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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”.

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