Wreckage By Leakage

Illustration by Angus Greig

The top 10% of India’s income holders held a share of 56.1% of India’s GDP as of 2019. The share of the top 1% of India’s income holders stood at 21.4% in the same year. This was considerably higher than the share of the bottom 50% of Indian income holders which then stood at 14.7%. Considering this evident divide, surely one can make a moral and an economic case for some sort of income redistribution from the richest of us to the poorest of us. The moral argument being, the famed lottery of birth, which states that no one chooses the circumstances they are born into, so people should not be held accountable to them. Thus, the consequences of this lottery are morally unfair and the state should intervene to limit these consequences, so that everyone has a fair shot at a fulfilling life regardless of where they come from. On the other hand, the economic argument takes into account the marginal utility of money (the amount of utility one derives from acquiring an additional unit of money) for the rich and the poor. If one was to stack the money someone like Jeff Bezos made in a year and the amount a daily wage worker made in a year, the marginal loss in utility for Mr. Bezos for losing the top 1000$ from his pile would be considerably lesser, compared to the marginal gain in utility for Mr. Daily Wage-Worker for acquiring that same 1000$. These arguments have been made time and again, by people across the political and social spectrum. Naturally, almost all the countries in the world have established some sort of a welfare system fuelled by this idea of income redistribution.

Having established that income redistribution is a widespread and all-pervasive idea for a fair society, I wish to introduce the not so popular trade-off that exists in this entire redistribution endeavour. Proposed by the economist Arthur Okun, in his seminal book, Equity and Efficiency: The Big trade off, the equity-efficiency trade-off forms the bedrock of redistribution analysis in economics. What this trade off says, is that the process of redistribution of the economic pie, results in the overall shrinkage of the same pie. Which means, if one wants to achieve a more equitable distribution of income in an economy, one will have to do so at the expense of reducing efficiency in the economy, inadvertently leading to a reduction in size of the overall economy. Okun explained that this loss in efficiency is attributable to three factors,

i. the incentive effect it has on the people receiving this income, ii. the incentive effect it has on the people from whom the money is taken away, iii. and also the administrative cost of transferring the money.

To illustrate these factors, let us work through an example.

The government has established that to survive in the country, it is necessary for an individual to earn at least 10k per month. This amount accounts for food, rent and other miscellaneous expenses an individual may have. If an individual earns anything less than 10k, the government will step in and provide the remaining amount, so that the take home pay at the end of the month is 10K. To fund this program, the government levies a marginal tax of 20% on every person earning more than 40K per month. Which means for every unit of money earned above 40k, the person will have to pay 20% of it in taxes.

(This is a highly simplistic illustration and I have tried my best to include all the possible important caveats. I thus, urge the reader to see that, the central arguments of the illustration still hold)

• Incentive effects on program beneficiaries (the people receiving this income).

If one was to look at it logically, a rational person earning anything less than 10k will just quit their job. There is simply no economic incentive for people in this group to work. At the end of the month, their take home pay is going to be 10k regardless of how much ever they make because the state will step in and provide the remaining amount. Furthermore, for people earning just above 10k, let’s say 11 or 12k, they too will quit. As for these people, it is simply not worth it to work when they can, not work at all to earn just a little less. Put in economic terms, the cost of working simply does not justify the very slight benefit (earning 11 or 12k instead of 10) they get from working.

Now of course, this is a highly simplistic explanation, that is in no way a complete picture of reality. There are certain other important factors that influence work decisions such as whether the individual has a family, the age group the individual belongs to, whether ‘the work’ itself is a fulfilling activity for the individual etc. Furthermore, many such cash transfer programs require individuals to stay in employment if they are to receive the benefits. It is also true, that an individual quitting may not be a bad idea, if that individual is a low skilled teenager who can now choose to study further, or a single parent working two jobs, who can now let go of the extra job to spend time at home. The loss of efficiency and economic output in these cases, are surely worth the equity consequences and possibly, may even be worth it economically in the long run.

• The incentive effect on the newly taxed (the people from whom the money is taken away)

Judging the reaction of those who are facing the taxes to fund this program, is a little more complicated. An individual from this group may feel like his real income has reduced and choose to work more to recuperate the lost income. In economic analysis, this is called the income effect. On the other hand, one might feel that the benefit of working that much extra to earn more than 40k per month has reduced, because the government is taking away a considerable chunk of it. An individual might just substitute that extra work, with not-work i.e., leisure, since the incentive to work and not consume leisure, has considerably reduced. This is called the substitution effect.

Standard economic analysis assumes that generally, out of the two effects, the substitution effect dominates. This implies that for the newly taxed people in our illustration, when the returns to labour (wages/salary) decreases, the incentive to work less and enjoy more leisure is more powerful than the incentive to work more because one’s income has reduced. This is a fair assumption to make, since the people who are newly taxed have incomes that easily provide for their family and maintain their lifestyle. Hence, when their real income is reduced due to the redistribution programme, the loss they feel for giving up work and not earning the same amount, is considerably lower than the gains in utility they will achieve by consuming more leisure.

