Why society has reason to bless the risk-takers

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The United States is often thought of as a country where people are prepared to take economic risks; without risk-takers capitalism is unlikely to work very well and so - the story goes - it is no accident that the most successful large economy in the world is one where the entrepreneurial spirit burns especially bright.

But just how bright is that? Recent research provides some fascinating answers to the question of just how much economic risk people in the US find acceptable. And these answers shed important light on the value of forms of social insurance and fiscal redistribution that cushion individuals against such risks.

First to the results. Four US economists recently conducted a survey of the attitudes to risk of over 11,000 adults*. The key question in their survey went like this: "Suppose that you are the only income-earner in the family, and you have a good job guaranteed to give you your current income every year for life. You are given the opportunity to take a new and equally good job, with a 50-50 chance that it will double your income and a 50-50 chance that it will cut your income by a third. Would you take the new job?"

Note one thing about this offer: on average, a move to this new job increases your income for the rest of your working life by 33 per cent. You might think this looks a pretty good gamble. If you did you would be in the minority in the US. Over 75 per cent of the sample surveyed would reject this opportunity. Even when the downside risk was reduced substantially, so that the worst outcome was a 20 per cent fall in income but the chance to double income remained the same, about two-thirds of the sample rejected the offer. Interestingly, there is not a big overall difference between the sexes in answers. But there are differences by religion; Jewish people were significantly more inclined to accept the risk than other groups.

Now if people are this risk-averse - and the survey is based on a very large sample - it suggests that the value of the social insurance created by welfare systems and by the redistribution in income caused by progressive taxation may be very large. This is a point often ignored by commentators on welfare and taxation.

The more common view is that the welfare system and redistributive taxation generate economic costs, in terms of diminished incentives, but that against this there is a strong moral case for helping the worst off. There is then a trade-off between economic efficiency and helping the disadvantaged.

Clearly there are lots of things right in this view - there are efficiency costs in very high taxation and in providing benefits at a level that makes the option of working unattractive to many, and there is also a strong moral case for helping the least well-off. So in certain cases the trade-off view is reasonable. But by implying that there is always and inevitably a trade-off between economic efficiency and helping the disadvantaged it ignores some powerful mechanisms working the other way; there are strong reasons to believe that many aspects of welfare and taxation encourage productivity and increase national output. And this has a lot to do with aversion to risk.

Consider again the results of the US research and think what those answers suggest about people's attitudes to further education or to training for a specific job. Spending time and money on further education or specialised training probably generates a high average return for most people but it is risky; there may be no job at the end of the training or the exams may turn out to be too hard. Suppose you have to finance the training yourself and if you do not make the grade and find no job the level of unemployment benefit is very low. Given a high degree of risk-aversion the option of a low-paid, but currently available and fairly safe, job may seem preferable.

From a social point of view this could be highly undesirable; if the returns to further training are as high as in the survey question and if the risks for individuals even out in aggregate then the case for encouraging people to take the gamble of investing in themselves becomes very strong. Two obvious ways to encourage such risk-taking are to subsidise education and to reduce the downside risk of poor after-training job prospects through income support and unemployment benefits.

The free-market counter to all this is simple: while risk-aversion means that forms of co-insurance are valuable it does not imply that the state should provide that insurance. In principle, this is a good reply but, in practice, in those areas where the effects of risk are likely to be greatest the provision of insurance by companies may be lacking.

Private insurance markets cannot be expected to work well when the insurer finds it hard to know what individual risks are and how hard individuals are trying to avoid them. Think again of the training examples; would one expect insurance companies to offer cover against failing exams or against future unemployment? Probably not: the chances are that the people who might buy such insurance are not a random sample of students but predominantly those who either know they may have problems or are not prepared to work to avoid them. Government provision of insurance to all - financed through taxation - cuts through this problem.

It may appear paradoxical to see part of the value of social insurance (or the tax/welfare system) as being a spur to entrepreneurship, efficiency and higher incomes. This may be because many of the highest profile people who are successful are keen to explain how they achieved their aims through hard work and talent rather than from help from the state. This should not blind one from the pretty obvious point that if there is insurance against some of the worst outcomes that could arise from taking a risk then more people will take risks. And it is the poor, or those from poor families, who are likely to be most put off risky investments in their own education or gambles in a risky enterprise which can have high pay- offs; the wealthy can afford to take more chances.

What we all lose from the reluctance of talented people to gamble is the greater wealth, on average, they would generate if they took risks; there are numerous ways in which that wealth accrues to society more widely and does not just go to the risk-taker. This way of thinking about some of the benefits of social insurance is hard-headed and calculating; it does not focus on need or on the pain of poverty but looks at lost opportunities for higher national output.

I make no excuses for this. The sooner we realise that there are strong grounds for supporting welfare spending and redistributive taxation purely on efficiency grounds the better. The proposition that efficiency losses generated by redistributive taxation and by welfare systems are inevitably a price to be paid for helping the disadvantaged is false.

David Miles is Professor of economics at Imperial College, University of London and an adviser to Merrill Lynch.

* "Preference Parameters and Behavioural Heterogeneity: An Experimental Approach in the Health and Retirement Survey", by Robert Barsky, Miles Kimball, Thomas Juster and Matthew Shapiro, National Bureau of Economic Research Working Paper number 5213, August 1995.

US individuals rejecting the move to a risky job

(50-50 chance of doubling income, 50-50 chance cutting income by one-third)

Proportion (%) of US individuals in each group rejecting the risk

All Males Females Protestant Catholic Jewish Other

76.2 75.2 76.9 76.2 73.1 69.5 75.9

Source: Barsky, Kimball, Juster and Shapiro

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