Synopsis: The problems with taxation as a means to redistribute income

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Discussion:

This article discusses the problems with redistribution as a means to reduce inequality, i.e. taxing the rich to give to the poor. In economics, this works theoretically, as giving money to the penniless who will spend it immediately should boost consumption and GDP. However, if done wrong, this can cause more harm than good.

In 1920, the English economist Author Cecil Pigou argued that shifting purchasing power to the poor will do little to dampen the spending habits of the rich, but will boost output as the poor will immediately spend the money on necessity goods.

The argument rests on the assumption that the poor would spend more if they had the means and the rich would smooth over their spending patterns. To investigate this assumptions, Messrs Kaplan and Weidner of Princeton University and Violante of New York University used large microeconomic datasets to see household income and wealth across eight different economies.

They looked for families that lacked a buffer of liquid assets to offset short-term changes in income. These families were the ones who would theoretically spend immediately from a government windfall.

Herein lies the problem: this “hand-to-mouth” term is not so straightforward – many American households may not have liquidated assets, but do have large illiquid ones.

One reason why people are so short on cash is because of the housing debt. In America, those with small mortgages live less hand-to-mouth than those with large ones.

Another reason why is due to age. The research shows that those around 40 years old are most likely to be cash strapped.

The findings show that “cash shortfalls affect behaviour”, in that those with high liquid wealth spend the least from an unexpected windfall, those living “hand-to-mouth” spend more, but it is those with lots of illiquid wealth but low income that spend the most. This links in with another study by Merrs Cloyne and Surico of Bank of Britons and London Business School respectively, which shows that “taxing those with illiquid assets could cause more of a fall in spending than previously expected”.

Yet another research paper shows that the assumption that the more a worker’s wages fall the more they support redistribution rises may not be true. In fact, support for redistribution has not changed, or has fallen, as inequality has risen.

One major culprit could be age – those under 40 follow the predicted pattern but those over 65 do not, perhaps because when the survey was first conducted in the 1970s the now-65-year-olds were more cash-strapped, but they are not any more. (More on why they are not cash strapped is explained under ‘Context’.) They fear that redistribution would cut health benefits.

Overall, these findings show a few things:

1) Stimulus packages should also be aimed at the wealthy, too;

2) Taxes on the wealthiest should be phased to allow them to liquidate their assets, and;

3) Politicians betting on the popularity of redistribution among voters should realize there may be great aversion from the retirees.

Context:

1) It is worth reading my other blog post about why not to tax the rich, although it has nothing to do explicitly with inequality. This can be found here.

2) Why is it that “the chances of being wealthy but cash-strapped peak around the age of 40”? This has to do with the life cycle. The original research paper can be found here. The life cycle is explained in the previous blog post, which can be found here.

3) One question that is not answered is why “the wealthy-but-income-constrained react most, spending 30% of any windfall, suggesting they are even more cash strapped”.

4) It is important to remember for the previous point that there may not be a symmetry between windfall gains and sudden taxes or losses of income, i.e. people may not spend as much when they have windfall gains than they save when they are taxed.

Synopsis: An analysis on the relationship between inequality and growth.

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Discussion:

This article aims to understand the relationship between inequality and growth better. In 1975 an American economist, Arthur Okun, stated that there was a trade-off between equality and efficiency.

Inequality is undoubtedly important, as, otherwise, the lure of large financial rewards, innovation and risky entrepreneurship would cease to exist. Nevertheless, inequality could hinder growth if “those with low incomes suffer poor health and low productivity as a result… [as well as threatening] public confidence in boosting policies like free trade”, according to the article. Government responses to inequality can also create a crisis; according to a 2010 book written by Raghuram Rajan, the Governor of the Reserve Bank of India (RBI), governments often respond to inequality by “easing the flow of credits to poorer households”. More about why this creates a crisis is explained in "Context".

Finding the exact relationship between inequality and growth can be challenging. While some studies suggest that inequality is just mildly bad for growth, others suggest that the nature of the relationship changes as poorer countries become richer. Still others say that, rather than the level of inequality, it is the trend in inequality that matters.

A research paper by IMF economists Messrs Andrew Berg and Jonathan Ostry in 2011 shows that perhaps it is the duration of growth spells that will give us the answer to the link between inequality and growth. They reckon that sustaining a growth spell is much harder than getting an economy growing. They also suggest that, according to the article, “when growth falters, inequality is often a culprit”.

Still others say that inequality is not a culprit but rather governments that tax and spend to try and reduce it. In another paper, Messrs Berg, Ostry and Charlambos Tsangarides analyse the separate effects of inequality and redistribution. They gather data about market income and net income in 173 economies. It is shown that in economies that redistribute heavily, their Gini coefficient is cut substantially. In economies that do not redistribute heavily, their Gini coefficient is cut considerably less. The paper shows that governments of more unequal countries redistribute more, and rich economies redistribute more than poor ones do.

While spreading wealth does not carry growth penalties – growth in income per person is not considerably less in countries with more redistribution – Messrs Berg, Ostry and Tsangarides suggest that redistribution may lead to shorter growth spells.

Inequality has more of a correlation with low growth, i.e. the higher the Gini coefficient, the lower the average annual growth. Therefore, redistribution that reduces inequality may boost growth.

Perhaps, the lesson to be learned is that reckless redistribution may harm growth, but sensible redistribution may help.

Key words:

On the chart labelled “A little off the top”, there are two words in the legend: net income and market income. Net income is income after tax and transfers. To see a precise definition of market income, read the glossary in this S&P article, which I will be analyzing in a blog post soon.

Context:

1. In the third paragraph, the author states how “governments often respond to inequality by easing the flow of credit to poorer households. When the borrowing binge ends everyone suffers.” In fact, this is one of the main reasons for the 2008 financial crisis that stemmed from the US. On this note, it is worth mentioning that allowing sub-prime lending (easing the flow of credit to poorer households) is actually a means of redistribution by the government.

2. To read the IMF paper by Messrs Berg, Ostry and Tsangarides, click here.

3. Arthur Okun, quoted in this article, is well known for Okun’s Law, which details the relationship between a country’s unemployment and production. The relationship he observed is inversely proportional: increases in unemployment lead to decreases in production. To read more about this on Investopedia, click here.