Ideology and Economic Policy

Draft

Economists are very good at advising on the best means of achieving given policy objectives – so long as the social objectives are clearly and fully laid out for them by the politicians. But most of the time the social goals are not specifically defined and so economists inject their own value judgments into the public policy debate.

This draft paper spells out some of the often-hidden trade-offs involved and the policy options for resolving them. It is designed to elicit discussion.

Ideology and Economic Policy: Part One

Suppose the Government invites the country’s top economists from a wide range of the political spectrum – to provide advice on a proposed structural reform. After studying the details, they unanimously agree that over time the reform will improve national productivity and employment and that the winners will considerably outnumber the losers. But their research also tells them that the economic gains will be slow in coming and that in the interim (a) the adjustment costs will be quite severe (e.g. the reform will displace many workers who are hard to re-employ, causing a sustained waste of productive resources as well as human costs); and (b) relatively poor households (e.g. low-paid workers or struggling small businesses) will be the main losers.

In these circumstances, and without precise guidance from governments, the panel of economists will find it impossible to agree on the “best’ policy course to follow. Instead, it is likely to present the Government with a list of policy options each with different economic and income distribution outcomes and equity/efficiency trade-offs and then leave it to the elected politicians to select from the list.

Part 1 of this paper looks at four policy options which involve proceeding with the postulated reform without any redistribution to losers. Part 2 discusses option 5 – proceeding with the reform but with compensation for some or all losers. Part 3 discusses the possibility of going down an alternative reform route – one which offers equally good GDP outcomes but with more benign social effects. The paper then highlights the value judgments involved in choosing between the six options.

Part 1: Four “no redistribution” options

Option 1: Efficiency-first

The first option might be for the Government to proceed with the reform without worrying at all about winners and losers.

This option effectively relies on the so-called “potential Pareto efficiency test” . This assumes that if the winners from a reform are capable of compensating the losers and still remain better off than before (i.e. the winners ‘outweigh’ the losers), then the community must be better off even if there is no actual compensation. The reform postulated in the introduction is seen to meet this test: it boosts national productivity and employment, so (with constant marginal utility across individuals) it must increase aggregate wellbeing and that is sufficient reason for the government to implement the reform , while letting the existing welfare safety net take care of distribution effects and adjustment pain.

The Pareto approach can be viewed as the baseline “efficiency first” option against which other options need to be assessed. It side-steps the issue of transitional adjustment costs by looking only at two aggregate equilibriums the starting point and the point when the reforms have had their full effect. And it side-steps the distribution issue by assuming that a dollar’s worth of gain to one individual has the same utility weight as a dollar’s worth of loss to another.

Apart from its simplicity, the Pareto approach to policy reform is built on three logically appealing premises:
“¢ Australia’s welfare safety net is very effective in targeting people in need, so it can be left to cope with any distribution effects;
“¢ adjustment costs are largely a symptom of labour market failure, so governments should be addressing the root cause over-regulation of wages and labour markets rather than reacting to the symptoms; and
“¢ all the alternative policy options are worst in particular, any attempt to actually compensate the losers would run into a number of conceptual and practical problems (moral hazard, risk of arbitrariness and political opportunism in implementation) and require higher taxes, with associated economic costs.

Many economists have legitimate concerns about the Pareto approach. These are partly based on fairness (why ask the victims of policy reform to shoulder the whole cost when everyone else benefits?), partly on political legitimacy (what will it do to social cohesion and community attitudes to reform in the future?) and partly on economic considerations (is it really the best way of maximising utility?). The concerns will become clearer when the alternative options are considered.

Option 2: Set a higher return hurdle

A second policy option would be for the Government, when evaluating the reform, to demand a higher economic return, so as to make up for the regressive distribution effects and transitional social and economic disruption. If, for example, the normal viability test for a win/win (distribution-neutral) reform is to require an increase in GDP per head of at least 0.5% (in discounted present value terms), the hurdle rate could be set at say 1.5%. If the proposed reform meets the higher hurdle rate, the Government should proceed without compensation.

This approach also gives efficiency high priority and leaves some losers paying the bill for reform but it redefines the efficiency/equity trade-off, assigning losers more “weight” than winners. By setting itself a higher target return, this option effectively assumes that the losers (in this case the poor) get more satisfaction from each additional dollar consumed and suffer more pain from each dollar foregone than the winners (the well-off), so. The validity of this assumption is hard to ‘prove’ but it is consistent with casual observation and has backing from some happiness surveys . Most Australians, if asked, would probably agree that an economic reform which is socially disruptive should be treated with more caution than one that is not disruptive.

Choosing the appropriate hurdle rate (including the extra “loading”) would inevitably involve ethical judgments and an element of arbitrariness. But no policy proposal with winners and losers can be evaluated without falling back on interpersonal comparisons of utility. For example, the baseline (Pareto) approach, by focusing on efficiency alone and assigning the same utility weighting to everyone (rich and poor), is making a value judgment which is no less arbitrary.

That said, it would be inappropriate for an economist to pronounce definitively on the precise “loading” that would be needed to justify the reform. The decision should be left to the Government’s “political judgment”.

Option 3: Manage the reform program so that the distribution effects tend to cancel each other out

Another approach could be to proceed with the reform but at the same time try to introduce ‘complementary’ reforms which have offsetting effects on distribution and transitional disruption. Under this approach often called ‘log rolling’ – the losers from one reform are the winners from another. One obvious example would be where tariffs are adjusted in a coordinated fashion, so industries facing reductions in their own protection benefit indirectly from reductions in prices of their inputs.

Log rolling was common under the Hawke and Keating Governments in the 80’s and 90’s. They wanted to reduce industry protection, open up the economy to competition, stop trade unions from abusing their market power, contain wage inflation and free up a little the workplace. They knew however that on their own, these measures would have painful effects on some vulnerable workers. So, apart from expanding social security and the so-called social wage, the Government put in place industry support plans to safeguard some key threatened industries like steel, motor vehicles and heavy engineering, increased price surveillance and improved retraining facilities . As events turned out over the period between the mid 80’s and early 90’s, lower-paid workers came off second best. But the intention was sound and the plan helped to deter industrial unrest and allowed early implementation of the reforms.

The option of log rolling is not one that is easy to implement nowadays because there is only limited scope for grouping together related but complementary reforms. And the age of corporatism consensus policy-making – is dead. But in the right circumstances, it remains a viable option. For example, when the Howard Government introduced its recent workplace reforms, it could have simultaneously made a much bigger investment in education and training for disadvantaged workers.

Option 4: Delay or stagger the reform

If the social effects are considered too disruptive and the Government feels it is necessary to mitigate these effects, one option would be for the Government to phase in the reform very gradually or defer its starting date. This option has been used in the past for example, with National Competition Policy and the lowering of tariffs on textiles and clothing.

Staggering or delaying a soundly-based economic reform involves a conscious decision to forego immediate efficiency gains e.g. denying consumers early price reductions, in order to reduce the social and economic disruption. But it provides a breathing space and allows a smoother transition. It can make economic sense too if it makes the electorate more receptive to future reform.

Part 2 will follow.