What is the Easterlin Paradox?

The Easterlin Paradox tells us whether we are more contented and at an advantage, as our living standards improve. In the 1970s Richard Easterlin came to the conclusion that even though studies that showed that, although succeeding generations are usually more affluent than their previous counterparts, people seemed to be no happier with their lives? It is a thought-provoking paradox to study when you are writing about measuring economic welfare and the standard of living. The Easterlin Paradox refers to the element that happiness data are typically stationary in spite of considerable upsurges in income. This amounts to a rejection of the hypothesis that current income is the only argument in the utility function.

Supporting evidence. 

We find that the joy responses of around 350,000 people living in the OECD between 1975 and 1997 are positively associated with the level of income, the welfare state and (weakly) with life expectancy; they are negatively correlated with the average number of hours worked, environmental degradation (measured by Sox emissions), crime, openness to trade, inflation, and unemployment.

These effects isolate groups in a pattern that appears broadly plausible (e.g., the rich suffer environmental degradation more than the poor). Based on actual changes from 1975 to 1997, small contributions to happiness can be attributed to the increase in income. Interestingly, the actual changes in several of the ‘omitted variables’ such as life expectancy, hours worked, inflation and unemployment also contribute to increased happiness. Over this time period since life expectancy has risen and the others have, on average, fallen.

How is economic growth is sensitive to happiness?

De Neve and his colleagues believe that the impact of economic growth on happiness is vastly lopsided. Their statistical analysis is based on several bulky international data sets surveying life fulfillment, it found that happiness is around six times more sensitive to economic growth when that “progress” is negative. If you have six years in which the economy grows a couple of per cent a year, followed by one year when the economy shrinks by 2 percent, the economy itself will have made considerable progress but the wellbeing of citizens will not.

The basic paradox that Easterlin has pointed out is that, past a specific level, a country getting wealthier doesn’t seem to make the population any happier. we know that people do keep getting happier but at a much lower rate, that basic idea has proven very widespread. it’s allowed people to argue that we don’t have to chase that Great Deity, GDP, and we can thus do things that make entities happier and not richer. It’s a good argument to use when someone objects that taxing the heck out of the wealthy will reduce progress for example. For one can just reply that more growth wouldn’t make people happier while taxing the heck out of the rich would. It’s used as the opening argument in The Spirit Level in this manner: as higher GDP doesn’t put people at an advantage so we can, therefore, concentrate upon inequality instead.

I’ve never thought that was quite accurate. My argument is that it’s not the level of economic wealth above the basic level that makes people happy or unhappy. Rather, it’s the direction of change of it. If a country is getting richer at a gradual pace then people will be happier than if the economy is shrinking, so the association of greater happiness with the richer countries is not really because they are richer, but because in becoming rich those countries have obviously had decades, if not centuries, of gradually rising incomes: that very thing that makes people happy.

The Easterlin Paradox is wrong. Period.

Ron Bailey has a good over view of recent research that shows that the Easterlin Paradox isn’t a paradox, it’s wrong.

Everyone who is serious about their economics agrees that there’s frequently (and some insist always) a trade-off between productivity and equity. Yes, OK, so it would indeed be more efficient, everyone would get wealthier quicker, if we didn’t do any redistribution of incomes.

Say, just as an example you understand. And everyone else chimes in which, but well that would be unfair. Of course, we should tax the rich in order to pay for the care of those who simply cannot care for themselves. And that second argument most certainly wins at some level. Taxing millionaires to care for Down’s Syndrome children will get nearly everyones‘ vote. It doesn’t work all the time though: taxing the rich in order to provide inflation proofed pensions for Congressmen is a harder sell, even though it does indeed happen.

This is true even if we do accept that taxing the rich leads to some inefficiency. The gain made from taking care of those who cannot do so themselves is greater than the possibly minimal loss of taxing that small an amount of money. We gain more in the equity than we lose in the efficiency.

Yet we can also imagine situations (like my native Britain in the 1970s) where the top tax rate is 98%. The loss in efficiency is possibly greater than the gains in equity: that’s really what a large part of Thatcherism was all about. Thus we want to balance equity and efficiency in our taxing and redistribution.

And this is where the political use of the Easterlin Paradox comes in. Both Layard’s work on happiness and The Spirit Level looked at Easterlin’s finding and concluded that above a certain level no more happiness was to be had. And, given that the aim of the whole game is the greatest possible happiness, we now don’t have to worry about that equity and efficiencytrade–offf. For there is no trade off left: above that level of maximum happiness income we can always increase happiness by higher taxation and redistribution to the poor. For the extra money being taxed off people doesn’t make them any happier: and the extra growth that we’ll not have through the high tax rates wouldn’t either even if it did happen.

So, therefore we can tax the rich as much as we like and there’s no fault to this plan.

But if Easterlin is wrong then this analysis fails. We are making the rich unhappier by confiscating their cash. This doesn’t change the basic calculus, that the rich should pay (as Smith put it) more than in proportion to their income. But it does put a limit on how much of this we can do.

That’s really what the argument over Easterlin’s Paradox is all about. It’s a fundamental crutch to a set of arguments about how much redistributive taxation we can or should have. If it’s untrue then that argument gets undermined. And as it turns out, it is untrue, thus we might well be having too much redistributive taxation.

I will admit though that my own view is that it’s not levels of income that matter at all. Nor even relative incomes. I, on the basis of no evidence at all, go with the idea that it is changes in income which matter. People whose incomes are continually rising are optimistic about the future: they’re happier. This is true whether we talk about an individual regarding the sunny uplands of wealth they’re about to achieve or a nation seeing continual economic growth. It is the change in level, not the level itself, that matters.

The connection between levels and changes is simply that a nation that’s been having good economic growth for a few generations is going to be a rich nation. An individual with a continually increasing income is going to be pretty high on the income distribution in that country.

The problem with this thesis is that if we simply look at the levels of income, as all the research does, we cannot distinguish between the two explanations. Mine about changes and everyone else’s about levels will look the same if we just look at those levels.

Fortunately, in a year or two, I think we’ll actually have a decent data set which will enable us to distinguish between the two explanations. Across the EU they’ve been asking the same “how happy are you?” questions for some years now. And the recent economic troubles have meant that people in different countries have been seeing very different economic fates over these last three years. In some countries GDP per capita has fallen 10, 15%. In others there was a small blip and the usual rise continued. Comparing the changes in happiness levels with the change in GDP, when these annual surveys become available, can thus be matched against each other and we should be able to see whether I’m right or, as is often the case, entirely wrong.

It wouldn’t surprise me (nor anyone else I would think) if Greek or Spanish satisfaction with life has declined in these past few years. Nor that German hasn’t changed much: and if those changes do accord with the changes in GDP then I might actually be correct. Happiness depends upon changes in income, not upon levels of it.

We’ll just have to wait a couple of years so that we can look at the information.