Risk mitigation to reduce barriers to innovation broadly defined - 3 illustrative policies
Introducing the Stone Centre Working Group on Economic Dynamism and Distributive Justice
A dynamic economy hinges on people’s ability to harness our expanding knowledge, take risk, and innovate. In recent decades, such dynamism has been hampered by growing inequality in wealth distribution, and people’s increased insecurity about expected future income.
When this happens, the pool of potential innovators shrinks to those that are less risk averse - a minority of the population. This is how ‘innovation clubs’ are born, which aren’t only characterised by issues of wealth distribution or access to credit, but also ethnic minority exclusions, and geographical locations.
Is it possible to give greater economic decision-making power to the less wealthy so as to promote a more dynamic economy?
It is with this question on the agenda that the Stone Centre at UCL convened the Stone Centre at UCL Working Group on Economic Dynamism and Distributive Justice. The Working Group met in December 2022 and brought together experts that could shed light on this question from a variety of disciplines:
- Philippe Aghion (Harvard University), David Autor (MIT), Jan Eeckhout (UPF), Zoe Hitzig (Harvard University), John Van Reenen (LSE), Sam Bowles (Santa Fe Institute) and Wendy Carlin (UCL) for economics
- Petra Moser (NYU) for economic history
- Amy Kapczynski (Yale) for law
- Luis Bettencourt (University of Chicago) for ecology and evolution
The Stone Centre Working Group on Economic Dynamism and Distributive Justice. From left to right: Sam Bowles, Petra Moser, John Van Reenen, David Autor, Wendy Carlin, Luis Bettencourt, Philippe Aghion, Zoe Hitzig, Linda Wu, Jan Eeckhout, Alessandro Guarnieri, Thomas Lazarowicz, Amy Kapczynski.
Stone Scholar and Oxford PhD student Alessandro Guarnieri joined the working group during its first meeting. He reports on three illustrative policies the group discussed that could reduce barriers to innovation.
Risk-mitigation to reduce barriers to innovation broadly defined - 3 illustrative policies
A dynamic and innovating economy should not mean rising income and wealth inequality. This notion drives the agenda of the Stone Centre Working Group on Economic Dynamism and Distributive Justice. The Working Group brings together academics, early career researchers and PhD students to discuss and incubate research ideas around this theme.
At the Working Group’s first meeting in December, Phillipe Aghion (Collège de France and INSEAD) presented empirical evidence from Aghion et al. (2019) showing in state level data for the US that there is a positive correlation between social mobility and the number of patents per capita. While the income share of the top 1% increases with greater innovation, for the bottom 99% there is no correlation between the Gini index (i.e. the Gini coefficient once the top-1% of the income distribution is removed) and innovation intensity. This evidence, he argues, challenges the idea that a capitalist economy which generates prosperity through high innovativeness cannot also provide social insurance and support social mobility. In the context of the Working Groups objectives, the research question that naturally flows from Aghion’s evidence is what sort of policies can successfully democratize entrepreneurship and harness currently underutilized talent to promote innovation?
This question was picked up by the convenors of the Working Group, Sam Bowles and Wendy Carlin, who spoke of the importance of risk mitigation in reducing barriers to innovation. They note that the potential pool of innovators shrinks as risk aversion rises, and risk aversion increases with the growth of wealth inequality and greater insecurity about expected future income. The goal then is to design policies which mitigate the risk exposure of those with limited wealth. In particular, socially desirable risk insurance should come from the collective aggregation and distribution of risk, i.e. to combine the results from risk-taking among a larger community of innovators and share these through insurance policies.
Bowles and Carlin’s presentation aimed at building a common vocabulary/framework for discussing wealth inequality, insurance, and inheritance. Their model broadly defines innovation as any kind of productive risk-taking, which does not necessarily involve knowledge spill overs. The idea behind their definition is to bring the ability bear risk (as opposed to just exerting effort) into the equation for successful entrepreneurship. They identify and discuss three illustrative policies that would reduce the risk-exposure of the less well-off in society and support higher and more efficient levels of innovation.
Policy No. 1: Extending Domar and Musgrave (1944) - linear tax and lump-sum transfer
The first example builds on the work of Domar and Musgrave (1944), in the form of a linear tax and lump-sum transfer system that would reduce risk-exposure without affecting the returns to risk-taking.
