December 29, 2013
Redistribution and the Well-Being of the Poor
Redistribution and the Well-Being of the Poor-Becker
Optimal tax theory in economics typically follows the approach pioneered by the English economist James Mirrlees, and has a trade off between efficiency and the redistribution of income that is said to represent "equity". This is often a useful framework to discuss redistribution, although it does not provide any easy answers about what is the "optimal" degree of redistribution. Without claiming to know what that optimal is, one conclusion is clear: while redistribution should be part of the optimal policy mix, it is not the most important problem facing the US economy.
When equality and redistribution are pushed too far, devastating effects on behavior occur. I saw this clearly on a visit to China in 1981, just as China slowly started its first reforms. I was invited to China to speak about how markets operated, but I asked to visit several factories in Beijing. Everyone at these factories basically received the same wage, and essentially could not be fired for absenteeism or low effort. The result of this was that no one worked very much, or invested in education, patterns that were common in rural as well as urban areas. The enormous reforms that then took place in China led to major increases in inequality along with record-breaking rates of economic growth. China's inequality is now comparable to that in the US, as measured by the Gini coefficient, a well-known measure of overall inequality.
Just as extreme equality would have enormous effects on behavior and efficiency, so too would extreme inequality, where a few families continued over time to control most of the wealth and income. In evaluating whether the US has too much inequality, a few facts are relevant. First is that the degree of inequality has grown rapidly since 1980, especially in the share of income going to persons in the top one percent of income, but also in the distribution of income among the remaining 99%.
At the lower end of the income distribution, real earnings of workers without a college education rose little since 1980, and may even have fallen, depending on the adjustment for changes in the price level. The gap between the earnings of persons with at least a college education and all others widened greatly during that period. The inequality between the earnings of men and women fell substantially, as women's education grew more rapidly than men's, and as the relative earnings of women of the same education as men also increased.
Despite this large growth in the gains from a college education, the fraction of young men who graduate from college did not increase by a lot during past 30 years. The big obstacle has been the high dropout rate from high school, which has only fallen modestly despite the large efforts being put into increasing the graduation rate. If completing high school could be given a large boost in an effective way, that would both reduce inequality of earnings and raise efficiency in the human capital investment process.
A highly disturbing fact is that a large fraction of young men are not at work, in school, or actively looking for work. For example, some one eighth of white men and one third of black men in their mid twenties to early thirties fall into this category, and much larger fractions of younger men do as well. Part of the reason is the low earnings of young men without much education or other skills that discourage them from looking for work. Another related reason is government welfare in the form of food stamps, unemployment compensation, medical coverage from Medicaid, and some rent subsidies when they do not work regularly.
These transfers are part of the already substantial amount of redistribution in the United States. A recent Congressional Budget Office study shows that the bottom quintile's income share rose from 2.3% of aggregate income to 9.3% after adjustment for transfer payments and federal taxes. Similarly, the top quintile's share of total income went down from about 58% to 47% after taxes and other adjustments.
In light of these facts, a small amount of further redistribution is unlikely to do much damage, but any significant amount would have negative consequences for efficiency of the economy. Lower income households would work less in order to qualify for welfare benefits, unless the redistribution to these households took the form of policies like the earned income tax credit (EITC) that subsidizes low-income earners. High income households would work less too, but probably more importantly, they would engage in additional efforts to hide income, invest abroad, shift to capital gains from regular income, and time their income receipts to reduce their tax burden.
The important point on efficiency is that the effect on the efficiency of the economy as taxes and subsidies rise does not increase linearly with the increase in taxes and subsidies, but increases at the square of these rates. Even a small increase in these rates would cause a big efficiency lose if it builds on a high tax or subsidy base.
The biggest problem for the American economy currently is not the level of redistribution, but the slow rate of growth because of depressed investments. Greater investment in technology and capital is a necessary ingredient of better growth. Some of these investments may reduce the demand for less skilled labor. This indicates that the best policies are those that increase investments and at the same time add to the earnings of lower income individuals and households. Greater investment in education and other human capital of those who do not invest a lot in themselves would be a prime way to do both.
Does Redistributing Income from Rich to Poor Increase or Reduce Economic Growth or Welfare? Posner
The United States spends heavily on redistributing income by taxing the affluent and using the revenues from taxation to support a variety of federal and state means-tested welfare programs, such as food stamps, Medicaid, social security disability benefits, and the Earned Income Tax Credit. And a number of other programs, such as social security retirement benefits, unemployment benefits, the minimum wage, Medicare, and subsidies for education, have a large redistributive component, though they are not means-tested. The aggregate annual amount of redistributive transfers is in the trillions of dollars.
Conservatives want to cut expenditures on such programs in order to limit taxation and the national debt and also to encourage work. Some of them agree with Mitt Romney, who famously in his unsuccessful 2012 presidential campaign described the lower half of the income distribution in the United States as composed of persons unwilling to take responsibility for their lives. (He issued a retraction.)
