is only partly inheritable or obtained through 'appropriate' use of one's own previous income or one's parents' income. To a considerable degree therefore merit is random or the result of one's own hard work.

Rent-extracting ability, on the other hand, has a very low genetically inheritable component and is obtained almost entirely through 'inappropriate' use of one's own previous income or one's parents' income.

If we observe low mobility combined with other evidence of rent extracting, it would suggest that the optimal tax should be higher (or a reformation of institutions to minimize rent-extraction possibilities).

[Frances Woolley]

primedprimate: "Rent-extracting ability, on the other hand, has a very low genetically inheritable component and is obtained almost entirely through 'inappropriate' use of one's own previous income or one's parents' income"

I think for Nick's argument it doesn't matter whether things are genetic or environmental, as long as they are passed from parent to child, either by nature or nurture.

[Nick Rowe]

Frances: thank you very much for saying that.

I think Frances and primed are getting at the heart of the mobility issue. The question is whether merit is more or less heritable (whether via nature or nurture) than rent-extracting skill, because that determines whether high or low inter-generational mobility is an indicator of meritocracy or kleptocracy.

But I'm too far into the Irish tonight to remember what the sign is.

[Christiaan Hofman]

Mobility matters because what also matters, in fact what may matter most, (and you ignore completely) is opportunity. Unless, of course, you redefine "ability" and "merit" to include "opportunity". In which case you get what is often meant when people speak about "merit", and when you get a plutocracy (like the EU government structure) being presented as a "meritocracy".

[Nick Rowe]

Christiaan: suppose individuals differed also by "opportunity". And that "opportunity" is also heritable. I think we would need to distinguish between "opportunity to exercise merit", and "opportunity to exercise rent-extraction skills". Then I don't think it would make any difference whether we separated "ability" and "opportunity", or simply multiplied them together and called their product "ability".

[NoniMausa]

The fans of meritocracy neglect the crucial fact that human merit exists to a large degree only in concert with the actions of others. Teams, not individuals, make individual merit manifest, and in fact multiply it considerably.

Consider for instance someone with undeniable merit. Rudolf Nureyev was a genius. But would his genius have been realized in the absence of a tradition of ballet, ballet schools, other ballet dancers, and finally an audience primed to see and pay for his magnificent performances? Something would have been evident, I am sure, but not genius in full flower.

The same applies to ordinary people working in concert. 1,000 coffee shop employees make the chain function, and together create, say 1,000,000 merits in all. Their "merits" are multiplied by the context to 1000 per employee.

This is where the rent extractors come in. No coffee shop employee gains back the full fraction of merit their effort has generated.

"Scarcity" is only one element in economic discourse. More important, for thousands of years, is plenitude. Who gets the control and enjoyment of the excess wealth poured out from collective activity? That is the fundamental issue with almost all politics and war.

Noni

[Nick Rowe]

Noni: does the sum of the marginal products equal the total product? Under constant returns to scale, they do. Under perfect competition, there is locally constant returns to scale. Otherwise, they don't.

[Min]

"Suppose we could all agree on a definition of "merit" as "ability to contribute to the common good"."

Except, of course, that there is no such thing. Now, it may be possible to define it as the ability to contribute to the common good, on average, averaging across the populace and averaging across the person's abilities. However, such a thing would still be context dependent, and the context is always changing.

As for natural aristocracies, we already have one, between humans and other chimpanzees. Attempts to establish them for humans, such as in caste or racial hierarchies, have been successful for centuries, but all have ultimately failed. Mobility, per se, may not matter, but opportunity does. Relative lack of opportunity can lead to (unnatural) aristocracies, which can last a long time and pretend to be natural.

[Tom Brown]

"Attempts to establish them for humans, such as in caste or racial hierarchies, have been successful for centuries, but all have ultimately failed"

The guys Noah Smith is debating with recently sound like they'd like to bring them back (the "neoreactionaries"), and a bit more "enthic uniformity," and good traditionalist Austrian economics or mercantilism (Lol), among other things:

http://noahpinionblog.blogspot.com/2014/04/what-is-right-with-modernity.html

Here's a taste:

https://radishmag.wordpress.com/2013/05/24/heroes-of-the-dark-enlightenment/#kevin-macdonald

Magic the Gathering meets Cliven Bundy? What do you think?

