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Economics VATSANALYSIS

Do we perform better when we are rewarded?

You are given a wax-candle, a box of matches and a box of pins. These are placed on a table next to a wall. Without using anything else, you have to fix the candle on the wall and light it in a way that no wax drips down the table. How would you solve this problem?

The above is called the Candle Problem. Two groups were asked to solve it. One of the groups was promised some money if they finished the task in a given time. The other group could take as long as they wanted; they weren’t getting any money whether they solved it or not.

Which group do you think finished the task faster?

The group that was not given any monetary incentive took lesser time to solve! I know, I know.

You can watch the above video to understand what explains this non-intuitive result but the short answer is – when a task requires creative thinking, we perform worse when working for a reward (think performance bonus). A reward leads to a bias called “functional fixedness” that makes us slower at coming up with creative solutions.

The speaker in the above video goes on to add that when the task is a straightforward one (simple set of rules + clear destination), then monetary incentive does lead to better performance.

Let me now flip the original question – do we become more productive when our earnings are taxed less?

For example, would the top 1% rich in the world be any less productive / innovative if we increased their taxes?

There is this ‘intuitive’ prevalent belief that low tax rates are necessary at the top, because the likes of Ambani need to be given the incentive to work hard, be creative, and launch the next Jio to change the game for everyone.

But the sad truth is that there is no evidence this actually happens, as Abhijit Banerjee and Esther Duflo investigate and observe in their book – Good Economics for Hard Times.

There is absolutely no relationship between the depth of the cut between the 1960s and 2000s in a country and the change in growth rate in that country during the same period.

Abhijit V. Banerjee & Esther Duflo – Good Economics for Hard Times

One of the possible reasons why the rich continue making more money even when you tax them is that a rich person who makes 100X more than a poor person is not really working 100X times harder or innovating 100X times more.

Click on the image to read the full article (could be behind paywall)

Since the major chunk of all the money that the rich person makes, is simply not coming from his / her efficiency (or productivity), even if they feel like not working as hard because of higher tax (hypothetical scenario), it does not cause any significant dent in their overall earnings.

The speaker in the below TED talk also suggests the same (just watch the first three minutes if you are pressed for time).

By the way, if a person A who makes 100X more than a person B, is not not really creating 100X value compared to B (or anywhere even close to that), what explains the income difference? Rent seeking is one of the answers.

‘To put it baldly,’ says the economist Joseph Stiglitz, ‘there are two ways to become wealthy: to create wealth or to take wealth away from others. The former adds to society. The latter typically subtracts from it, for in the process of taking it away, wealth gets destroyed.’ Rent seeking is nothing more than a polite and rather neutral-sounding way of referring to what I call ‘accumulation by dispossession’.

[…]

As Stiglitz remarks, ‘Some of the most important innovations in business in the last three decades have centered not on making the economy more efficient but on how better to ensure monopoly power or how better to circumvent government regulations intended to align social returns and private rewards.

Harvey, David – Seventeen Contradictions and the End of Capitalism

If you are someone who knows more about Economics than me and find some of my arguments faulty, do let me know. Over the past few months I have been trying to understand how much of the outrage against the rich getting richer, is justified. Growing inequality is bad, but do we blame Ambani for that or the government? There is a lot that I am still reading and my perspective at this point in time is definitive by no means. Also, I don’t want to imply that all that Ambani does is make money by rent-seeking. I am sure he is also generating real value. But how much? Does the increase in the amount of wealth of the top 1% (or the top 0.1% or the top ten) truly reflect the increase in value that they generate? So far, all that I have read tells me – clearly not.

Let me end this post with a profound statement Nick Hanauer makes in the above embedded TED video – “people are not paid what they are worth; they are paid what they have the power to negotiate”.

Categories
Economics VATSANALYSIS

Does democracy make it difficult to introduce useful reforms?

NITI Ayog’s CEO Amitabh Kant was all over the news recently for the one line that he said in a video interview (that you can still see on Youtube) – “we are too much of a democracy”.

The context: relationship between dealing with democratic decision-making and ability to usher in “hard reforms”. Kant seemed to suggest an inverse correlation – the more democracy there is, the harder it is to introduce reforms. But is it really true?

Last week, I was having a conversation with a startup founder who said something similar. I don’t remember the exact words, but let me share an extract from a World Bank paper that sums up this intuitive logic that many seem to hold.

Reforms are often unpopular because they tend to reduce living standards in the short run. Even reforms that increase overall prosperity (measured in GDP growth) may be unpopular if compensation schemes for the losers are not credible; and if benefits are far in the future and costs more immediate.

These problems are compounded by the fact that democracies offer more channels of protest and influence on policy-making to subordinate groups than authoritarian regimes. Democratic rule may fragment decision-making authority among branches of government, allowing opponents of reform to interfere more easily with program design.

In contrast, authoritarian governments have less need to respond to either popular opinion or vested interests and hence can more readily base their decision on criteria of economic rationality. They are better able to make long-run plans than are democratic governments tied to electoral cycles; and have greater centralization of power that facilitates the implementation of reforms.

World Bank Policy Research Working Paper, 2016

Now comes the twist – this same World Bank paper goes ahead and analyzes 140+ countries to see if data supports this hypothesis and the answer is – NO! There is in fact robust evidence for a positive link between democracy and growth-enhancing reforms. A move from below-average to above-average level of democracy for example, increases the probability of reform by 20% +

Source: World Bank

Another paper from 2010 had a similar conclusion. The authors plotted a) the global democratic index from 1960 to 2004 and b) reform index for the same period (feel free to read up on how these indices were calculated in the linked paper). Almost always, the two graphs matched – implying that the more democratic the world gets, more reforms happen.

Now this is just a correlation, so causation may be debated but what the above charts show, is still significant – a belief that ‘hard reforms’ happen better in non-democratic setups is not backed by any statistical evidence.

So now we know the link between democracy and reforms. What about growth? Do democratic countries grow faster? Data says – yes. Below is a graph from a study by MIT, published last year.

So even when data doesn’t justify less democracy for the sake of better reforms / growth, why do some folks believe so? Amitabh Kant may have an agenda but what about the startup founder who is extremely rational and wouldn’t last in the industry if he didn’t rely on hard data to make business decisions (his company has been doing good)?

In the same conversation that I mentioned earlier, he narrated to me the story of chewing-gum ban in Singapore that was brought in at a time when miscreants were using the gum to block metro doors. He remarked how radical changes like the chewing-gum ban are so difficult to introduce in a democracy like India. But what he was telling me was a story – one that fed his intuitive idea of how the world probably works (by focusing on exceptions than what usually happens).

There is a deep gap between our thinking about statistics and our thinking about individual cases.

[…]

…even compelling causal statistics will not change long-held beliefs rooted in personal experience.

Daniel Kahneman – Thinking, Fast & Slow

The “China growth story” is another example that makes it easy for many to resist looking at the aggregate global evidence. It is easier to give in to the urge to conclude that democracy in general comes in the way of reforms / growth without asking – is China an exception or a rule? Has China grown in spite of democracy or because of its absence? Most of us never ask these questions; we simply form our opinions and beliefs based on stories that sound reasonable and once the opinion is formed, data becomes irrelevant – stories are all that remain.