No Such Thing as a Free Lunch: Principles of Economics (Part 84)

“State ownership! It leads only to absurd and monstrous conclusions; state ownership means state monopoly, concentrated in the hands of one party and its adherents, and that state brings only ruin and bankruptcy to all.”

― Benito Mussolini

Income Distribution and Poverty (Part D)

by

Charles Lamson

The Redistribution Debate

Debates about the role of government in correcting for inequity and the distribution of income revolves around philosophical and practical issues. Philosophical issues deal with the "ideal." What should the distribution of income be if we could give it any shape we desired? What is "fair"? What is "just"? Practical issues deal with what is, and what is not, possible. Suppose we wanted zero poverty. How much would it cost, and what would we sacrifice? When we take wealth or income away from higher-income people and give it to lower-income people, do we destroy incentives? What are the effects of this kind of redistribution?

Policymakers must deal with both kinds of issues, but it seems logical to confront the philosophical issues first. If you do not know where you want to go, you cannot talk very well about how to get there or how much it costs. You may find that you do not want to go anywhere at all. Many respected economists and philosophers argue quite convincingly that the government should not redistribute income.

Arguments against Redistribution

Those who argue against government redistribution believe that the market, when left to operate on its own, is fair. This argument rests on the proposition that "one is entitled to the fruits of one's efforts." Remember that if market theory is correct, rewards paid in the market are linked to productivity. In other words, labor and capital are paid in accordance with the value of what they produce.

This view also holds that property income---income from land and capital---is no less justified than labor income. All factors of production have marginal products. Capital owners receive profits or interest because the capital they own is productive.

The argument against redistribution also rests on the principles behind "freedom of contract" and the protection of property rights. When I either agree to sell my labor or to commit my capital to use, I do so freely. In return I contract to receive payment, which becomes my "property." When a government taxes me and gives my income to someone else, that action violates these two basic rights.

The more common arguments against redistribution are not philosophical. Instead, they point to more practical problems. First, it is said that taxation and transfer programs interfere with the basic incentives provided by the market. Taxing higher income people reduces their incentive to work, save and invest. Taxing the "winners" of the economic game also discourages risk-taking. Furthermore, providing transfers to those at the bottom reduces their incentive to work as well. All of this leads to a reduction in total output that is the "cost" of redistribution.

Another practical argument against redistribution is that it does not work. Some critics see the rise in the poverty rate during the early 1980s and again in the early 1990s as an indication that antipoverty programs simply drain money without really helping the poor out of poverty. Whether or not these programs actually help people out of poverty, the charge of bureaucratic inefficiency in administration always exists. Social programs must be administered by people who must be paid. The Department of Health and Human Services employs over 120,000 people to run the Social Security system, process Medicaid claims, and so forth (Case & Fair, 2004). Some degree of waste and inefficiency is inevitable in any sizable bureaucracy.

Arguments in Favor of Redistribution

The argument most often used in favor of redistribution is that a society as wealthy as the United States has a moral obligation to provide all its members with the necessities of life. The Constitution does carry a guarantee of the "right to life." In declaring war on poverty in 1964, President Lyndon Johnson put it this way:

There will always be some Americans who are better off than others. But it need not follow that the "poor are always with us." . . . It is high time to redouble and to concentrate our efforts to eliminate poverty. . . . We know what must be done and this nation of abundance can surely afford to do it.

Many people, often through no fault of their own, find themselves left out. Some are born with mental or physical problems that severely limit their ability to "produce." Then, there are children. Even if some parents can be held accountable for their low incomes, do we want to punish innocent children for the faults of their parents and thus perpetuate the cycle of poverty? The elderly, without distribution of income, would have to rely exclusively on savings to survive once they retire, and many conditions can lead to inadequate savings. Should the victims of bad luck be doomed to inevitable poverty? Illness is perhaps the best example. The accumulated savings of very few can withstand the drain of extraordinary hospital and doctors' bills and the exorbitant cost of nursing home care.

Proponents of redistribution refute "practical" arguments against it by pointing to studies that show little negative effect on the incentives of those who benefit from transfer programs. For many---children, the elderly, the mentally ill---incentives are irrelevant, they say, and providing a basic income to most of the unemployed does not discourage them from working when they have the opportunity to do so. We now turn briefly to several more formal arguments.

