We are not I am: towards an economic paradigm shift?

Thank you to Daniel Fichmann for review and valuable suggestions.

The challenges that countries face are daunting; from climate change, loss of biodiversity, rising inequality, automation and AI, ageing of the population, purchasing power challenges (rising prices of food, energy, costs of living), enduring underdevelopment in large parts of the world, and pandemics. It is against this backdrop that the voices calling for innovative – and at times drastic (e.g., the degrowth literature) – approaches to tackle these challenges are getting louder and louder. And as economists we should ask ourselves, does standard economic theory fall short of providing answers and recommendations to resolve the systems-crisis we are facing? Perhaps re-examining the key founding principles of our current economic paradigm – neo-classical utilitarian economics – can shed some light on this discussion.

Neo-Classical Utilitarianism, which developed out of a desire to improve our understanding of how markets function, is based upon a number of key premises. I recommend the course of Yale Professor Ian Shapiro for an exciting discussion on how classical utilitarianism developed into neoclassical utilitarianism and economics: https://www.youtube.com/watch?v=8PAweBFTd2k. The first premise is that neo-classical utilitarianism imposes a structure on the preferences of each individual. It is assumed that individuals must have a preference relationship between any two sets of goods; either they weakly prefer A to B, or they weakly prefer B to A, or they are indifferent between A and B (completeness of preferences). Reflexivity and transitivity (if A is preferred to B, and B is preferred to C, then A is preferred to C) of preferences are two other key assumptions. The latter assumption implies that indifference curves cannot cross. Second, it is assumed that individuals have decreasing marginal utility, which means that each additional consumption item results in a smaller increase in utility. Third, levels of utility across individuals cannot be compared, i.e., interpersonal utility comparison is not possible. Utility is ordinal (in contrast to classical utilitarianism, which is cardinal) and the level of distances between indifference curves do not mean anything. In this setting, economists then look for the Pareto possibility frontier, which links all optimal levels of utility, where you cannot make any individual better off without making at least one other individual worse off.

Pareto efficiency is at the core of neo-classical analysis and the policy recommendations that it provides. Neo-classical utilitarianism takes individual rights and entitlements very seriously. Initial endowments and outcomes of market transactions do result in different Pareto efficient/ optimal outcomes. As interpersonal utility comparisons are not possible, both the outcome where resources are split equally between individuals and the outcome where the rich take everything and the poor starve, can be Pareto efficient outcomes (as are many other splits in resources as long as indifference curves are tangent). It is then the role of political distributive decision making to redistribute resources and move from an unequal Pareto efficient outcome to a Pareto efficient outcome that is considered to be fairer. ?

These findings are so strongly embedded within our economic thinking that we tend to ignore the paradigm’s simple underlying assumptions. For instance, individuals’ preferences are such that “more is always better”. In other words, there is nonsatiation. This raises the question whether neo-classical utilitarian economics is aligned with the fact that resources are finite? Indeed, our standard economic models don’t consider the consequences of natural resources being finite. That is to say that the standard monotonicity assumptions don’t adequately consider the negative repercussions of consuming all finite resources. From that perspective, an individual may rationally prefer a consumption bundle with less goods because the one with more goods leads to disutility in the long run. On this topic: see the interesting article by Anna Pettini and Laura Musikanski (2023): “Doomed to Consume? Non-satiation as a Flaw in the Current Economic Paradigm and What Communities Can Do About It” in the International Journal of Community Well-Being. Similarly, the recommendations from neo-classical models would change if we were to consider constraints in, for instance, the maximum increase in temperature that we are allowed to reach (possibly as part of an ethical self-imposed constraint to protect the life quality of future generations) in order to avoid climate change from happening.

