The Philosophers Behind Our Economic Policy Fights

As Republicans and Democrats continue to speak past each other in fight after fight over economic policy, a little philosophy lesson will help everyone understand the basis for all the disagreements. The reason why compromise has been so hard to find is that the two sides do not agree on the definitions of such seemingly simple concepts as what it means for the country to be better off, what would constitute an improvement in the general welfare, or even what is fair.

To understand this basic difficulty in defining a common language of economic policy, you need to understand three important philosophers who each advanced a mechanism for evaluating if a policy improved the social welfare of a community or nation. These are certainly not the only three philosophers to discuss such notions, but these three are the ones economists are most likely to know and apply to economic policy analysis, and they also serve nicely to illustrate why our politicians favor or oppose policies at the heart of our current political-economic debates.

First is Vilfredo Pareto, an Italy philosopher and economist in the late 1800s and early 1900s. Pareto said a policy improves social welfare only if every person either is made better off or left unaffected by the policy. That means that if even a single person is made worse off by the policy, it is not what economists call Pareto-improving. Basically, this means situations where people are voluntarily participating in transactions meet Pareto's condition because a person wouldn't voluntarily make a deal that makes him worse off.

Pareto is the philosopher for free-market politicians and economists. The free market automatically produces outcomes that are Pareto-improving because all the action is voluntary. If Pareto is the philosopher guiding your policy positions, then you will oppose income-redistribution schemes such as tax increases to fund social programs and most mandatory programs such as Obamacare because a mandate would be unnecessary unless some people did not want to participate. A consumption tax should be your tax of choice if you follow Pareto, since it is only levied on voluntary transactions and the amount is clear to all parties (unlike income taxes). Government action should only be taken to provide true public goods like national defense or in the presence of clear market failure, opening the way for environmental regulations, for example.

The second philosopher to study is Nicholas Kaldor, a Hungarian economist who became British and produced his key works in the mid 1900s. Although Kaldor was not a trained philosopher, he wrote extensively on social welfare issues. Kaldor claimed a policy improved social welfare if those who gained were made enough better off that they could compensate the people harmed due to the policy change. In simple terms, policies that create winners and losers can be Kaldor-improving as long as winners win more than losers lose; that is, the aggregate gains must be larger than the aggregate losses. Kaldor did not actually require the compensation to occur, just that it was possible.

When people start talking about benefit-cost analysis, think Kaldor, because benefit-cost analysis sums up the gains and losses from a policy change and compares that aggregate net benefit to the cost of implementing the new policy. That is Kaldor's test in action.

Kaldor looms large in international trade policy, because increasing free trade produces both winners and losers, but the gains exceed the losses. Jobs are lost in sectors competing with less expensive imports while jobs are created in exporting industries and industries that gain business when we spend the money we saved thanks to the new imports.

Politicians following Kaldor would favor free trade, but those insisting on the stricter Pareto condition would oppose free trade pacts. A similar divide would occur on large-scale public projects (like a dam or interstate highway) that require some people or businesses to be involuntarily relocated. All Pareto-improving policies are also Kaldor-improving, so a follower of Kaldor can support all the things that fans of Pareto would support. Because Kaldor's condition for a policy being welfare-improving is weaker than Pareto's, more policies can pass Kaldor's test than Pareto's.

The third philosopher to influence our decision makers is John Rawls, an American whose theories of social justice and policy were summarized in his 1971 book, A Theory of Justice. Rawls is the least-discussed of the three by economists, but he clearly, if not influences, at least represents a segment of politicians. Rawls believed a policy improved social welfare if it benefitted those least well-off among us. What happened to all the rest of us did not matter to Rawls, only those at the bottom counted in determining whether a policy is a good one or not.

So when President Obama wants to take money from those with high incomes and give it to those with low incomes through all sorts of welfare programs, Rawls would support him. Redistributive policies fail both Pareto's and Kaldor's test for being welfare-improving, but pass Rawls' test. Clearly many politicians, generally Democrats, are following Rawls given the number of redistributive programs the federal government has and the rate at which they have been increasing.

If one (or two) of these three divergent philosophical approaches are core principles for many politicians, it is easy to see why the policy arguments in Washington have been so intractable. Many policies that Democrats (following Rawls) define as increasing the national social welfare (making us "better off" as a country), Republican politicians would define as bad policy because the policy is not Pareto-improving or even Kaldor-improving.

In the reverse, Republicans propose policies that they claim are pro-growth, involving tax cuts now with the promise of more jobs soon thereafter, because they are Pareto-improving (some people are better off and no people are hurt). Democrats oppose these policies because unless given assurances that the poor will benefit from the jobs to be created they do not see the gain for those at the bottom and, thus, doubt the policies will be Rawls-improving.

It is very difficult to find policies that are welfare improving according to all three tests outlined here. Encouraging people to volunteer to improve the lives of the poor, perhaps by tutoring, career coaching, or similar charitable activities, would be one example. Tax deductions that create incentives for donations to organizations that work to benefit the poor would be another.

The paucity of policies that can meet the conditions proposed by these three philosophers explains the frequency of political disagreements on economic policy. If one believes a proposed policy would make the country worse off, opposing the policy is the right thing to do. The problem for those wishing to see more compromise among our politicians is that while one political party is promoting a policy they believe will be welfare-improving, the other party usually believes the policy will actually make things worse. The inherent problem is that the two sides define welfare-improving in two different ways.

Because these competing philosophies are like opinions, not facts, it is extremely difficult to convince the other side to change their minds and begin to support policies they previously opposed. Until our opposing politicians can agree on the definition of what makes our society better off, they will not agree on economic policy either. The lesson of Pareto, Kaldor, and Rawls is that the political battles are not going to end any time soon.