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The Theorist

From the November/December 2007 Issue

MIT’s Iván Werning uses theoretical models to find the best economic policies on estate taxes and unemployment insurance, writes CAREN CHESLER.

Ivan Werning_portraitEmpirical economics is fine for exploring things that have already happened. For example, you can look at the history of energy prices and determine how much of an increase forces consumers to reduce the heating of their homes. But Iván Werning is drawn to a different side of economics—the theoretical. Because he’s fascinated by public policy, he considers things that haven’t yet occurred.

“It’s good to understand things that are already happening,” he says, “but it’s only going to inform you about the policies that exist. I think the idea is to test different policies to determine what would be the best policy.” Werning, the son of a mathematician, was born and educated in Argentina, where he witnessed the devastating impact of economic disaster firsthand. He earned his Ph.D. in economics from the University of Chicago in 2002. So far, Werning, now a 33-year-old tenured economics professor at the Massachusetts Institute of Technology, has focused on estate taxes and unemployment insurance. With both, he’s shown why current policies are not necessarily best.

In his paper entitled “Inequality and Social Discounting,” written with Harvard University economist Emmanuel Farhi and published this past June in The Journal of Political Economy, Werning explores inequality and whether estate taxes should help mitigate it. If you’re born to rich parents, you’re more likely to be rich as an adult than if you are born to poor parents. Wealth gets passed on.

Previous studies have shown that the most efficient economic system causes inequality to grow. Policies that reduce inequality are believed to have a trade-off: If you punish people too much for doing well—by reducing their incentives to pass on wealth to their children—these people will reduce their effort, to the detriment of the economy as a whole. But allowing inequality to increase concentrates the world’s wealth into fewer and fewer hands.

Werning found that the models at the core of these judgments were incomplete. Allowing inequality to grow, unfettered, is economically optimal only if one looks at just the first generation. But if you take into account the children of first-generation parents, and their children’s children, then the most preferable system is not one that allows inequality to grow, but one that attempts to stabilize the distribution of wealth.

His paper shows that the transmission of wealth should be regulated to prevent an accumulation of luck—that children should essentially be insured against the family into which they are born.

In a follow-up paper, entitled “Progressive Estate Taxation,” also written with Farhi, Werning discovered that the best approach would be to encourage parents to leave bequests to their children, and that government should, through subsidies, help the poor pass on money to their heirs.

He found that subsidies to the less well-off, not taxes on the rich, were the best incentives for reducing inequality.

Werning and Fahri found that these subsidies to the less well-off, not taxes on the rich, were the best incentives for reducing inequality. “Current policy is definitely on the side of taxing and not subsidizing. Our model doesn’t necessarily lead you to that conclusion,” Werning said.

In his work on unemployment insurance, Werning, writing with Robert Shimer of the University of Chicago, tried to determine the optimal level and duration of benefits. In “Liquidity and Insurance for the Unemployed,” the authors concluded that benefits should not run out if a person remains unemployed. Under current policy, benefits end after six months.

Most economists believe workers should not be paid so much that they would rather remain unemployed. They grapple with how large benefits should be and for how long workers should receive them. These economists worry about “moral hazard:” the tendency of insurance to encourage the behavior that is insured against.

One frequently cited study by economists Lawrence Katz and Bruce Meyer showed that if the duration of benefits in the United States were extended from six months to a year, workers would remain unemployed for four to five weeks longer.

“The prevailing logic was simple: you want to reward those who find work early relative to those who find work late,” Werning said.

Werning’s unemployment study is unique—and reached a different conclusion—because he broke down the factors facing the unemployed into two parts: First, the unemployment subsidy itself (the check people get when they’re out of a job). Second, the consumption patterns of the unemployed (Do they continue to eat steak dinners? Do they buy new cars?). Werning found that the unemployed naturally reduce their consumption over time, even if you keep sending them checks. This finding contradicts the belief that you have to stop benefits in order to make people feel a hardship.

The setups that Werning writes are always very parsimonious, says Farhi, and there’s a great rigor in the analysis, with an emphasis on getting the deep economic intuition right. “With Iván, there’s always a very central question, a very central tradeoff, and he distills it into very sharp results.”

Caren Chesler is a writer based in New York.

Image credit: photo by Bill O’Connell.

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