Another significant shortcoming is that neo-classical utilitarianism focuses on an individual’s preferences in isolation and does not consider that individual utility cannot materialize without interacting with other individuals. The utility that I obtain from going to a restaurant depends on the interaction with other people during the meal. The utility I obtain from eating bread not only depends on the quality of the bread but also upon the baker who smiled when he sold the bread to me. The disutility I receive from someone else’s smoking is not addressed directly between individuals but through Pigouvian taxes paid to the government. But also: the utility that I can experience builds on the work and effort of many other individuals, both today and in the past, in ways that are not reflected within the price that I pay for a market transaction. We enjoy the benefits of the society we live in that the generations before us have built, and we not necessarily have to pay for that today when we make a market transaction. The strength of inclusive societies is that development is realized together. Our success is not only ours but depends on the effort and motivation of many other people. This type of discourse is perhaps only made when incumbents – for instance residents of a particular country – make a claim to respect their entitlement in contrast to newcomers who have not contributed to the (e.g., social protection) system they will benefit from. In modern societies, the importance of the “I” is over-emphasized in that the contribution of the “we” is not valued sufficiently. On the topic of the limits of meritocracy – with emphasis on “limits” as meritocracy is a key driver of societal success and prosperity – there is an excellent book by Professor Michael Sandel: “Tyranny of Merit: What’s Become of the Common Good?”. It is a great read on the limits of meritocracy.

As a result, we should ask ourselves whether the modern economic questions that we face require a departure from the neo-classical utilitarian paradigm towards an economic paradigm that puts individual inter-connectivity (from “I” to “we”) more at the centre. Finding solutions for the domestic challenges that countries are facing will require a “we-are-all-in-it-together” economic and societal approach. Increased cross-border mobility of individuals may bring about additional challenges when citizens decide to, for example, step out of their society and move to another country after having absorbed all the benefits of their home country. And “we” goes beyond a focus on people who are alive today, but also takes into account the rights of future generations. (From an inter-generational equity perspective, John Rawls’s “original position” should be applied in a dynamic setting). Thus, finding solutions for the global challenges that countries are facing will require global cooperation, beyond the (short-term) individual country interests. International dialogue, cooperation and respect have become more important than ever, including in the area of taxation.

One possible avenue would be to integrate a “rights-based approach” within our dominant economic paradigm, possibly to integrate it within the neo-classical paradigm. See the work of Amartya Sen who has made proposals for incorporating individual entitlements, capabilities, freedoms and rights into the conceptual foundations and technical tools of economics and social choice, thereby recognizing that freedom and rights should be brought directly into social-economic evaluation beyond the mere calculation of utility.

The human rights-based approach has been an integral part of the economic development literature, and it is based on the UN framework for human rights but has not made its way into the neo-classical economic paradigm. In the tax literature, the “needs-based” approach has been used to advocate for exempting women’s sanitary products from VAT. There are many important human rights (reflected also in the SDGs). The right to work in just and favourable conditions, the right to adequate housing, the right to social security, the right to education and the enjoyment of benefits of cultural freedom and?scientific progress, and government accountability and transparency. The list of rights and entitlements is long. Having a human rights-based approach means making contradictions visible by analysing inequalities and by identifying who has power over whom in a particular context, to understand how and when people’s freedom to decide over their lives becomes limited.

Could we make a claim that, when market outcomes are such that they violate the rights of individuals, that these rights overrule the call for Pareto-efficiency? From a welfare perspective, could a rights-based approach limit the number of Pareto-efficient outcomes to consider (e.g., it would exclude the Pareto efficient outcome where the rich take a lot and the poor face poor levels of well-being), and possibly to include in the list of optimal outcomes those who are Pareto inferior but do respect human rights of the entire population? This is a question that the Social Choice literature covers (but, I do admit, its findings have not been incorporated into standard tax policy analysis).

Turning back to tax: it remains an open question to which extent basic rights need to be addressed through the tax system, or whether the main role of the tax system remains to raise revenues that are used to ensure that the basic rights of individuals are met, for instance through transfers or the provision of public education and social housing. The answer will also depend on the extent to which countries have a well-developed transfer system in place that can be used to support the poor and their basic needs. At the same time, asymmetric information and power imbalances tend to result in economic rents, which could be taxed at higher rates without creating distortions while strengthening the fairness of the tax system.