18 CHAPTER Taxation and Redistribution PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 18-2 Taxation and Redistribution  Over half the federal budget goes toward redistribution  Directly redistributive programs include:  Social security  Medicaid  Unemployment compensation

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 18-3 Principles of Taxation and Redistribution  Taxes pay for public sector output  Frequently, taxation and spending pursue income equality  Goal of redistributive programs  Use resources of some taxpayers to improve welfare of others

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 18-4 Equality as a Social Goal  Motivations underlying redistributive programs:  Create more income equality  Improve welfare of least well off  Redistributive programs targeted domestically

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 18-5 Equality of Opportunity and Equality of Results  Equal opportunity  Everyone starts with same chance  Desire for game with fair rules  Fair rules  Rules that can be agreed upon

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 18-6 Goal of Equality  Equality of opportunity is a normative goal  Many individuals feel that less than equitable results of opportunity warrant income redistribution policies

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 18-7 Utilitarian Justifications  Social Utility  Sum of individual utilities in a society  Maximize social utility  Transfer income from high to low income individuals  Social welfare function  Utility function for society as a whole  Admits possibility that it can be increased by income transfers

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 18-8 Utility Maximization of Those Least Well Off  Focuses on those at bottom of society  Recognizes disincentives toward earning income inherent in redistribution schemes  Suggests taxing high-income earners and redistributing to low-income earners until utility of person with lowest well-being maximized

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 18-9 Charity as a Collective Consumption Good  Will be underprovided if left to private sector  Charitable Giving as a Pareto Superior Move  Charity increases standard of living of less fortunate  Givers and recipients made better off

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Incentive to Free Ride  Charity has some characteristics of a public good  Potential givers have incentive to become free riders  Role of government to overcome free rider problem and provide optimal amount of redistribution

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Redistribution as Insurance  Acts as type of income insurance  Partially protects people from having low incomes  Premiums paid in high-income years exchanged for payments in low-income years

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Progressive Taxation and Wage Adjustment  Market adjustments to wage structure partially offset redistributive effects of taxation  More progressive tax structure raises pretax income of high-income workers  Lowers pretax income of low-income workers

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Progressive Taxation and Wage Adjustment

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Distributive Government  Shift of government spending toward redistributional programs  Increasing proportion of population dependent on government for their incomes  More worthwhile for special interests to lobby government

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Incentive Structure of Government Programs  Do government programs do what they are supposed to do?  Welfare programs provide incentives to remain unemployed  Programs create transitional gains  Abolishing programs results in transitional losses

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Incentive Structure of Government Programs A Price Floor

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Redistributive Programs and the Poor  Short run  Can reduce income of poor  Long run  More difficult to escape poverty

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Incentives to Earn Less Income  Redistributive income  Payments to lower-income individuals  Higher income tax rates for welfare recipients if benefits lost included in addition to taxes paid  Incentive structure encourages people to remain on welfare  May create poverty by creating permanent class of welfare recipients

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Hard-Core Poor and Marginal Poor  Hard-core poor  Poor because of injuries, disease, or disability  Marginal poor  Poor because of lack of education, pregnancy, economic downturn  In position to improve economic status  Goal of redistributive programs to help hard- core poor  Help marginal poor in the process

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Growing Dependency on Government Programs  Welfare dependency  Marginal poor who gradually become hard- core poor

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Politics of Redistribution  Redistribution programs becoming larger portion of government’s budget  Increases incentives for special interests to lobby government  Establishment of redistribution programs creates welfare industry

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Administrator Incentives  Bureaucrats have incentive to maximize budgets of their bureaus  Negative effect of government programs result of rational self-interests of government administrators  Political incentives can cause inefficient programs to be favored over potentially effective ones

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Goals of Redistribution  In 2000, a family of 4 would have received $87,000 if transfers equally divided among poorest 20% of citizens.  Why does poverty remain?

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe The Politics of Redistribution  Much income redistributed from middle incomes to middle incomes  Much redistribution not targeted specifically to needy  Redistribution programs subject to interest group pressure  Redistribution programs designed through political process