# Microeconomics: Theory Through Applications, v. 1.0

by Russell Cooper and A. Andrew John

## 12.4 Government Policy

### Learning Objectives

1. What actions does the government take to influence the distributions of income, wealth, and consumption?
2. What is the rationale for these government interventions?
3. What limits the effects of government redistribution?

Governments play a significant role in the distribution of income, consumption, and wealth. The argument for government intervention usually takes the form that the market outcome is too inequitable, relative to, for example, a Rawlsian view. We now look at various forms of redistribution through government actions, paying particular attention to their effects on incentives.

## Incentives

Redistribution is more than setting taxesA payment made to the government that is associated with an economic transaction. and transfer paymentsA payment from the government to an individual or firm. to give money from one person to another. The problem is that redistribution can affect people’s incentives in various ways.

## The Incentive to Be Truthful

Go back once more to our chocolate bar economy. We proposed a scheme whereby high-ability individuals would be taxed 25 chocolate bars, with this being paid to low-ability individuals. A tax-and-transfer scheme of this kind would allow us to achieve the equitable outcome mandated by the Rawlsian or Marxian view.

Low-ability households evidently have an incentive to participate in this scheme: they give up 50 bars and get back 75 bars. The redistribution is in their favor. The story is different for high-ability people. They give up 100 bars and get 75. Before abilities are known, everyone likes this social contract. But once ability is known, high-ability people prefer not to participate. If they can produce and then hide some of their chocolate bars, they have an incentive to

• produce 100 chocolate bars,
• pretend to be a low-ability person and declare production of 50 bars, and
• take the transfer of 25 bars and consume 125 chocolate bars.

High-ability people can get away with this if chocolate bar production cannot be monitored. They have an incentive to rip off the system by pretending to be low ability. Because all high-ability people behave this way, the contract will fail: no one will pay taxes, and everyone will demand a transfer.

In this extreme example, the incentive problem completely destroys the redistribution policy. In reality, there is some redistribution through taxes and transfers because the government, acting through the taxation authority, is able to tax households at different rates: low-income households face lower tax rates than higher income households. In addition, low-income households receive transfers from the government. Governments can carry out such policies because they have access to information about the income households earn. Yet incentive problems like the one we have outlined pose very real difficulties for governments. Rich people have an incentive to hide their true income and do so through legal and illegal means. For example, a recent story in the New York Times began as follows: “In the wealthy, northern suburbs of [Athens, Greece], where summer temperatures often hit the high 90s, just 324 residents checked the box on their tax returns admitting that they owned pools. So tax investigators studied satellite photos of the area—a sprawling collection of expensive villas tucked behind tall gates—and came back with a decidedly different number: 16,974 pools.”See Suzanne Daley, “Greek Wealth Is Everywhere but Tax Forms,” New York Times, May 1, 2010, accessed January 30, 2011, http://www.nytimes.com/2010/05/02/world/europe/02evasion.html?hp.

## The Incentive to Work

As the real return to working increases, households will generally work more. Labor supply is upward sloping: increases in the real wage lead to more people participating in the labor market and individuals’ choosing to work more hours. Households care about the real wage after taxes—that is, they decide how much to work based on the wage they receive after paying tax. Everything else being the same, an increase in the tax rate on labor income reduces the real wage received by households, and they will work less in response.

Contrast high-ability and low-ability workers. High-ability workers are more productive. From society’s point of view, it is better for them to work more. But if tax rates are higher for higher-income people, then these people will have an incentive to work less, so total output for the economy will be lower. This lost output is the efficiency loss from the progressive tax system.

## The Incentive to Train

Redistribution can also affect the incentive to study and acquire additional skills. Once again, we use our chocolate bar example. We still have two types of individuals: high ability and low ability. Which type you are when you are born is completely beyond your control; it is just a matter of luck. But the actions you take, given your ability, are something you control.

Suppose that high-ability people can only produce 100 chocolate bars if they first go through some training. Further, assume that this training is not fun: everything else being the same, people would prefer not to spend time training. Instead, they would prefer to use their leisure time in other ways. Under the social contract, the efficient way to organize society would be for high-ability people to incur the cost of training to produce more output.

If the tax-and-transfer system completely equalizes incomes, however, high-ability people will not think it worthwhile to train. This highlights a problem with the Marxian view of “from each according to his ability, to each according to his needs.” The incentives needed to induce people to produce according to their ability may be inconsistent with allocating goods according to need.