Despite redistribution, economic inequality in the United States has risen in recent decades. In 1982, the top 1 percent of American earners received 13 percent of total income; by 1997, this had increased to 17 percent; today the figure is 22 percent. The poorest 20 percent of U.S. households have only 5 percent of the nation's total personal income and the richest 20 percent have 50 percent. Between 1997 and 2008, median U.S. household income fell by 4 percent after adjustment for inflation, and between 2007 and 2011 it fell by 8.9 percent. A median is not an average; average income rose because the incomes of high earners rose--and so the effect was actually to increase inequality of income.
The trend of rising inequality appears to be attributable mainly to increasing returns to well-educated people as a consequence of a shift in the economy to methods of production and distribution that require application of knowledge and intelligence—in other words, the dramatic increase in automation as a result of the computer revolution—rather than strength or stamina, but to other factors as well, such as falling marginal income tax rates. The growth in automation is unlikely to stop or slow—in fact it seems likely to speed up—and so without substantial social intervention the trend of rising inequality is likely to continue. (The Affordable Care Act will have some redistributive effect, but how great a one cannot as yet be predicted.)
Rising inequality of income and wealth creates anxieties that can have dire economic consequences by increasing the demand for trade protection, restrictions on immigration, union protections, other anticompetitive measures, and government subsidies; it can also create class resentment, and thus lead to inefficient regulatory measures. The economist Raghuram Rajan speculates that increased inequality was an indirect cause of the financial meltdown of 2008 and the ensuing economic crisis.
Measures to reduce income inequality, especially measures that raise the median household income (as distinct from reducing inequality by leveling down the incomes of the well off, which could have serious disincentive effects), could increase economic efficiency by reducing political pressures for inefficient policies. That was the rationale for the adoption by capitalist nations of "socialist measures," beginning with Bismarck's programs of government health, accident and disability insurance, and old-age pensions—all designed to secure capitalism against communism and other radical political ideologies.
So let me consider the costs of increased redistribution from the top of the income distribution ladder to the bottom. I'll assume that the redistribution is financed by taxation, with higher tax revenues generated either by higher marginal rates or by reducing deductions and exemptions. So the national debt would not be increased. The social cost of the redistribution would be limited to reduced work effort.
But this involves a paradox: redistribution is challenged on the ground that it undermines the work ethic of both the rich and the poor—the reduction in the (after-tax) income of the rich, brought about by redistribution, causes them to work less but so, it is argued, does the* increase* in the income of the poor. Both groups, the argument goes, are incentivized to substitute leisure for work. Besides being contradictory, neither point seems powerful. It is not surprising that there is very little evidence that increasing marginal income tax rates reduces work effort. A person who responds to a fall in his (after-tax) income by working less compounds his loss of income. Leisure is unlikely to be a good substitute. High-income people who work hard tend to like both working hard and making money, and they are likely to be highly competitive, and want to keep abreast or ahead of their peers in money making. Furthermore, most high earners are employees rather than being self-employed, and few employees, even among the highly paid, have any job security. If they respond to a higher marginal tax rate by working less hard, they not only further reduce their net income and jeopardize their chances for generous bonuses and rapid advancement; they may well jeopardize their employment. Suppose a person who earns $250,000 before federal income tax pays $50,000 in tax, and now his tax bill is increased by 20 percent, to $60,000. Will he work less hard? That seems unlikely to me. I think if anything he's likely to work harder.
The more serious effect of higher marginal tax rates than the effect on the work ethic is the effect in inciting a search for loopholes, creating pressure for new loopholes as well and also shifting effort to activities that involve big tax breaks, including foreign investment. A better way to increase tax revenues than raising tax rates is tax reform that broadens the tax base by eliminating deductions and exemptions that serve no economic or other social purpose. The important thing from the standpoint of income redistribution is to increase tax revenues by one means or another.
At the bottom of the income distribution, there is a real reason for concern about the effects of redistribution on the work ethic: the incremental income from working may be negligible if the increment carries the recipient of benefits over the benefits threshold: he may lose in benefits all of or even more than his income increment from working. This effect is recognized, however, and can be eliminated or at least reduced by a graduated reduction in benefits, to assure that benefits fall by significantly less than the recipient's increased working income.
There is evidence that increasing the length of entitlement to unemployment benefits elongates job search by the unemployed. This is not necessarily a bad thing, because a longer search may result in a better job. Offsetting this is the risk that employers will worry that a job applicant who has not worked for many months will have lost skill and motivation—but knowing this, the unemployed will be reluctant to protract their period of unemployment by not looking for work vigorously. Notice too that curtailing unemployment benefits will push more unemployed workers to seek social security disability benefits, upping the cost to the taxpayer.
If, as I suspect, a modest increase in marginal tax rates (or diminished deductions or exemptions), with the revenues generated by the increase used to increase welfare benefits, would have few adverse effects on economic output, the reduction in economic inequality that would result would be cost-justified by the effect on the adverse socio-economic costs, listed earlier, of the current high level of income inequality in the United States.