[Matthew]

Excellent point. High income mobility--both intergenerational and intragenerational--is probably a sign of an inefficient labor market that has trouble matching skills to jobs. More mobility is not necessarily good, nor does it negate the need for redistribution.

[PeterN]

You may be able to define merit as "ability to contribute to the common good", but I don't see what good this does if there is no useful means to determine the "common good". The usual dodge in economics is to leave utility undefined, but say it has an ascertainable money exchange value through arbitrage.

However since this arbitrage works on the combined result of merit and rent extraction skills, the trick won't work to separate the two.

You have to take a position on what the common good is, and that's a difficult and dangerous task. The judgment of history on attempts to put such definitions in practice has been rather negative.

That's not to say the subject isn't important. Most of the disputes between the political right and left in the US come down to some combination of definition of merit and property rights to extract rent (intellectual property and other rights to exclude, inheritance, profits of the financial sector, secular Calvinism...).

[Frank Restly]

Nick,

"Standard Optimal Tax Theory says that if we lived in such a world we should put a tax on merit, and only on merit. And we should put the tax rate high enough to ensure that all individuals earn exactly the same after-tax income, regardless of merit."

Maybe the guys who wrote the "Standard Optimal Tax Theory" should look at both balance sheets and cash flow statements. Optimal tax theory should say that those with the highest merit should bear the greatest risk in realizing the gains on those merits. That can be achieved by EITHER raising tax rates (cash flow risk to those with merit) OR by selling risk assets (balance sheet risk to those with merit).

In the first case (cash flow management), currency becomes a risk asset in and of itself. In the second case (balance sheet management), currency is neutral.

[Randy]

Had a thought that some of this discussion relates to the Temporary Foreign Worker program here in Canada. But I a'int no economist and can barely understand what Nick writes most of the time. I'll try anyhow.

Assume that a Temporary Worker - TFW- has merit. The unscrupulous employer has the ability to manipulate that merit in the new host country, due in part to the vulnerability the TFW has with regard to status in Canada, and so the TFW has perhaps lower merit under this situation than citizens. Well lower merit in the sense that they can be perhaps paid less in the host country, but see themselves as able to accept that because in the long run they may believe that their merit will increase as compared to that status had they not shown this mobility.

The unscrupulous employer also has the ability to manage his/her "rent extraction skill", where "rent extraction skill" means "ability to transfer income from others to themselves". So an individual's income depends on his "total ability", which is the sum of "merit" plus the effect of the negative "rent extraction skill" that the unscrupulous employer applies.

In many parts of the world (including Canada unfortunately) TFW's choose to move to areas and jobs that they themselves recognize as having a potential to increase their merit relative to their home country. And perhaps hope that the negative rent extraction differential will eventually turn more in their favour.

[Avon Barksdale]

Mankiw got to the heart of this issue much more clearly in his paper, Defending the 1%.

Nick, I find your arguments troubling. Your are suggesting that utility maximization is really the only goal and that people are not entitled to the fruits of their labour. This is normative, of course, so there is no "theory" to which we can appeal to say that people are entitled to one thing or another.

But here's the problem with your ideas. Since we can't directly observe merit, we should use tags and any tag that connects to merit, the more the more efficient the targeting. Tall and more attractive people make more money than short unattractive people (yes, it is statistically significant). Utility maximization says we should have a height and prettiness tax - and we should impose it regardless of income. The transfer from people with high merit to low merit means that we must tax potential to avoid shirking. This is the only way to maximize utility. If you find this idea ugly, as I do, then perhaps you really don't think that utility maximization is all that matters.

It gets worse. To make these comparisons real, you need to compare marginal dollars across individuals. Joint utility is fun, but this is really not possible - the weak axiom works well on the individual, not so much between individuals (without heavy assumptions). Do people have a right to their own organs? Some people are born without working kidneys - should we "tax" super healthy people by making them give up a kidney?

Your logic on utility maximization gets even uglier. Suppose that the Confederacy had managed to "prove" that slavery of a minority of the population maximized utility because the free people attained such a high level of consumption. Should Lincoln have said, "Good point."?

[Avon Barksdale]

As for rent extracting, why do you think, as an economist, that the optimal solution is taxation? Would it not make more sense to remove the rent seeking possibility in the first place?