Utilitarian Justice First put forth by the Englishmen Jeremy Bentham and John Stuart Mill in the late eighteenth and early nineteenth centuries, the essence of the utilitarian argument in favor of redistribution is that "a dollar in the hand of a rich person is worth less then a dollar in the hand of a poor person." The rich spend their marginal dollars on luxury goods. It is easy to spend over $100 per person for a meal in a good restaurant in New York or Los Angeles. The poor spend their marginal dollars on necessities---food, clothing, and medical care. If the marginal utility of income declines as income rises, the value of a dollar's worth of luxury goods is worth less than a dollar's worth of necessity. Thus, redistributing from the rich to the poor increases total utility. To put this notion of utilitarian justice in everyday language: Through income redistribution, the richest sacrifice a little and the poor gain a lot.

The utilitarian position is not without problems. People have very different tastes and preferences. Who is to say that you value a dollar more or less than I do? Because utility is unobservable and unmeasurable, comparisons between individuals cannot be easily made. Nonetheless, many people find the basic logic of the utilitarians persuasive.

Social Contract Theory---Rawlsian Justice The work of Harvard philosopher John Rawls has generated a great deal of contemporary discussion both within the discipline of economics and between economists and philosophers. In the tradition of Hobbes, Locke, and Rousseau, Rawls argues that, as members of society, we have a contract with one another. In the theoretical world that Rawls imagines, an original social contract is drawn up, and all parties agree to it without knowledge of who they are or who they will be in society. This condition is called the "original position" or the "state of nature." With no vested interests to protect, members of society are able to make disinterested choices.

As we approach the contract, everyone has a chance to end up very rich or homeless. On the assumption that we are all "risk-averse," Rawls believes that people will attach great importance to the position of the least fortunate members of society because anyone could end up there. Rawlsian Justice is argued from the assumption of risk aversion. Rawls concludes that any contract emerging from the original position would call for an income distribution that would "maximize the well-being of the worst-off member of society."

Any society bound by such a contract would allow for inequality, but only if that inequality had the effect of improving the lot of the very poor. If inequality provides an incentive for people to work hard and innovate, for example, those inequalities should be tolerated as long as some of the benefits go to those at the bottom.

The Works of Karl Marx For decades, a rivalry existed between the United States and the Soviet Union. At the heart of this rivalry was a fundamental philosophical difference of opinion about how economic systems work and how they should be managed. At the center of the debate were the writings of Karl Marx.

Marx did not write very much about socialism or communism. His major work, Das Kapital (published in the 19th century), was a three-volume analysis and critique of the capitalist system that he saw at work in the world around him. We know what Marx thought was wrong with capitalism, but he was not very clear about what would replace it. In one essay, late in his life, he wrote, "from each according to his ability, to each according to his needs," but he was not specific about the applications of this principle.

Marx's view of capital income does have important implications for income distribution. In the preceding posts, we discussed profit as a return to a productive factor: Capital, like labor, is productive and has a marginal product. However, Marx attributed all value to labor and none to capital. according to Marx's labor theory of value, the value of any commodity depends only on the amount of labor needed to produce it. The owners of capital are able to extract profit, or "surplus value," because labor creates more value in a day than it is paid for. Like any other good, labor power is worth only what it takes to "produce" it. In simple words, this means that under capitalism labor is paid a subsistence wage.

Marx saw profit as an illegitimate expropriation by capitalists of the fruits of labor's efforts. It follows that Marxians see the property income component of income distribution as the primary source of inequality in the United States today. Without capital income, the distribution of income would be much more equal.

Despite the fact that the Soviet Union no longer exists, Marxism remains a powerful force in the world. China, Vietnam, Cuba, and a number of other countries remain communist, and many believe that the Marxian critique of capitalism was correct even though one version of an alternative has failed.

Income Distribution as a Public Good Those who argue that the unfettered market produces a just income distribution do not believe private charity should be forbidden. Voluntary redistribution does not involve any violation of property rights by the state.

In part 77 of this analysis, however, you saw there may be a problem with private charity. Suppose people really do want to end the hunger problem. As they write out their checks to charity, they encounter the classic public goods problem. First, there are free riders. If hunger and starvation are eliminated, the benefits---even the merely psychological benefits---flow to everyone, whether they contributed or not. Second, any contribution is a drop in the bucket. One individual contribution is so small that it can have no real effect.

With private charity, as with national defense, nothing depends on whether I pay or not. Thus, private charity may fail for the same reason that the private sector is likely to fail to produce national defense and other public goods. People will find it in their interest not to contribute. Thus, we turn to government to provide things we want that will not be provided adequately if we act separately---in this case, help for the poor and hungry. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 341-344*

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