(Spending) money makes us happy

Maybe our preoccupation with earning money is a bit misguided — and for more than one reason

magine receiving a bonus of, say, £2,400. Not an insignificant amount — it is close to the median disposable monthly household income in the UK. Imagine how it is being transferred into your bank account, checking your balance and seeing that it has indeed gone up by that amount. Now imagine spending that same amount. You can choose to blow it all in one go on a bathtub full of champagne, or in small chunks — maybe some clothes or gadgets, a nice meal out, some overdue repairs on your house or your car. Which of the two imagined situations makes you happier?

Two recent papers suggest that, for most people, it is consumption rather than income that predicts well-being. Thomas Carver and Arthur Grimes, two economists at Motu, a New Zealand economic and public policy research institute, come to this conclusion in a paper using their country’s General Social Survey data. Independently, Gordon Brown and John Gathergood, psychologists at Warwick University and Nottingham University, used longitudinal US household survey data. They too found that changes in life satisfaction are associated with changes in consumption, not income.

“No shit, Sherlock”, you may think, or at least wonder, “so what?”

Sure, more attention tends to go to income than to consumption in the most prominent economic statistics and commentary: we hear about wage inflation and savings rates, about median household income, or about income and wealth inequality. We don’t hear quite as much about household consumption or about inequality in how we spend money.

Not all expenditure is created equal

Now, arguably income is tantamount to our potential to consume, and so it can be implicitly seen as a proxy for consumption. As it is easier to measure, it might make sense to study the link between income and happiness, while quietly assuming that what is really being investigated underneath is the link between consumption and happiness.

Source: Brown & Gathergood, 2019

But for that to really hold, consumption would need to rise with income, and that is not the case. At the bottom of the income scale, people typically spend more than they earn (and the difference is made up with support and benefits they receive). As people earn more, however, they save an increasing proportion of their income. Some of this goes to building up a buffer for a rainy day, providing security for unforeseen circumstances, which undoubtedly contributes to overall wellbeing. But we do consume proportionately less and less as our income rises

Of course, we don’t get the same enjoyment out of spending money on toilet paper or utilities as on holidays or meals out. Gordon and Gathergood’s analysis draws a clear distinction across the diverse categories of expenditure. They find a significant difference between conspicuous consumption (relatively luxury goods and services that are highly visible by others, and that signal status and economic power), and non-conspicuous consumption (the stuff nobody sees). It’s the former that really makes us happy.

Conspicuous consumption is often paid for by credit cards. Many people pay their bill at the end of the month, but quite a few don’t — credit card debt in the UK stood at nearly £2,700 (€3.100, $3,500) per household at the end of 2018. That costs money (at typical interest rates something like £800 per year) — and this interest, really, is the money we’re prepared to spend on consuming itself.

Spending to be able to spend

Enter the taxman

The fact that people are prepared to pay in order to consume has not escaped the taxman either. Many countries operate a tiered sales tax or Value Added Tax (VAT) that is higher for goods that fall into the conspicuous consumption category. This is easy money: people are typically less price sensitive when it concerns luxury items, so adding a bit of extra tax is not going to affect sales much. Kaching go the government coffers.

Some economists even advocate shifting the tax burden on citizens entirely from income to expenditure. Robert Frank, among the most prominent ones, favours of a progressive consumption tax, which works much like the more common progressive income tax. Instead of paying a higher percentage of the top slice of our salary in income tax, we would pay a higher consumption tax the more we spend.

Prof. Frank’s main motive is social in nature. He sees income inequality as a distraction: what really matters is consumption inequality. The way the rich spend their money — on bigger houses, on flashier cars, on more expensive holidays, clothes, and so on — trickles down and affects the consumption of the less wealthy. They too want a bigger house etc, and their expenditure becomes ever more driven by social pressure to ensure their consumption is adequate according to the perception of their peers. This leads to an infernal spiral, in which people who can ill afford it eventually find themselves in financial trouble — not because of income inequality, but because of inequality in consumption.

Some evidence for this hypothesis, or at least for the negative externality of rich people and their conspicuous consumption, can be found in a study by Rainer Winkelmann, an economist at the University of Zurich. Prof. Winkelmann found that people feel less satisfied with their income if they see too many luxury cars in their neighbourhood. In municipalities with twice the number of Porsches and Ferraris per capita as the national average, the reduction in satisfaction with income is equivalent to a drop of 5% in that income.

Only upsides?

To fix this kind of problem, you don’t need a high income tax. Let the rich get richer, and leave them alone as long as they leave their money in the bank. But when they come to spend it on a Ferrari or a beach house, whack. The big benefit is that, by avoiding the deadweight loss of income tax, you do not discourage people from earning more (and saving and investing more). By taxing consumption progressively, you actually encourage people to save and invest.

No tax as long as your money stays in here! (image: skeeze)

It would not even be particularly hard to implement such a tax in practice. There are only two things you can do with your income: spend it or save it. If citizens report their savings as well as their income, the difference between the increase in savings and their income is how much they consumed, and that is then taxed according to a progressive scale.

If the rates are set such that it is a neutral operation for middle income households with a typical expenditure pattern, the vast majority of the population would be able to continue enjoying their consumption without much encumbrance. The consumption of the very rich could be taxed at whatever rate is necessary to really make a difference on their actual overly conspicuous consumption. If, say, a 50% tax on expenditure above 50 million dollars doesn’t make them consider whether they really need to buy a fifth Porsche, then maybe an 80% or a 150% tax will do it.

Eventually this might mean a shift away from the production of very expensive goods: fewer Bentleys and Lamborghinis. But would that be a bad thing? Those resources could now be deployed into the development and production of less expensive goods aimed at people with more modest spending power, where the demand is higher. Even if that irks the top 0.001%, it will increase the wellbeing of many times more people in the bottom 99.999%.

We do, however, seem to nowhere near the implementation of such a system. How come nobody has tried an approach that appears to be an economic panacea that solves many social and economic problems?

The answer to that question probably belongs in the domain of politics, rather than economics. And that is a different story.

Originally published at http://koenfucius.wordpress.com on May 10, 2019.

Thanks for reading this post — I hope you enjoyed it. Please do share it far and wide — there are handy Twitter and Facebook buttons nearby, and you can click here for a LinkedIn link, or simply copy and paste this link. See all my other posts (I publish one every week) here. Thank you!

Accidental behavioural economist in search of wisdom. Uses insights from (behavioural) economics in organization development. On Twitter as @koenfucius

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