Rent seeking almost always comes from government redistributionalist programs where the benefits are narrowly targeted and the costs spread over a large population. (The redistribution can be in the form of a barrier to entry like our dairy farmers.) And you think that making the government LARGER by taxing rent seeking will improve the situation? Come on, that is not how lobbying works. The rent seekers will capture the rent tax soon enough.

[Nick Rowe]

Avon: utilitarianism does have some troubling implications. Your kidney example is a good one. One could think of others: "Sorry, but you would make her/him ecstatically happy if you married her/him, and absolutely miserable if you didn't, so you have to." Why should we have rights over anything? We would all be slaves to the common good.

[Frank Restly]

Avon,

You can have small government with high tax rates - the two are not mutually exclusive. A government can collect more revenue than it spends and either burn the rest or pay off existing debt.

[Avon Barksdale]

Frank,

Taxing is not book keeping. It's about moving resources from one place to another. "Burn the rest" means that the government destroys the creative output of society. With that line of thinking, we should rejoice in natural disasters, Nature just did the redistributing for us.

Sorry, but high taxes is big government. It is redistributing one way or another (some ways are more efficient than others, mind you).

[Avon Barksdale]

Nick,

These are more than just troubling implications. If you only take from a theory the implications you like and ignore the rest, then you are using your theory like a drunk uses a lightpost, for support, not illumination.

Read Mankiw's article, "Defending the one percent". It's worth it.

[Min]

"Rent extraction skill" is even more of a non-concept than "ability to contribute to the common good". How much skill does it take to sit on your ass?

Unfortunately I do not much time these days, so I can only touch on this. On a low level, poor impulse control, if you want to call that a skill, can facilitate rent extraction. At the same time, it may be the result of minimal brain damage. At a higher personal level, patience, if you want to call that a skill, can facilitate rent extraction. To crib an example from Gurdieff, the highwayman lying in wait all day with his rifle in the hot sun requires patience. But patience is also a skill that may be enlisted in service of the common good. It is not a rent extraction skill per se. On a higher social level, the organizational skill of being able to harness the menace of people with poor impulse control is a rent extraction skill. But at the same time, it may be put to productive use instead of rent extraction.

We are probably better off talking about rent extraction traits and deficits, such as anti-social personality traits, lack of empathy, willful ignorance, ruthlessness, sloth, greed, untruthfulness, etc.

[Avon Barksdale]

Noni and Nick,

It's not merit that is the issue here, but freedom. An island of one is not "free" in any real sense. Freedom only has a context within society. How much freedom we should have is normative.

I believe that we should have as much freedom as possible to realize our own endowments, whatever they may be, and enjoy the fruits of our own labour. We will require limits on our freedom to use the fruits of our own labour in the provision of purely public goods (defence, police, and some limited poverty reduction). Let Coase take care of externalities as much as possible through well defined property rights (which of course is a form of government intervention). Tax as efficiently as possible to provide public goods - consumption taxes only, and take Chamley Judd seriously - remove all taxes on capital income. (Nick, tax on capital income is in part justified by utility maximization because it provides a tag on high ability).

The more we depart from this, the more our future will involve low growth, fragile markets, and government failures.

[Frank Restly]

Avon,

"Burn the rest means that the government destroys the creative output of society."

Is government part of society in your world? Do you measure the creative output of society by how many much money it can print or borrow into existence?

"With that line of thinking, we should rejoice in natural disasters, Nature just did the redistributing for us."

You look at government as a adversary (not part of society), I do not.

[AlanDownunder]

There are a number of ways to make r <= g. First, rentier-unfriendly options like more anti-trust and less IP. Next, as a backstop, restoring redistribution toward prevailing C20 levels. Only after the first methods are employed (or defeated) should the backstop be addressed. It is meaningless to address the backstop in isolation.

[Nick Rowe]

Avon: Mankiw's article on taxing height was very good. I haven't read his 1%, but I think I will. I have mixed views on utilitarianism vs libertarianism. But regardless of my views, we ought to explore the implications of each. Here I am exploring the relation between meritocracy and utilitarianism (and Akerlovian(?) tagging).

"As for rent extracting, why do you think, as an economist, that the optimal solution is taxation? Would it not make more sense to remove the rent seeking possibility in the first place?"

That is certainly the first best solution. If we cannot observe rent-extraction, we may need a second-best solution.

Alan: "There are a number of ways to make r <= g." The relation between interest rates vs growth rates is a quite separate issue. And we do not want an economic in which r < g, because that would be an economy with dynamic inefficiency. That's the secular stagnation debate.

