An intuitive model about the complex tradeoffs between development and inequality

The time has come to evaluate alternative models of development that include biodiversity and inequality in the equations of our development definition and policy management.

Before listing all the assumptions that are required to come up with a valid simplification of our world, it is important to define why this article is relevant at all, or why do we need to write more about sustainability and inequality.

If we look at the economy as a big factory, as when we only look at GDP, we can confirm that this is the time of greatest material capacity. Without stepping into the details and flaws of the GDP accounting (defensive expenses, wars...), it is a fact that real or nominal GDP are at historical highs. For those thinking that is wrong to make policy or civilization purpose to maximize such indicator only, this post will be relevant.

In a world with critical planetary boundaries, the next great species extinction, human caused global warming and growing inequality, it seems reasonable to add other elements than GDP as a guidance for policy and even personal purpose. A model beyond growth, a model that recognize that a living planet is basic for our existence and joy, and that only moderate amounts of inequality, and relative (and not absolute) amounts of poverty are acceptable, GDP or income growth is not enough.

Economists try to bring numeric measurements at the center of the policy, and isolate ethical aspects, giving trust to markets and individual choice for the allocation of resources, the merits of work and the optimal scale of the pie. Some may argue that is power and not merit what explain most of today’s distribution of the economic pie, and the decisions affecting the usage of the natural commons, even at their extinction.  In any case, those that recognize a significant amount of market failure in labor revenue, wealth distribution or environment collapse, are probably interested in a model that give tools and have goals beyond economic and industrial growth. That, not only means giving more power to the government, but also a more universal prioritization to the resource consumption, based on local needs and not enterprise lobbying.

Those who recognize that economics is a tool at service to life and not the other way around, can use the following model to shape their individual and collective choices to shape policy towards a development that respects planetary boundaries, social integration and the universality of the human rights. Hope that serves at least as a valid though game, to design new futures on times of crisis, which are, by definition, times of opportunity.

The model

Consider the following economy:

• The government needs to decide how much to tax the main inputs in production, those being capital and labor, and to distribute that revenue in forms infrastructure, goods or direct transfers to citizens. The government knows the amount of natural capital available, and how much is extracted by the companies. The government does not know the technological or cost structure of the companies, nor the utility of the citizens.

• Companies decide how much capital and labor to hire, based on the cost of production, which is equal to the amount paid by labor unit and capital unit (with taxes). In order to improve their efficiency, they need to decide how much to invest in research to create a technological capital that accumulates and deteriorates over time. 

• Citizens can be capital and labor holders, and they decide always to work when possible, that means, when there is demand from the companies, and lend capital at certain rate of interest given by the market. The society values smooth consumption at a decreasing rate, and natural capital availability (clean water, clean air, affordable energy, forests, other species, wildlife...).

• The natural capital is limited and required to create physical capital; it regenerates at a certain rate, but its rate of regeneration diminishes if the natural capital go down. Without natural capital, no physical capital can be created and hence no production is possible.

• Trade is possible between other economies, on physical capital and goods

• The initial amount of capital assigned to every citizen is very unequal, with most of the people having little or no physical capital ownership, and a few having most of the physical capital endowment

Policy as usual

In the following, we will describe the current status of a given economy and also its predictions:

• In an economy where no limits to the amount of natural capital are placed, and taxes on physical capital are small enough...
• Natural capital is consumed at a rate higher that its replacement rate, leading to a collapse at some point
• The reduction of natural capital makes natural shocks more likely, reducing total output, available physical capital, affecting relatively more to the poorest

• In an economy where labor is relatively high taxed, and abundant, hence unemployment is possible:
• Labor gives less return and pays little, comparing to capital, and therefore inequality grows as a result

• In an economy where government tax highly labor, and little physical capital (due to the high mobility of capital), and the expenses are mainly dedicated to support infrastructure and not universal income
• Most of citizens are little protected to shocks or unemployment, and hence its utility or wellbeing is very damage
• The minority see its wealth grow, with little impact on utility, as current consumption levels where already high, and natural capital goes down

We can notice that most of the policy and status variables, are common ground in the world:

• Very unequal initial physical capital endowments

• Little regulation on natural capital consumption and pollution

• Significant amounts of unemployment, or people close to poverty levels

• Labor is heavily taxes, while capital pay little taxes

• There is not universal coverage in case of economic shocks and unemployment

Some countries are slightly less/more unequal, social, environmentally friendly, but the global traits are fairly represented here, with some range, but showing still a general tendency for growing inequality and natural collapse.

Steady State Policy

Imagine now the following scenario:

• Natural capital: there are limits to the amount of natural capital consumption, and hence the amount of physical capital creation
• Taxes: Labor is not taxed, while capital is the source of most of government revenues.
• Government expenditures: Focus not only on basic infrastructure, but also on minimum income, to ensure everyone has safety values of income in case of shock or unemployment.
• Work distribution: it is possible to divide work to reduce involuntary unemployment

In such a case, physical capital generation will be limited, and, if additional units of physical capital are required, it should be bought in the global market. 

Labor will be less costly, since there are no taxes to it, and hence more attractive and abundant than physical capital. 

• If the price of global market capital is high enough, and labor cost is small enough, employment will grow, as more factor will be used.

• If other markets place limits to physical capital usage, there will be a limited supply of capital, so labor will not have such competition with capital

• If demand of labor increase, more population will receive income, which will increase overall utility and reduce inequality, as the physical capital owner will finance most of government expenses

• Since labor require a marginal amount of the natural capital to be effective with respect to physical capital, the natural capital depletion, for the same amount of output will be reduced

• Since there is a stable amount of natural capital, at least at a local level collapse will be less likely, as shocks depends on global coordination. That also mean that this economy could sell capital to collapsed economies, if they chose the non-sustainable path in the long term.

• Long term output is higher, as natural capital is respected

• The lump sum government transfers and the less likely shocks make overall utility higher, and a smooth path of consumption is possible.

• Companies and governments can make products competitive if the income is used also to invest in technology that make production less physical capital intensive (decarbonization, holistic farming), and labor more productive (artificial intelligence, proper soil management).

The second policy relies on a moderate amount of competition in physical capital use, and probably makes consumption more expensive in the short run (same demand and less output), but there are many key industries like agriculture, energy generation, health and education services, where a less capital intensive production can be as productive as the industrial one, so there are solid industry evidence to support that types of economy.

While the interactions between capital tax, prices and overall utility require proper modelling, it makes intuitive sense to apply limits to the usage of a scarce resource like natural capital, to avoid a sure collapse if the rate of extraction and production does not go down. It is also clear that current amounts of wealth and income concentrations, together with unemployment puts under a lot of stress our current national security and social cohesion.

If policy aims to enhance the conditions of development, respecting the times and limits on Earth, and the basic laws of thermodynamics, together with moderate amounts of inequality and human rights protection, we should aim to design new futures and policy, balancing the tradeoff between development, life and inequality, as any economist goal is the management of the scarcity, to satisfy human and ethical goals, not only material ones.