Assuming that a little inequality is better than a lot of lost chocolate bars, the social contract needs to be amended to create an incentive for high-ability people to train. The solution is to give them some extra chocolate bars as an inducement to train and thus produce more for society. The result is inequality in consumption.

## The Leaky Bucket

The incentive problems that we have discussed so far result in an equity-efficiency trade-offTrade-off that arises when policies that deliver a more equitable distribution of resources also generate deadweight loss.. Arthur Okun, a famous economist in the 1960s, proposed a very useful thought experiment for thinking about such trade-offs. He imagined that redistribution from the rich to the poor is like carrying a bucket of water from one person to another. Unfortunately, the bucket leaks. So the process of transferring water from one person to another also means that there is less total water available.

At one extreme, if the bucket does not leak, then there is no trade-off. You can redistribute water evenly in society without any loss in efficiency. At the other extreme, all the water gets lost in the transfer. The only way to achieve equality in this society is simply by destroying the wealth of the rich. Okun invited his readers to contemplate how much leakage they would be willing to tolerate to make society more equal. If you are in favor of a more equal society, then you too should think about the extent to which you think it is worth sacrificing some of our output to share the rest out more equally.

## The Inheritance Tax

At the beginning of this chapter, we listed the wealthiest people in the United States in 2006 and 2010. Do you think that 50 years from now, the families of these people will appear on the Forbes list of the wealthiest people in the United States in 2060? The answer to this question partially depends on the choices of these wealthy people: how much of an estate will they decide to leave to their families? It also depends on how much of the estate the government will tax.

When we talked earlier about the dynamics of inequality, we noted that there were links across generations of a family. Some of those links come directly from expenditures on children. Everything else being the same, richer families have more income to spend on their children’s education, and thus their children are likely to be more productive. The transfer of wealth is a second link that leads income (earned on financial investments) to be higher for children of wealthier families.

According to the current tax code in the United States, the tax rate applied to an estate appears to be progressive, with higher tax rates levied on larger estates. But there is an exclusion of $5 million, and only estates above this level are taxed at a 35 percent tax rate. So if you were left an estate valued at$6 million, you would pay a tax of $350,000 (= 0.35 × [$6,000,000 − $5,000,000]). Not surprisingly, the inheritance tax is hotly debated. Opponents of the tax argue that individuals ought to have the right to spend their lifetime income on whatever they want, including their children. Proponents of the tax see it as a way to increase mobility within the wealth distribution and argue that it promotes equality of opportunity. ## Transfers The government redistributes across households using taxes and transfers. This redistribution is reflected in the difference between the Gini coefficient for market income and postinsurance income in Table 12.3 "Household Income by Quintile". Transfers arise through unemployment insurance payments to unemployed workers, government-financed health care to the poor and the elderly, and other government schemes.Chapter 15 "A Healthy Economy" returns to the topic of government transfers associated with health care. Transfers, like taxes, can affect incentives. Suppose the government makes transfers of$100 to everyone in the economy with income less than or equal to $1,000. Think about an individual who works 40 hours at a wage of$25 per hour to earn a weekly income of $1,000. What are the gains to working 41 hours? If the individual works an hour more, then her income (before taxes and transfers) will increase by$25 to $1,025. But by working an extra hour, she no longer qualifies for the transfer of$100. So she would lose $100 in transfers: the extra hour’s work would reduce her income by$75.

Not all transfers are public; some are private. Many of the wealthiest people in the world are also some of the most generous in terms of setting up private foundations. For example, the Bill and Melinda Gates Foundation (http://www.gatesfoundation.org/Pages/home.aspx) was created in 2000 “to help reduce inequities in the United States and around the world.” The reported value of the trust endowment is $34.6 billion, which includes$1.6 billion from Warren Buffett, the number two person on the 2006 and 2010 Forbes lists. Another common form of private transfers comes from tuition reductions from private universities. As a leading example, Princeton University replaced student loans, which had to be repaid, with outright grants to qualified students. Other universities provide both grants and subsidized loans.

### Key Takeaways

• Governments use a variety of tools, such as income taxes and inheritance taxes, to influence the distributions of income and wealth.
• Governments are motivated by the view that market outcomes are not equitable enough.
• Actions to redistribute are limited by the adverse incentives created by taxes and transfers.