Drive an Escort, not a Ferrari, and be happy

Marek Kohn meets a man with a plan to get rid of the fat-cat factor

What makes owning a Ferrari so satisfying? Robert Frank, who seems to know his cars, suggests the "thunk" that the door makes as it closes.

Ferrari owners, however, might say the thunk is just evidence of the engineering quality they have paid such a lot to acquire. In other words, they would argue their satisfaction derives from the value of the car.

Classical economic theory would agree with them. And that, Frank argues, is where classical theory goes wrong.

If there were no Ferraris, and if Porsches were the most prestigious cars around, the rich would be just as happy with the thunk of a Porsche door. It is not so much the price that counts, but the fact that it is the most expensive, proving that they are at the top of the pile.

This simple insight, Frank believes, provides the answer to many of the problems of western society. If we can only grasp its implications, he says, most of us will be happier and better off.

The Professor of Economics, Ethics and Public Policy at Cornell University is in London with his latest big idea, contained in a new book, co-written with Philip Cook, called The Winner-Take-All Society. He is assured a hearing because a previous book, Passions Within Reason, was an acknowledged ground-breaker.

In that, he challenged traditional economic assumptions by arguing that irrationality often pays. In human situations, Frank said, excessively self-interested people who seemed to conform to rational rules often fared worse than those with an irrational commitment to abstract ideas of fairness.

The message of The Winner-Take-All Society is summed up in the subtitle: "How more and more Americans compete for ever fewer and bigger prizes, encouraging economic waste, income inequality, and an impoverished cultural life."

In person, Frank looks like a man who doesn't have to compete too hard: the polo shirt and chinos are comfortably rumpled, the physique is that of a man who plays squash but doesn't have to. No professorial grandeur either, but an infectious enthusiasm that helped win him a warm reception from both economists and evolutionary thinkers at a London School of Economics Darwin seminar last week.

The Winner-Take-All Society, like the earlier book, argues that if we accept that humans are more than rational beings, we can understand and organise ourselves better. In a "winner-take-all" market, a small difference in performance may lead to an astronomical difference in reward. Take competitive athletics: a fraction of a second may separate the winner and the runner-up in a race, yet it is only the winning athlete who collects the gold of the merchandising deals. In more and more walks of life, from fat-cat boardrooms to hospitals, these same winner-take-all rules apply.

Rewards depend not simply on how you perform, but on how you perform in relation to the next person, and the rewards at the top are disproportionately high.

This is all wasteful of both money and human effort. Instead of finding realistic and productive jobs that suit them - as engineers or teachers, say - many people rush to compete for positions in law or accountancy. They do so, in part, for the reason that leads 80 per cent of people to think they are better than average drivers. It seems to be human nature to overestimate our abilities.

Frank acknowledges this system has some benefits, but stresses its inefficiency: "We could get most of the gains at a fraction of the cost."

The solution he offers is a change in the tax system. We should be taxed, not according to how much we earn but on how much we spend. This tax, moreover, should be levied directly, via our tax returns, rather than indirectly through VAT. The taxable sum each year would be what's left after our savings and personal allowance have been deducted from our income.

The effect would be dramatic. We could avoid paying tax by saving; indeed we would gain income from the interest. More than that, a consumption tax would curb the "arms race" where people compete by out-consuming each other, and encourage savings that could be invested usefully and fruitfully. In short, Frank argues, his tax can "create resources virtually out of thin air".

If it's so simple, why has nobody suggested it before? Because, he says, conventional economists don't understand people, and this is where we return to the Ferrari owners. "The economic establishment doesn't acknowledge that satisfaction depends on position," he says. It assumes "that your satisfaction depends on how much you have in absolute terms".

In other words, conventional wisdom is that people like to own Ferraris because it proves they can afford them, but Frank says they merely want to prove they are higher up the pecking order than Porsche owners.

The conventional view underpins "fat cat" executive salaries in Britain and the US, but has failed to explain why chief executives in Germany and Japan, paid relatively far less than the fat cats, bother to turn up for work. According to Frank's theory, they are happy because they are still paid more than their nearest subordinates, and that is what counts.

The new tax system could solve the fat-cat problem by discouraging wasteful consumption. "The progressive consumption tax would generate a ripple effect all the way back down the economic totem pole," he says. "The Ferrari would drop off the table; the Porsche would fill its niche. What about the people who drove the 911? Well, they can now drive the Nissan 300ZX or the Toyota Supra Turbo... "

So you might not have quite such an expensive car, but you could still be sitting on the top of the pile. "You'd go from a $207,000 Ferrari to a $105,000 Porsche 911 Turbo, and with the tax, the Porsche would cost $30,000 or $40,000 less than the Ferrari still, so that's money you'd have left to put in your savings account."

But what would his tax mean for someone at the level where proposed tax thresholds tend to hover, on pounds 35,000 a year? "His tax wouldn't go up at all, really," Frank says, sounding like a politician for a moment. "But now that person is able to derive the same subjective satisfaction from owning a car that is cheaper than the car he now drives. The Ford Escort's going to have new lustre!"

Frank is certain that in the long run his system has no drawbacks, but he foresees someshort-term difficulties. He refers to "loss aversion", under which people will fight harder to avoid losing something than they will to gain something.

"Any time you make a proposal for a change in policy, you inevitably generate some winners and losers," says Frank. "The people that stand to lose in the short run dig in their heels and fight bitterly to oppose the change, whereas those who would benefit are happy about it, but don't work nearly as hard in favour of the change. You've really got to work hard to change anything ever."

But he says the proposal is "unassailable", and so must succeed. "Eventually some country will do this, and it will work, and others will copy it. We'll look back and say, 'How could we not have stumbled on to this earlier?'"

'The Winner-Take-All Society' is published by Free Press, pounds 16.99