Wednesday, April 29, 2009

Luck and success - the debate on raising taxes

I had blogged earlier on how initial conditions, family and societal environment, and contextual factors, all of which are the result of luck than any skill or hard work, play critical role in influencing outcomes. In his recent book, Outliers, Malcom Gladwell has demonstrated with numerous examples (Bill Gates, Beatles, Ice hockey players etc) the critical role of luck and opportunities in determining success in life. In fact, Gladwell even feels that talent is more a function of the persistance and tenacity than any inherent skill, and that skill and hard work entails dollops of luck.

Now, in the context of opposition against President Obama's decision to raise the marginal tax rates from 35% to 39.5% (by letting some of President Bush's tax cuts expire in 2010), Robert H Frank argues that there exists a very strong link between success and luck. He writes,

"Contrary to what many parents tell their children, talent and hard work are neither necessary nor sufficient for economic success. It helps to be talented and hard-working, of course, yet some people enjoy spectacular success despite having neither attribute. Far more numerous are talented people who work very hard, only to achieve modest earnings. There are hundreds of them for every skilled, perseverant person who strikes it rich — disparities that often stem from random events...

Even in markets where luck plays no role, minuscule differences in performance often translate into enormous differences in salaries. In music, even sophisticated listeners have trouble detecting differences between the handful of best cellists in the world and those in the next tier. But recording companies need only a few cellists. And if there is a discernible difference, however small, between the two groups, the best will land lucrative recording contracts while those just below them may struggle to make ends meet on an orchestra player’s salary."

Conservatives have for long claimed that the most productive people should face lower tax rates to give them strong incentives to work harder and produce more. However, Prof Frank draws attention to the staggering disparities in income and wages between those at the top and those slightly below, far out of proportion to their relative skill level and hard work, that characterises an increasing number of occupations - law, consulting, investment banking, corporate management - apart from the traditional winner-takes-all markets like sports and entertainment. He therefore rubbishes the anti-tax protesters claims that the government has no right on their incomes, earned by the dint of their hardowrk and skill.

Economists have found that random events like episodes of bad health, accidents, marital dissolutions and family emergencies play a large role in short-run year-to-year fluctuations in income, thereby eroding the credibility of the ability-alone-drives-success school. Given the substantial role played by luck in determining success and outcomes, Hal Varian has argued in favor of a model where those at the top end of the income table should pay a larger marginal tax rate so as to discount for the extra share of luck they have enjoyed. He writes, "If luck plays a substantial role in the determination of income, it makes sense to have a progressive income tax, creating a form of social insurance in which the lucky subsidize the unlucky."

The luck-determines-success school, where the rich get richer and the poor get poorer, is a manifestation of the Mathew effect (Matthew 25:29, King James Version),

For unto every one that hath shall be given, and he shall have abundance: but from him that hath not shall be taken away even that which he hath.

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