Monday, August 03, 2009

Economic Incentives & the Olympics

In all the current talk about possible higher tax rates on the rich, much is made in some circles about how this "penalizes" the rich. On the face of it, the notion that a person who only makes $5 million in take home pay instead of $6 million is somehow a victim is absurd, but let's consider the argument for a moment.

Those concerned about taxation rates being too high on the rich do have one valid point that if tax rates go too high, people who might otherwise have done something economically productive might choose not to take the risk of losing money since the reward will be too low after taxes are taken into consideration. This is certainly a legitimate perspective when the top marginal tax rate is 94%, as it was in the 1940's. However, when the top marginal tax rate is in the 30s as it is now (actually much lower when AMT considerations and lower capital gains rates are considered), this argument is not nearly so powerful...especially considering virtually every other developed nation has higher tax rates than the US and still manages to turn out plenty of highly successful businesses that compete just fine with American ones on the global stage.

But there are some who seem to feel that ANY progressively increasing tax (or at least any tax increase on high earners) amounts to penalizing the rich and perhaps outright socialism. One interesting analogy I've heard is that a progressive income tax is like asking Michael Phelps to share his gold medals with all the other swimmers in the Olympics because it's "unfair" that one person should have so much more than others. This argument is often portrayed as a clear example of why capitalism is vastly superior to socialism, because only the possibility of receiving the one gold medal will bring out people's best performance.

However, on closer inspection, the Olympics actually serves as a very useful model for how a society might build an effective socialist society. The reason is this: every athlete at the Olympics receives excellent food and accomodations, among other things. Of course, the Olympics committee could choose to provide nothing for any athlete except the medalists. This, actually, would be a far better model for unfettered capitalism. In this warped Olympics, the medals would be much larger (hence, more valuable) and perhaps a larger proportion of athletes might receive them since, after all, the Olympic committee wouldn't have to worry about wasting money on things like food & lodging. However, the athletes would then have to barter their medals in exchange for food & lodging and any other needs and wants they have while at the Olympics ("Oh, you want to make an international call home to your family? Well that's gonna cost you half of that bronze medal.") Yes, some athletes would be better of in this Olympics--Michael Phelps would probably own most of China by now--but the vast majority would be far worse off.

A fundamental problem in capitalism is that people are incentivized out of the same "budget" as people are fed and provided with basic needs. It's all done with dollars and there are a finite (though generally growing) number of dollars in circulation at any time. This isn't necessarily a problem if the number of dollars is growing faster than the rewards for those at the top, and this is generally the case for a nation that is still developing its economy with reasonably sound policies. But when the rewards for those at the top are growing faster than the number of dollars in circulation (which can be roughly thought of as the overall size of the economy), then we do have a case where the rich are growing richer at the expense of the poor. And once an economy reaches a certain point of development, it becomes difficult to find to find ways to continue to grow the economy at a fast enough pace to keep up with those at the top.

It seems to me that the US has been struggling with this fundamental problem since the 1970s. Numerous studies have pointed to wage stagnation for most workers since that time. And while we've come up with numerous tricks to increase overall wealth (immensely) for those at the top of the economic heap, the rest of the population has been forced to try and keep up through longer working hours, increased leveraging, and asset bubble after asset bubble. As these bubbles pop and the country deleverages, however, it's becoming increasingly clear that the net economic effect of the last 3-4 decades has been a massive increase wealth at the top and little gain, at best, to possibly a sizable loss in wealth at the bottom.

The Olympics does not have to worry about athletes going hungry or homeless because of the increasing size of medals for the winners. That's because the Olympics creates separate budgets to deal with each of these needs, and clearly making sure all athletes are fed and sheltered is a paramount need, taking precedence over the size of medals. Yet, even though the medals aren't nearly as large as they could be if the Olympic cut back on the budget for taking care of all athletes, Olympic athletes still put enormous amounts of dedication into delivering the maximum possible performance they can deliver. The actual market value of the medals that athletes receive generally is quite small relative to the amount of time and work that goes in to earning one (and for those who argue that medalists often receive very rich endorsement deals, consider that many Olympic medalists come from countries where this is not possible and the only tangible reward will probably be the medal).

As a believer in a hybrid economy--one in which everybody's basic needs are met, but market forces and incentives still play a significant role in the overall economy--I think there's a valuable lesson in the Olympics. It is absolutely possible to meet everybody's needs in a community while still providing adequate incentive to spur significant achievement.


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