Universal Basic Income – not all “basic” things are bad

A couple of weeks ago, Finland announced that they were going to completely reform their benefits system by doing away with all means-tested (and other) benefits and replacing them with a “universal basic income” of €800 per month.

A very good summary of the majority of the benefits and potential drawbacks can be found here – I strongly recommend you go and read it. It falls a little short in some areas: for example, it doesn’t really investigate whether or not the new system will be more or less expensive of the old system, yet still dismisses as false claims that the new system will be too expensive.

However, more importantly, even though the article claims that it would reduce instances of “out-of-work claimants afraid to take up short-term job offers for fear of losing benefit entitlement” this misses off a crucial element (although the main thrust of this point is correct).

In particular, it ignores the fact that some people currently in employment might decide to remove themselves from the workforce – some people currently in work might decide that €800 per month is more than sufficient for them to live on and that they can therefore get by without working. This would result in people that were previously productive (i.e. contributing to GDP) no longer working, such that GDP could fall.

However, the size of this effect could be quite small. Indeed, it could be argued that the people most likely to be disincentivised by the new system are those that are already out of the workforce in the first place. If this is the case, then the policy likely would have a negligible impact on GDP since the reduction in the size of the workforce it would inspire would be limited.

Moreover, even for those that are disincentivised, the overall size of the disincentive depends on the amount of the basic income relative to the amount that someone could expect to obtain from remaining in the workforce, as well as the sort of lifestyle that the basic income can obtain. If the basic income is small relative to the wages obtainable through employment and/or relative to the cost of maintaining the desired lifestyle, then the disincentive effects of the policy are likely to be negligible.

Indeed, these disincentive effects are likely to be outweighed by the positive incentive provided by the removal of means-tested benefits. This removal reduces the marginal tax rate paid by those that would otherwise be on means-tested benefit, thereby increasing their incentive to increase their income.

To see this, suppose (in a hypothetical stylised example) that someone earns €10,000 through working and obtains €9,600 in means-tested benefits that are withdrawn at a rate of €1 per every extra €2 earned – in this scenario, the person gets €19,600 per year through income and benefits combined. Further, suppose that the income tax rate is 0% until someone earns more than €25,000. Under the means-tested benefit scenario this person has the chance to increase their in-work income to €12,500 – this might seem automatically worthwhile because they will get €2,500 per year more. However, the fact that their means-tested benefits are withdrawn gradually means that the total amount they would get is lower than this. Specifically, their means-tested benefits would now only amount to €8,350, such that this person would obtain €20,850 per year. This is an increase in total money of only €1,250 despite the person’s increase in work income of €2,500. In other words, this person faces a marginal tax rate of 50%, which could provide a large disincentive from taking on more work.

The situation with the universal income is much simpler – the person gets €9,600 benefit regardless of their paid income. Hence, any increase of the person’s income (below the income tax threshold) is kept by that person, so that in this scenario the person’s total annual money would increase by the full €2,500 to €22,100. Therefore, under universal income, a potentially very strong disincentive to work is removed, encouraging people to work and thereby increasing GDP.

As such, the issue regarding work incentives and the impact the policy will have on employment via the change in work incentives is far more nuanced than the article suggests. Hence, the article may well understate the benefits to this policy.

Climate change and the discount rate: Part 2

As an (unplanned) follow-up to my previous post regarding the impact of the discount rate on analyses of the net benefits of mitigating climate change, let’s have a look into recent estimates of what the appropriate discount rate for assessing said mitigation benefits should be.

More specifically, the NBER recently linked to a paper written by Giglio, Maggiori, Stroebel, & Weber that purports to show that 1) the discount rate that should be used to assess the net benefits of mitigating climate change is at most 2.6%; and 2) therefore,  rates of return on some risky asset classes are not appropriate proxies for the discount rate.

It is the first claim that is demonstrably erroneous, and means that the discount rate that should be used is likely to be higher than 2.6% (and, hence, also implies that the paper’s second claim is not proven). As mentioned in my previous post, although using a discount rate as artificially as low as 2.6% would result in there being a positive net present value of mitigating climate change, using a (more appropriate) higher discount rate reverses that result.

(As an aside, the aforementioned NBER paper is riddled full of holes – for example, the authors claim that “there are no property taxes [that affect the return on property investments] to be considered in the UK”. This is patently false – the authors have ignored, or are simply unaware of various taxes that property developers and management companies have to pay. Either way, this simple error casts serious doubt on the accuracy and reliability of the rest of their results.)

The authors obtain the 2.6% estimate from a previous paper of theirs (rather shockingly, this flawed paper was published in the Quarterly Journal of Economics). In that paper, they looked at differences between the UK and Singapore prices of residential properties with time-limited leaseholds and those that are freehold. This difference reflects the value people place on holding a freehold relative to holding a leasehold with a certain number of years remaining and, hence, can be used to infer a discount rate for cash flows that occur in the very long run.

However, the results of that paper are driven by a fundamental misunderstanding of how long leaseholds and freeholds are treated by someone purchasing a house. The paper claims that leaseholds of more than, say, 500 years are different from freeholds because the leasehold can still expire and rely on this to validate their result. As such, the paper ignores the fact that, for all intents and purposes, a lease that long is treated in exactly the same way as a freehold (by buyers, sellers, estate agents etc.)

