Success as Pollution: Layard Meets Coase

In his book and in this paper [pdf], Richard Layard points out that one's perceived position in the income distribution is a better predictor of self-reported well-being than one's absolute income level, given that a certain minimum income threshold has been reached. So, every time you move up in relative income, someone else moves down. This makes you happier, but makes everyone with a diminished relative position less happy, even though their absolute income has not changed, or may even have increased, but less than yours.
Layard interprets your gain in relative position as a straightforward negative externality — in the book he actually calls it “pollution” — and prescribes a straightforward Pigovian tax to minimize its harm. It is supposed that such a tax is not distorting, does not cause a loss of efficiency or create deadweight losses, because the externality was, in this case, caused by an oversupply of labor stimulated by the race for relative position. That is, the race for position causes an inefficiency, relative to the Benthamite standard, and the tax is merely corrective, bringing us to the amount of work that will create the greatest happiness. The loss of economic wealth is irrelevant, insofar as the excess wealth produced by the surplus in labor was not having a positive net hedonic effect.
Layard's argument entirely turns on whether it is correct to conceive of the your decline in reported subjective well-being as solely the result of my perceived “polluting” act of upward income mobility — whether your feeling bad when I do better is a true, normatively relevant negative externality. This is how he blithely dismisses an imagined libertarian challenge to his understanding of the issue:

Libertarians object to this whole line of argument on the grounds that it panders to envy. They do not apparently mind pandering to greed. We should of course try to educate people away from both envy and greed, since neither is conducive to happiness. But at the same time we should set our other policy instruments at whatever level is optimal for the state of mind which currently prevails.

Layard's argument here provides some evidence that Layard is not entirely ignorant of the revolution in thinking about externalities brought about by Ronald Coase's paradigm shattering “The Problem of Social Cost.” [pdf] Let's back into Coase by thinking about Layard's flip rebuttal to his imagined libertarian critic.
Layard recognizes the possibility of preference change — that people could become less envious or greedy — and this points to some kind of understanding of the essentially relational nature of an external effect. If you cared less about where you stood with respect to other people, then how much money I make would have less of an effect on how you feel about how much you make. This is Coase's central insight about externalities: it takes (at least) two to tango. My relative success has no “polluting” effect whatsoever if you don't care about it. (You're a good Buddhist, say.) The “pollution” is a joint product of my move up and your preference to not move down. The correct approach to the problem, if there is a problem at all, depends on what the lowest cost solution happens to be. If you changing your preference is cheaper than taxing me, then you ought to change your preference.
To which Layard replies, “. . .we should set our other policy instruments at whatever level is optimal for the state of mind which currently prevails.” This has to be incorrect, because the least cost solution to the putative externality problem may be a transition to a different prevailing state of mind. Furthermore, it seems clear that it may be morally obligatory to refuse to optimize relative the current state of mind, even if it expensive to move away from it.
Consider the Jim Crow American South, or apartheid South Africa. Suppose it was the case that any increase in income among blacks leads to a reduction in self-reported subjective well-being among whites, a reduction that totally swamps the utility gain to blacks. Suppose further that a reduction in income among blacks causes a increase in “happiness” among whites that totally swamps the utility loss to blacks. If “we should set our other policy instruments at whatever level is optimal for the state of mind which currently prevails,” then it is pretty obvious that an immiserating tax on blacks is optimal for the state of mind that prevails. Racist oppression is obligatory.
The Benthamite has two possible replies. (1) Yes, an immiserating racist tax is in fact optimal. This will produce the greatest amount of net happiness relative to the prevailing state of mind. (2) No, an immiserating racist tax is not optimal, because there is (a) an alternative (non-racist) set of preference profiles for members of the community which, if satisfied, would create a greater amount of net utility than the current set of (racist) profiles, (b) there is a feasible path from here to there, and (c) the utility gain of having arrived there will offset the utility loss of getting there.
If (1) is the reply, then we must reject Layard's Benthamism. Racist opression is wrong, i.e., morally impermissible. If a candidate normative standard implies that racist oppression is morally obligatory, is it clearly disqualified.
If (2) is the reply, then it is false that “we should set our other policy instruments at whatever level is optimal for the state of mind which currently prevails.”
Clearly (2) is the better answer for the Benthamite, because it at least preserves the possibility of remaining a Benthamite. But then Layard will be forced to take the Coasian least cost avoider principle seriously. As it happens, one of Layard's main points elsewhere is that preferences must not simply be treated as given, but must be understood as endogenously determined. Culture, media, the general structure of economic and social incentives, can shape our tastes or preferences, and these are subject to evaluation as well as our actions and policies. Layard argues that “good tastes are those which increase happiness, and vice versa,” and argues at length that many tastes, such as those that are induced by advertising, performance related pay, and general individualist cultural milieu, are not good tastes. So, clearly, Layard doesn't really think that we should optimize relative to prevailing preferences, because we may have bad ones. And this more or less guts the rejoinder to the libertarian. Why cater to relative preferences about income?
In the case of the immiserating racist tax, I would argue that the other-regarding preference that blacks be made worse off is morally impermissible simply as matter of justice and independent of hedonic consequences. Not only should it not be given weight when tallying up what is or is not an efficient policy, we morally must not give it weight. I would argue the same thing about the other-regarding preference about one's relative position in the income distribution. But, it turns out, it's unecessary to argue this, for the happiness data itself suggests that Layard's case for higher taxes might be pretty weak if he acknowledges Coase.
According to this fascinating paper by Alesina, Di Tella, and MacCulloch the negative effects of income inequality on happiness is far from written into the stars:

We find some intriguing results. First, Europeans and Americans report themselves less happy when inequality is high; however the effect of inequality on happiness is more precisely estimated for Europe. Second, aversion to inequality is concentrated amongst different ideological and income groups across the two regions. There is no clear ideological divide in the US concerning the effect of inequality on happiness. In contrast, those who define themselves leftist show a strong distaste for inequality in Europe, while those who define themselves rightists are unaffected by it. The breakdown of rich versus poor also shows some differences between Europe and the US. In Europe, the happiness of the poor is strongly negatively affected by inequality, while the effect on the rich is smaller in size and statistically insignificant. In the US one finds the opposite pattern, namely that the group whose happiness seems to be most adversely affected by inequality is the rich. A striking result is that the US poor seem totally unaffected by inequality. Any significance of the inequality coefficient in the US population is mainly driven by the rich.

Now, Alesina, et al. are measuring objective inequality (via state by state Gini coefficient) rather than perceived place in the distribution. But I think they at least establish that the relevant class of preference is highly contingent and likely quite malleable. For instance, they show that right-wingers care more about relative position than left-wingers. If more right-wingers became left-wingers, presumably the “pollution” of upward status moves would diminish. The authors conjecture that inequality has no significant negative effect on the American poor because they believe they can move up, while inequality has a significant negative effect on the rich because they believe they might move down. (So, when the NYT and WSJ and LAT are trying to convince us that there is less mobility than we think, they are contributing to the unhappiness of the poor, and the happiness of the rich.) Presumably, a change in belief about the importance of relative position would mitigate the effects of relative position (as well as mitigating the effects of inequality).
What the Benthamite need to know is whether on average one is more likely to be happier if one cares less about relative position. If so (and it seems plausible), then caring less about relative position may well be the least cost “solution” to the relative income externality “problem.” And that's even if we treat preferences about relative position as having normative weight, which we shouldn't. Also, insofar as the current rate and progressivity of taxation is politically driven by preferences about relative position, it may be that people who care too much about relative position are the ones imposing negative externalities — showering “pollution” — on people in the highest tax brackets. The rich therefore may be entitled to a preference shift that will result in tax cuts.
Richard Layard, meet Ronald Coase.