Philosophy of Economics Part I: Normative Economics

Presentation to the Melbourne Philosophy Forum, April, 2009 (I think)


A philosophy of economics approaches the subject at a meta-level, integrating the discipline with being in general (ontology), the way that we know things (epistemology), and rational procedures (logic).

Normative economics is the study of economics in a way that includes value judgments. It includes:

  • political economy and class analysis; who owns what and why? what do they get from this ownership?
  • public financing and expenditure; where do governments get their money from? how do they spend it? who decides this?

  • power and responsibility; who has economic power and who doesn't? how does actual economic behaviour alter economic models?

Most studies in economics start with positive economics (the study of economics as a set of facts); here we shall start with normative economics (the study of economics as a set of values). Because economics is a social science values ought to have priority as human action is motivated from values; normative values therefore influence positive facts.

Political Economy: An Ontological Question

The notion of factors of production and economic classes is poorly understood today. It is a field of inquiry largely ignored since the development neoclassical economics in the latter part of the 19th century. The neoclassical economists contributed to the conflation by converting land into capital, essentially an accountant's recording rather than an economist's recording. But also some rather dogmatic and vulgar Marxists could only see the existence of the worker and capitalist classes. Finally, the conflation was partially due to the influence of American functional sociology in the 20th century which investigated relationships and activity on the basis of income, rather than ownership of the means of production.

In contrast all classical economists, including the physciocrats, Adam Smith, David Ricardo, Karl Marx, Léon Walras and John Stuart Mill, recognised the distinction between the factors of production (land, labour and capital), the respective sources of income derived from each of these factors (rent, wages and interest) and the respective economic classes (landlord, worker and capitalist); it is noted of course that an individual can be a member of multiple classes simultaneously and proportional to the way their income is derived. In addition to this it is useful to distinguish between public and private ownership of the factors of production, or socialism and capitalism, and between planned or market mechanisms for exchange.

Economic Class Ontological Source of Income Receipt of Income
Landlord Land Rent
Capitalist Capital Interest
Worker Labour Wages

These terms are quite specific and carefully defined in economics. "Land" does not refer to just the ground under one's fee; it also includes the oceans, the atmosphere, the electro-magnetic spectrum. It also means, natural resources in their unimproved state. A lump of coal due for the furnance is only partially "economic land"; it had to found, dug out of the ground and transported. "Labour" does not just refer to physical activity, but also all mental activity including entrepreneurship; it is all of human activity. Finally "Capital" refer to all products that result from economic activity, both simple and complex, including both commodities and the tools of production. Money itself is not capital, but rather a representation of the value of capital.

Public Finance and Private Activity: Epistemological Categories

Socialism is the public ownership of a income, enterprise, activity or factor of production; capitalism is the private ownership of the same. All economies have a mixture of both. In most economies the public, or socialist, sector receives its income from taxation of private sector activities, although in some cases revenue can be raised through investment interest and fee-for-service. Sometimes there are advocates for simply increasing the money supply (thus devaluing existing currency). These have their own economic effects.

If any good or service is taxed, in any way whatsoever, it acts as a disincentive to produce that good or service. Whether the tax is imposed on income, payroll, sales or whatever the effect is the same. In a normal economic situation (albeit with a perfect competition model assumed - other markets will still have the same effect from taxation) the market price of the good will the intersection between the consumer's desire to purchase a good at the cheapest price and the supplier's desire to sell the good at the highest price.

However when a good is taxed, the market price of the good or service increases. With the artificial increase in price, less of the good or service is supplied and less is demanded. This provides both the taxation revenue, but also results in a greater overall loss to the economy through reduced trades. This is in addition to any administrative cost that the taxation regime may incur.

The public sector should make up for this loss in trades through expenditure in public goods that produce positive externalities (those goods or services where there is additional benefit to 'neighbours' as well as the consumer), such as network infrastructure, home ownership, health and education standards, information provision etc, and reducing negative externalties (those goods or services where there is additional cost to 'neighbours' as well as the consumer), such as various forms of pollution, system risks (e.g., collapse of the bankings sector), critical depletion of resources ("tragedy of the commons"). In reality however, public monies are subject to political expenditure which is highly dependent of the system in place e.g., an alliance of landlords and some of the capitalist class (e.g., the oil industry) to promote invasions of oil-rich countries.