Moreover, the paper uses the result that rental values do not differ between freehold and leasehold properties (controlling for observable characteristics such as number of bedrooms etc) to claim that any systematic differences in unobserved characteristics between leaseholds and freeholds are unlikely to be prevalent. However, this ignores the fact that many properties (at least in the UK) are owner-occupied rather than rented. This means that the data they use misrepresent how people value residential properties and the factors that people take into account in their valuations. for example, it is plausible that someone purchasing a house to live in values it differently from someone purchasing the house as a buy-to-let – ignoring this means that the paper’s results are biased.

Furthermore, the paper relies on data covering only the period 2004-2013. In other words, a large part of the data used in the paper are affected by the impact of the global financial crisis, which is widely recognised to have depressed house prices. In addition, the paper fails to control for other relevant factors, such as changes in the housing stock in a particular area over time – as increases in the stock of housing in a particular area would affect the prices of existing houses, this is a grave omission.

Finally, the paper restricts their analysis to the prices of flats, and does not look at other forms of properties at all. This is a grave error since it biases their results towards being more leasehold-focused (flats are typically leasehold, whereas houses tend to be freehold). In other words, the paper fails to take into account a very large proportion of properties that are sold in the UK.

In other words, the result that the long-term discount rate is less than 2.6% is based on a flawed analysis. This means that the results of their latest paper (the one mentioned at the start of this post) are wrong. Indeed, the discount rate that should be used to obtain the net present value of the benefits from climate change is likely to be far in excess of 2.6%. Hence, the results shown in my previous post (that there is a net loss from mitigating climate change) still hold.

Climate change and the importance of the discount rate

The ongoing talks regarding climate change (and what to do about it) seem to take as given that “something” should be done to try to prevent climate change. Abstracting from arguments regarding any scientific consensus about whether or not humanity’s actions are at least contributing to climate change, these talks still do not question whether it is economically rational to do something about climate change.

Indeed, the fact that the impact of any climate change is likely to be (relatively) far into the future, whereas the costs that would be incurred to try to stop climate change would be incurred much sooner does make it difficult to evaluate the extent to which there is an economic case for doing something to stop climate change.

This is where something like the Stern Review should come in – it was an attempt to examine the economic impact of climate change and, hence, whether or not it made economic sense to try to counter the effects of climate change. Stern concluded that there was a strong economic case for acting to prevent/mitigate climate change. However, its approach was fundamentally flawed.

In particular, the Stern Review’s treatment of the “discount rate” (i.e. the amount used in the conversion of future sums to present values) meant that it overstated the current value of the future benefits of preventing climate change. Although the Stern Review accepts that there is some need for discounting due to the fact that £1 in the future can buy less than £1 today (i.e. inflation erodes the value of the same nominal sum), the Stern Review unjustifiably rejects the notion that people have an inherent preference for receiving beneficial things sooner rather than later.

The rejection of the second reason for discounting future sums means that the discount rate used by Stern is an artificially low 1.4%. This is in stark contrast to the 4% – 6% discount rate for developed countries that is suggested by Markandya et al (2001) and even below the 2% -3% suggested by Halsnae et al (2007) – both of these figures were estimated by the IPCC itself.

Although these differences of a few percentage points a year might not seem like much, over time they add up. To see this, the graph below shows the present value of receiving £100 x years into the future under different discount rates. The x axis indicates how many years into the future the sum is received, while the y axis shows how much that sum would be worth in present value. The black line indicates how the present value of the £100 declines over time under a discount rate of 1%, while the blue and red lines show the progression under discount rates of, respectively, 3% and 5%.

Discount rates

The difference between the three lines is stark – despite only a two percentage point difference between a 1% discount rate and a 3% discount rate, the gap between the present value under the different discount rate is substantial after just 10 or so years.

How, then, does using a more appropriate discount rate alter Stern’s conclusions. Well, Stern puts the central estimate of the global cost of not acting to prevent climate change at about 5% of global GDP – i.e. roughly $5 trillion. Let’s (conservatively) assume that the full extent of these costs would be incurred starting from 2100 – i.e. that in 85 years the costs of not doing anything to combat climate change would be $5 trillion. Using Stern’s own discount rate of 1.4%, that puts the net present value of mitigating climate change at about $1.5 trillion per year. Given that Stern estimates that the costs of mitigating climate change are about $1 trillion per year in about 2050 (and let’s not get into whether or not Stern has underestimated these costs as that has been covered thoroughly elsewhere, nor the fact that these costs would need to be incurred on an annual basis for at least 30-odd years before the benefits from mitigating climate change would be felt) – i.e. about $615 billion per year in the present day using Stern’s discount rate – Stern concludes that acting to mitigate climate change is economically rational.

However, using the more appropriate discount rate of 4% per year, the benefits from ameliorating climate change have a present value of the benefits from mitigating climate change of  about $178 billion per year, while the present value costs of mitigating climate change (using that same discount rate) are roughly $253 billion per year.

In other words, using a more appropriate discount rate means that Stern’s conclusions are completely reversed – instead of there being a net economic benefit from acting to mitigating climate change, doing so actually results in an economic loss.

It is rather damning that Stern chose to bury this part of his assessment in a technical annex to an addendum to his original review. And yet this report is relied on as evidence that there is an economic case for climate change despite the fact that the evidence does not support that conclusion.