(This essay was published in Hong Kong Economic Journal on 22 October 2015.)
Professor Angus Deaton won the Nobel in Economics this year for his work on consumption, poverty and welfare. I have always had great admiration for his work and have used his more recent work, The Great Escape, as the first book to read in my freshman common core course at the university on “Poverty and Growth in the World”.
Deaton’s work has three critical elements for understanding poverty and welfare in both developing and developed countries.
First is that income is not the only thing that matters in determining the well-being of individuals and households. By implication, the obsession in both rich and poor societies with using income as the only yardstick of welfare is incomplete and could be misleading for our understanding and for policy design to tackle poverty or inequality.
Time free from work is a non-income measure of well-being. Consider the following fact: as productivity increases so does income, but the amount of time a person spends at work decreases. This happens not only in terms of shorter workdays and workweeks, but also in terms of work years over the lifetime. Time not spent in work is not idle or wasted time. It is often time spent in investing in human capital (including time spent in studying, training, exercising and sleeping) and in playing, and is highly valued as enjoyment.
Increases in life expectancy due to better health have also greatly increased well-being. A better measure of well-being therefore must include not only differences and changes in income, but also the additional amount of time that becomes available to an individual when productivity, health and income increase.
These are not trivial effects that are theoretical niceties.
To appreciate the significance of Deaton’s first point consider the consequences of recognizing health as an element of well-being. A general empirical observation is that the rich have better health than the poor. Similarly individuals in developed nations on average have better health than those in developing countries. This is reflected in longer lives, fewer sick days, taller body heights, and other measures of health robustness.
These indicators are strongly correlated with income across individuals, across countries, and over time. But the effect of health on welfare is not perfectly correlated with income. It cannot be reduced only to income effects.
Consider whether increases in health widen or narrow the gap in well-being between rich and poor individuals, and between rich and poor nations. This will depend on who benefits more from the increase in health. Suppose a rich person has an income of $100 and a poor person has $25. If improvements in health occur in a manner that is equivalent to increasing each of their incomes by $25, then the relative gap (not absolute gap) measure in dollar terms between them is narrowed. If the form of improvements in health benefit the rich by $50 and the poor by only $5, then the relative gap in dollars is widened.
Empirical economic work by Gary Becker (also a Nobel economist) and others have found medical and scientific breakthroughs that reduce mortality among people younger than 50 from infectious, respiratory, digestive, congenital, perinatal, and “ill-defined” conditions are responsible for most of the increase in life expectancy of all individuals. But the effect not only increases welfare for all – it also reduces relative inequality between the rich and poor both within and across countries, and contributes to a more equal distribution of well-being.
However, the recent effects of medical prevention and treatment regimes that reduce mortality after age 50 – due to AIDS and conditions affecting the nervous system, senses organs, and heart and circulatory system – have contributed to increased health inequality across countries. It has also often increased inequality within the rich nations.
The second critical element of Deaton’s work is his emphasis on understanding individual consumption choices in a deep way. He focused on the lifetime outcomes of well-being and not just at a particular moment in time. Measures of the significance of health equally should adhere to this requirement: individual and household income measurements should not be restricted to a moment in time.
Contrast that insight with the widespread practice over the past half-century to measure economic inequality using Gini-coefficients of household income dispersion. This choice ignores health care as a component of well-being and fails to take into account lifetime outcomes.
Milton Friedman was the first to emphasize that individual and household incomes vary considerably from year to year, and Deaton developed that idea further. Empirical evidence of their theories came in Chasing the American Dream, in which sociologists Mark Rank, Thomas Hirschl, and Kirk Foster looked at 44 years of longitudinal data for individuals in the US aged 25 to 60. They showed that 12% of the population would find themselves in the top 1% of the income distribution for at least one year. What’s more, 39% of Americans would spend a year in the top 5% of the income distribution, 56% would find themselves in the top 10%, and a whopping 73% would spend a year in the top 20% of the income distribution.
The results are striking. A big part of short-term mobility in income is simply transitory ups and downs in income. For an individual and household, the more relevant consideration of well-being is not only outcomes at a moment in time, but also total outcomes over an entire lifetime. A recent study by the Institute of Fiscal Studies in the UK has found that the distribution of lifetime incomes is smaller compared to annual incomes.
The third critical element of Professor Deaton’s work is that it reminds us of the relevance of economic theory as a guide to policy design for the alleviation of poverty and inequality. Deaton has taught us that health is as important as income in human well-being. He has also taught us that lifetime outcomes are more relevant than snapshot outcomes at a moment in time. His work on the economic theory of consumption naturally guides us to focus on the importance of education, health care, and early childhood intervention policies that help young children in poor families, as a critical focus of any policy design to alleviate poverty and inequality.
Income redistribution policies that aim to support consumption by the poor will be successful in reducing measured poverty based on Gini-coefficients because they raise the incomes of the measured poor. Deaton has taught us that the alleviation of poverty is not about fixing measures. He also recognizes the inequalities that reward effort, risk taking, and luck are necessary even as society escapes from poverty.
The Royal Swedish Academy in awarding the Nobel Memorial Prize in Economic Sciences wisely and correctly observed: “To design economic policy that promotes welfare and reduces poverty, we must first understand individual consumption choices. More than anyone else, Angus Deaton has enhanced this understanding.”
M. Brewer, M.C. Dias, J. Shaw, “Lifetime Inequality and Redistribution”, Working paper W12/23, Institute for Fiscal Studies, Economic and Social Research Council, UK, Oct 2012.
G.S. Becker, T.J. Philipson, R.R. Soares, “The Quantity and Quality of Life and the Evolution of World Inequality”, The American Economic Review, Vol. 95, No. 1 March 2005, pp. 277-291