Chapter 7 Income Redistribution

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Chapter 7 Income Redistribution

• - Almost every action of the government results
  in a redistribution of income. For ex Some firms
  are asked to reduce pollution by government
  regulation. This causes them to hire less workers
  If these workers are low-income earners, than
  such environmental regulations may hurt the
  distribution of income.
• Income taxation is another, perhaps more
  relevant, form of income redistribution.
• But why does the government redistribute income
  at all?
• Remember the simple exchange economy of Chapter
  3, comprised of Adam and Eve exchanging apples
  with fig leaves.
• Assume that initially the agents start bargaining
  at some endowment g. Why should the government be
  interested in moving them to another endowment g
  and, as a consequence, to another point on the
  contract curve? Why is income inequality bad?
• The answers to these questions very from one
  person to another. Equity is a subjective matter.
  Even a statement like I care only about
  efficiency, not equity, is a value judgment
  within itself.
• A. Measuring Income Inequality
• - Lorenz curve gives information on the
  distribution of income.
• We first rank individuals from the lowest to the
  highest income brackets. We then calculate what
  percentage of the total income each income
  bracket has. For example, the richest 1 in US
  earns about 15 to 20 of total income.

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• When all brackets are done, we get the Lorenz
  curve.
• The diagonal line is the line of equal
  distribution.
• Gini coefficient is given by

Area A
Area B

• The Lorenz curve that corresponds to the official
  definition of income in 2001 US Census is
  depicted above. The data and the corresponding
  Gini coefficient is as follows.
• Income Quintiles
• Lowest Second Third Fourth Highest Gini
  index
• 3.5 8.8 14.5 23.1
  50.1 . 450

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• Another way of measuring income inequality is
  computing the number of people below the poverty
  line. In 2002, the poverty line for one person
  under 65 with no child was 9,359. In 2001 about
  10.1 of the general population between 18 64
  were below the poverty line.
• Though there seems to be a downward trend in
  poverty rates, inequality seems to be increasing
  in the US.
• In interpreting the US Census income data, keep
  in mind that only cash receipts are included.
  Other sources of income such as in-kind
  transfers, such as payments in commodities and
  services, are excluded from the computation of
  money income. All figures are before-taxes.
  Earned Income Tax Credit (EITC) transfers 31
  billion to low income households. These are
  ignored.
• B. Rationales for Redistribution
• Utilitarianism Consider the following additive
  social welfare function, W U1 U2 UN .
  What does this welfare function dictate about
  redistribution?
• To simplify matters, assume that a) all utility
  functions are identical and dependent only on
  income, b) the utility functions exhibit
  diminishing marginal utility, and c) total
  income is fixed.
• Then, W dictates that income be distributed
  equally. The reason is simple whenever income
  among two people are unequal, taking the income
  from the rich and giving it to the poor increases
  total welfare. Why? (Make sure to know this!!!!)
• This result is crucially dependent on the
  identical utility assumption. Also, the form of W
  is quite important.

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• Maximin Criterion In additive social welfare
  framework, if one unit of utility is taken from
  someone and given from someone else, W remains
  constant. This means that everybody is treated
  equally.
• Maximin emphasizes the role of the person with
  the lowest utility. The maximin social welfare is
  given by W minU1 ,U2 ,,UN .
• Then, the transfer of income is desirable from
  the societys point of view, as long it raises
  the welfare of the worst-off person.
• There are many problems with maximin criterion.
  For example, why should we accept a
  redistribution scheme that makes the worst-off
  slightly better while making the richest
  significantly worse-off? W would rise in such a
  case, but the policy is not very appealing.
• Pareto Efficient Income Redistribution Both of
  the previous welfare functions imply that
  redistribution may make some better off while
  others worse off. In other words, in the previous
  two views, redistribution does not necessarily
  lead to Pareto improvements.
• But what if by giving to the poor, the rich feels
  a warm glow, that makes them happier? In other
  words, what if the conditions of the poor enters
  the rich peoples welfare to render income
  redistribution a public good?
• If individuals are supposed to act by themselves,
  no or very little amount of giving will result.
  This is the usual inefficiency associated with
  free-riding.
• Then, by facilitating such voluntary actions by
  its coercive power, the government may ensure
  redistribution, which may indeed lead to Pareto
  efficiency.

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• C. Expenditure Incidence
• We now turn to the redistributive effects of
  actual government programs. What are the effects
  of a government policy that, say, subsidizes
  low-income housing? What are the effects on the
  distribution of income?
• If the subsidy causes a large number of poor
  people to demand more housing, then the
  (pre-subsidy) price of low-income housing may
  rise. Then, the subsidy will not benefit the poor
  to its full extent. Landlords will also gain. If
  the contractors, builders, etc. wages rise as a
  result of this increased demand, then these
  people will also gain.
• Various government policies may be valued
  differently by different income groups. One
  dollar spent on some public good is not valued as
  one dollar by everyone. For example, in some
  cases, in-kind transfers may sometimes lead to
  less value than their cost.
• Jones has to divide his monthly income of 300
  between cheese and other goods. Relative price of
  cheese is 2.

• In the figure on left, AB represents the budget
  constraint.
• Now assume that the government gives 60 lbs. of
  cheese to Jones, represented by the kinked budget
  constraint AFD line. Is this equivalent to 120
  of transfer, which would be represented by the HD
  line?
• The answer is no. The in-kind transfer of cheese
  carries him to the indifference curve U.
• However, if he rather got the cash, hed be
  sitting at a higher curve, U.