The public sector could receive its finances entirely from economic land. Nearly every economist in the world, whether liberal, conservative or radical, agrees that public finances should be derived from resource rents in preference to goods and services. The radical capitalist Milton Friedman argues that "In my opinion the least bad tax is the property tax on the unimproved value of land", whereas the neo-Keynesian Paul Sameulson argues that "pure ground rent is in the nature of a 'surplus,' which can be taxed heavily without distorting production incentives or reducing efficiency". The conservative Robert Solow has claimed "For efficiency, for adequate revenue, and for justice, every user of land should be required to make an annual payment to the local government equal to the current rental value of the land he or she prevents others from using", whereas the radical antifascist Jewish refugee and economist Franco Modigliani stated "It is important that the rent of land be retained as a source of government revenue". Finally, the maverick socialist William Vickery claims "While the governments of developed nations with market economies collect some of the rent of land, they do not collect nearly as much as they could, and they therefore make unnecessarily great use of taxes that impede their economies - taxes on such things as incomes, sales, and the value of capital goods." Herbert Simon (a Unitarian-Universalist) said "Assuming that a tax increase is necessary, it is clearly preferable to impose the additional cost on land by increasing the land tax, rather than to increase the wage tax."

Inelastic supply curve taxation; note that the tax falls entirely on the "supplier" (i.e., owner) of the good and that there is no deadweight loss. Image from Explodicle on Wikipedia.

Everyone of the people just quoted are winners of the Nobel Prize in Economics. The reason the socialisation of economic rents and the abolition of the landlord class works is twofold. The first is from the reasons stated above; every taxation on a good or service that is produced and variable in supply reduces the incentive to provide such a good in proportion to the degree of taxation. The second reason is the complement; it reduces the incentive to invest in economic land with a monopolostic orientation, rather than for use. Because economic land is in relatively fixed supply acquiring it reduces the amount for others; thus forcing the price upwards. It also gains value with others engage in economic activity (such as the building of infrastructure) nearby. The following is from Max Hirsch from around the time of Australian Federation;

In the heart of the city of Melbourne is a block of land, which, except that the trees which grew upon it have been cut down, is in exactly the same state as when the blacks roamed over the site of the future city. No labour has ever been expanded on it; no wealth has ever been created there. Fifty years ago the present owner of the land paid £29 for it to the government; lately he was offered and refused £30,000 for the same land.... This sum of £30,000 is now considered to be part of the wealth of the country. As a matter of fact, it is neither wealth nor capital, but the capitalised value of the power to lew tribute from labour and capital without rendering or having rendered any service in return.

One can see this problem as readily in developing and developed economies.

Advantages of Competition and Equality: The Logic of Behaviour

A common problem in welfare economics is a moral hazard called the "Samaritan's Dilemma", whereby actions to help the poor (and thus provide a positive externality through social integration) result in a non-productive dependency, where recipients "work the system" to take advantage of the provision of goods and services that are supposed to the raise them out of impoverishment.

Another variation on a similar theme can be found in Arthur Okun's classic text: "Equality and Efficiency: The Big Tradeoff" (1975) which questioned, to what extent should government pursue economic equality? Okun argued that often pursuing equality can lead to disproportionate costs in efficiency, through the reduction of incentive structures (e.g., taxes on capital and labour, goods and services) and higher administrative costs.

In contrast a very recent book, "The Spirit Level" (2009) written by two epidemologists, Richard Wilkinson and Kate Pickett, uses a wealth of data from the World Bank, the United Nations etc to show that that levels of various social ills - e.g., violent crime, mental illness, drug addiction, illiteracy, obesity etc. are almost always higher in more unequal societies and that such levels have deleterious effects on the economy as a whole as well as the individuals who suffer from them. Thus a high Gini co-efficient (a statistical measure of inequality) in wealth and income itself is a negative externality.

In part this confirms the results from The Economist's Quality of Life index published in 2005. As one would obviously expect there was an positive correlation between GDP per capita and quality of life. However there were significant disparities between the two depending on how that wealth was used.

The nations were the Quality of Life was significantly higher (10 ranks or more) than their GDP per capita in the larger economies included places like Sweden (+14), Italy (+15), Spain (+14) and New Zealand (+10). Places where the QoL index was significantly lower that their GDP per capita included the United States (-11), the United Kingdom (-16), Saudi Arabia (-23), and almost at the bottom of the list (despite being a mid-range economy according to GDP per capita), was Russia (-50).

The best places to live, overall, were Ireland, Switzerland, Norway, Luxembourg, Sweden, Australia, Iceland, Italy, Denmark and Spain, Singapore and Finland. If Norway, Sweden, Iceland and Finland seem to be uncomfortable places because of the climate keep in mind that the survey even included a small weighted value for how hospitible the climate was!

Simply put, having income is not enough. How a nation spends it is critically important to the quality of life of its citizens.