Furthermore, Okun also explained that due to these disincentives caused by a higher marginal tax rate, the ultra rich also have an incentive to develop clever schemes to avoid taxes by spending on tax deductibles and looking for new tax shelters. “High tax rates,” wrote Okun, “are followed by attempts of ingenious men to beat them as surely as snow is followed by little boys on sleds.”

Moving on, there are important caveats to this too. The extent of the substitution effect will depend on how high above the tax threshold of 40k a particular individual operating at. There may be a case when one may even work harder, if they have a specific savings goal in mind. For example, an individual saving money for a new business may work harder to hit that savings target in a given amount of time. In this specific case, the income effect would clearly dominate the substitution effect.

• The Administrative Cost.

This is a more straightforward efficiency implication of a redistribution scheme. If one is mandated to take money from the rich and give it to the poor, one will need to be paid to do so. Usually the ‘one’ is the government, specifically the government bureaucracy. Considering the well documented, dismal record of governments throughout the world, to achieve results in an efficient low-cost manner, a considerable amount of money disappears before it reaches the supposed beneficiaries. It is to be noted that these administrative costs are highly variable from country to country, driven by factors such as the size of the bureaucracy and the red tape and also, the oversight capabilities (so as to keep corruption in check) of the administration and the nation’s institutions. This phenomenon is aptly illustrated in the paper, ‘Corruption and the Cost of Redistribution’, written by Benjamin Olken, professor of economics at MIT and a director at J-PAL. The paper, published in 2005 studied the disparities in rice distribution figures under the OPK, which was the then largest redistributive program in Indonesia. The paper found that in the most conservative estimate, the disparity between government figures and actual distribution figures was 17.8%. On an average, the intended beneficiaries received 82.2% of what the Indonesian government said that they received. These individuals were better off, but certainly not as much as they should have been.

Having established the equity-efficiency trade off as an important factor to consider in any redistribution scheme, I would urge the reader to think about whether they felt that this kind of straightjacket redistribution was still worth it? To aid this thought experiment, we shall use the leaky bucket analogy developed by Okun himself.

Let us assume that the process of redistribution involves quite literally taking the money from the rich, putting it in a bucket and giving it to the poor. As we explored above there are inherent inefficiencies in the process, which in this analogy are the leaks in the bucket. Suppose these leaks are minimal and the poor receive 95 cents for every dollar put in the bucket. I presume most of us would be happy with that. But now the leaks get bigger and bigger. At what point do you think you’ll stop this redistribution process, deeming it unworthy of our effort? Okun himself would stop at a 60% leak. There may be some, who would not tolerate any leak and thus believe that any redistribution scheme is not worth it at all. On the other extreme, there may be some who believe in the Rawlsian view of fairness. For them, as long as the poorest are better off it does not matter what the leak is. They would not hesitate if the poor received only 3 cents of every dollar put into the bucket.

Moving on, one must ask whether there exists real empirical evidence to suggest the existence of this tradeoff, especially in our day and age. As Okun’s paper was written in 1975, there have been various papers proving, as well as disproving the existence of this tradeoff. The widely popular book, ‘The Spirit Level: Why More Equal Societies Almost Always Do Better’ by Wilkinson & Pickett (2009) argues that striving for more equality will lead to more efficient outcomes in the economy. While the paper, ‘The big trade-off between efficiency and equity—is it there?’ by Anderson & Maibom (2019) refutes the idea and concludes that a tradeoff does exist for countries operating closer to their maximum efficiency levels. While for countries that are significantly below their maximum efficiency levels, there is a scope for improving efficiency as well as equity at the same time.

Heavyweights like Milton Friedman and Joseph Stigitz too have interesting opinions on the matter. Friedman argues that this tradeoff is very real and any effort to reduce inequality by the government will result in loss of efficiency. Exhibiting his trademark distrust of the government bureaucracy, he further argues that having reduced the efficiency in the economy for the sake of equity (by means of an income redistribution programme), the inefficient government cannot be trusted to even achieve any of those equity objectives! Joseph Stiglitz on the other hand, does not overtly refute the efficiency cost involved in the redistribution of income but argues that the costs are worth it, as the ramifications of inequality for our modern democracies far outweigh those redistribution costs.

As for me, I stand somewhere in the middle. I believe the lottery of birth is unfair and we must do all we can to limit the consequences of that lottery. But at the same time we must realise that when we demand the government to do so by means of welfare programs, we as part of the civil society must equally prioritise efficiency in the program’s processes. The morally virtuous welfare objectives do not by any means justify infinite costs resulting from mismanagement, corruption and orthodox government practices, as it is you and I, the taxpayer who will eventually have to bear these costs.

It is evident that this tradeoff incites spirited debate, research, and narrative (as displayed by my three line rant above) making the landscape of welfare policymaking that much deeper and richer. Having introduced the reader to this very important tradeoff and the lively debate around it, I hope it’s evident that when it comes to complex policymaking, one must come back to the age-old cliché, there are no solutions in economics, only trade-offs!