In their framework, experienced risk and expected income are modelled as a ‘bad’ and a ‘good’. Figure 1 maps this out showing that increased exposure to risk requires increased compensation for bearing the risk. The risk-return schedule is drawn as an increasing and concave function to capture diminishing returns from risk-taking.
Figure 1. Optimal risk-taking.
The tax and lump-sum transfer system shifts the risk-return schedule to the left, reducing the level of risk exposure, which means in turn that at any given level of income, an individual’s optimal choice of risk has increased.
Under this policy, when preferences exhibit decreasing risk aversion, wealthier individuals undertake less innovation while the less well-off are more likely to engage. Since the proportion of households with incomes below the mean constitute the majority of the population, the proposed policy would unambiguously lead to a positive net increase in productive risk-taking.
Policy No. 2: Free tuition and a graduates' income tax as a form of insurance
The second example situates the funding of higher education within the same framework. It aims at mitigating the risk exposure associated with investing in higher education. While university education remains a strong predictor of higher expected future income, the direct cost associated with rising tuition fees (see Figure 2), coupled with the opportunity cost of forgoing earlier work opportunities, depresses overall investment below the ‘socially efficient’ level.
Figure 2. 20-year trend in average tuition fees among US universities. Source: U.S. News & World Report.
Bowles and Carlin propose to eliminate the immediate cost of higher education by subsidizing tuition fees as a way of promoting the public good. A graduates’ tax is then imposed which pays for the cost of education while substantially reducing the risk associated with the initial (one-off) investment.
Policy No. 3: Extending Shiller and Weiss (1999) - An incentive compatible home value insurance
The third proposed policy extends the work of Shiller and Weiss (1999) on insuring households against house price downturns. Home equity constitutes the single largest component of wealth for the majority of households (see Kuhn et al. (2018)). While owner-occupier real estate is generally considered a relatively safe investment (compared to the volatility of the stock market), the fact that housing makes up the largest asset in many households means capital loss from house price downturns can have a substantial impact on the household balance sheet.
In their paper, Shiller and Weiss propose an insurance policy which would “enable individuals to protect themselves against the risk of declines in the prices of their homes”. They identified two key problems with the policy:
- Economic Problem: (a) Designing an insurance scheme that does not diminish the commitment to maintain the upkeep of the property (‘moral hazard’). (b) Avoiding a skewed market, whereby households choosing to purchase insurance are an unrepresentative sample.
- Marketing Problem: making the policy attractive to homeowners.
One possible way of dealing with these problems is to offer insurance not on the change in price of an individual home but on the change in a real estate index for the neighbourhood. This would clearly eliminate the moral hazard problem. Since the policy also eliminates the need for monitoring homeowners’ behaviour, its expected implementation cost is also likely to be modest.
The Shiller and Weiss policy might also provide additional social benefits such as dampening house price bubbles and the disproportionate effect of house price collapses on low-wealth households. Bowles and Carlin cite examples of pilot insurance schemes which proved successful at raising demand for insurance including from existing owners.
Concluding remarks
Beyond the specificities of the above examples, the underlying message is the necessity to design policies which can mitigate people’s risk exposure as a strategy to democratize and improve innovation. Since those who face the largest risks are usually individuals from low-income and low-wealth backgrounds, such programmes would also succeed at increasing intergenerational mobility while stimulating economic growth as well as diversifying and providing more equitable access to the pool of innovators. As a result, people would welcome rather than fear a dynamic economy.
Bibliography
- Aghion, P., Akcigit, U., Bergeaud, A., Blundell, R. and Hemous, D. (2019), ‘Innovation and Top Income Inequality’, The Review of Economic Studies 86(1), 1-45
- Domar, E. D. and Musgrave, R. A. (1944), ‘Proportional Income Taxation and Risk-Taking’, The Quarterly Journal of Economics 58(3), 388-422
- Kuhn, M., Schularick, M. and Steins, U. L. (2018), ‘Income and wealth inequality in america, 1949–2016’, Journal of Political Economy 128(9), 3469–3519.
- Shiller, R. J. and Weiss, A. N. (1999), ‘Home equity insurance’, Journal of Real Estate Finance and Economics 19(1), 21-47
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