[Bob Smith]

Christiaan: "Mobility matters because what also matters, in fact what may matter most, (and you ignore completely) is opportunity. Unless, of course, you redefine "ability" and "merit" to include "opportunity". In which case you get what is often meant when people speak about "merit", and when you get a plutocracy (like the EU government structure) being presented as a "meritocracy"."

First, inherent in the concept of meritocracy is the notion of opportunity. Any system which does not provide opportunity for meritorious people to achieve their potential is, almost by definition, not a meritocracy.

But why does mobility indicate opportunity? If, say, baseball skills are largely inherited (as they no doubt largely are, whether by nurture or nature) the fact that Bobby Bond's son is (or was, before he started hitting the 'roids) a great baseball player, while my kids likely will never patrol left field for the Jays, is not a function of differing opportunities for them to develop their inherited baseball abilities, such as they are. The lack of inter-generational mobility may simply be an indicia that merit is strongly inherited.

Granted, mobility may be an indicia of opportunity when moving from a non-meritocracy to a meritocracy. The great surge in social mobility post-WW II US could reflect (and probably does) a significant expansion of opportunity to develop merit(think the GI-bill, improved education, de-segregation, whatever - Bobby Bond would not have been a great major league baseball player in 1940, not matter how gifted he was). But mobility is only an indicia of opportunity in that transitional state. Once you move past that state, the only mobility you would expect to see would arise from either (i) non-heritable merit or (ii) statistical variation in heritable merit (Barry Bond's younger brother, for example, also played professional ball for a decade, but was never able to crack the big leagues. I expect he had all the opportunities of his older brother).

[Declan]

Frances: "I don't know if anyone has ever formally modelled that, but someone should. It's lovely."

That's basically Piketty, Saez & Stantcheva isn't it?

[marris]

> That perfect meritocracy is not a good economic system. Not in my eyes, anyway. Because, for example, it would mean that an individual who was unlucky enough to be born with zero "merit" would get zero income.

Not good over what time horizon? What if the agents in that system will eventually figure out a way to engineer merit and increase everyone's merit level? If low tax rates give those with merit the resources they need to discover this, then the system with low taxes will hit that point first.

Also IIRC, there is no production incentive or trade in your example. Just a distribution process and agents with identical (?) marginal utility curves?

[whitfit]

Re Avon Barksdale (and I find it hard to address that pseudoname given the namesake character - who is your Stringer Bell? Marlo? Mcnulty?;), and Mankiw's "Defending the 1%".

It seems to me that this argument assumes that Steve Jobs, his most used example, creates the iPod, as a visionary entrepreneur. This may be true (ignoring any other contributions/developments in digital music players), but his income stream is then protected by the government with a grant of monopoly right over the "intellectual property".

I think this monopoly right (and other forms of legal protection for rights to income streams) is part of what drives inequality. Mankiw's anecdotes are compelling at a superficial level, but are hardly the full picture of how the very rich earn income.

[Nick Rowe]

marris: in my pure meritocracy example, we could have production and exchange, and each individual producing and earning income according to his fixed merit multiplied by hours worked. If you put a tax on income, there will be a disincentive to work, so everyone's income falls. But if you put a tax on merit, so you pay the same tax regardless of how many hours you work, there is no disincentive effect.

[casey]

Declan: "That's basically Piketty, Saez and Stantcheva isn't it?"

Yes, for a particular type of rent seeking (bargaining by high-level managers). Rothschild and Scheuer "Optimal taxation with rent seeking" is a more general and abstract version. http://www.stanford.edu/~scheuer/papers.html

[marris]

Is merit just another word for rate of production? If my merit is M and I work H hours, is my income M*H ?

Is everyone paying the same tax rate? Or is my tax rate a function of my M? Or am I paying a merit-based/lump poll tax (the total tax bill does not increase when H increases).

If my taxes are a rate, then I don't see why we couldn't increase utility at the margin by reducing my tax rate (so I work more hours and at least I am better off).

If my taxes are a lump amount, then I don't see how everyone will have the same after-tax income.

[Nick Rowe]

marris: "If my taxes are a lump amount, then I don't see how everyone will have the same after-tax income."

It's not the same lump amount for everyone. It's an individually-tailored lump amount. Yes, it does require the tax authorities have perfect information about each individual.