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Income Inequality and Wealth Redistribution
May20, 2013
Announcements
• Homework due Wednesday (May 22).
• New Homework posted to website before next class, due the following Wednesday (May 29).
Last Class
• Human capital theory of marginal value of labor to production
• Imperfections in wage determination– Unions
– Discrimination
– Wage differentials
• Both free-market principles and imperfections determine wages.
Learning Goals for Today
• Summarize the trends in US income inequality since 1980.
• Substantiate the argument underlying John Rawls’s ``Veil of Ignorance.’’
• Describe three methods of income redistribution.
– Argue why one (which?) is better than the other two, and why.
Trends in InequalityMedian Income by Quintile for US
(2009 dollars)
Quantile 1980 1990 2000 2009
Bottom 20% 15,889 15,643 17,590 15,289
Second 20% 34,588 36,488 40,218 37,045
Middle 20% 52,251 56,194 63,208 59,907
Fourth 20% 72,492 80,813 93,156 90,962
Top 20% 122,054 150,188 195,451 189,486
Top 5% 173,510 235,652 346,342 325,023
Trends in Inequality After 1980
Source: Inequality.org
Trends in Inequality Prior to 1980
Source: Inequality.org
Recent Trends in Inequality
• In 1980, CEOs earned 42 times the salary of average the worker.
• In 2000, CEOs earned more than 500 times the salary of the average worker.
• Dick Fuld (CEO of Lehman Brothers circa 2008) had a three-story car garage with a car elevator.
What About After Taxes?
Source: Inequality.org
What About Income Mobility?
• Some people argue that income inequality is not a problem in the United States because of the high degree of economic mobility across generations.
• US income mobility across generations is low and there’s no evidence that it’s increasing.
Correlations in the Earnings of Fathers and Sons
Country Correlation
United States .41-.54
Sweden .14
Canada .17-.19
Finland .22
Germany .10-.36
Malaysia .33-.37
Source: Bjorkland and Jantti, 2000
John Rawls and the Veil of Ignorance
• The "right" income distribution is a normative matter.
• Rawls proposed a "fair" income distribution is one that people would accept before they know their position in the distribution
– Equality of distribution is favored by anyone who is risk averse.
– Strong disincentive to investing in human capital, taking risk, working hard.
• Less liberal slant: See Robert Nozick, Anarchy, State, and Utopia (free market perspective on “fairness.”)
Acceptable Income Distributions
• If income is distributed equally, total output is smaller than in a country with earnings incentives.
• Rawls argued that inequality would be acceptable if it increases total output by "enough”.
• Rawls also argued that market systems produce more inequality than acceptable
– Fairness requires some attempt to reduce income inequality produced by the market
The Challenge of Income Redistribution
• Raising incomes of the needy reduce incentives to work and make prudent decisions.
– Difficulty distinguishing between needy and others
• Example: Hurricane victims
• No perfect solution
– Choose among imperfect alternatives
Methods of Redistributing Income
• There is substantial and growing income inequality in the United States.
• The problem is that redistribution can lead to inefficient outcomes.
• Methods for redistributing income
– How does each work?
– What are the costs and benefits of each?
In-kind Transfers and Cash Transfers
• In-kind transfers: direct transfers of goods or services
– Food stamps
– Medicaid
– Public housing
– Free schools lunches
• Cash transfers: direct transfers of cash (“welfare”).
– AFDC (60’s-1996)
– TANF (1996-present)
Aid to Families with Dependent Children (AFDC)
• AFDC: Aid to Families with Dependent Children
– Targeted to single-parent families
– Provided monthly benefits that depended on family size and family income
– Administered by the Federal government
• Potential problems
– Discourages marriage.
– Creates a work disincentive.
– Fear that people would become “dependent” on AFDC.
Temporary Assistance to Needy Families (TANF)
• Created as part of the Personal Responsibility and Work Opportunity Act of 1996 (PRWORA)
– Replaced AFDC with TANF
– Provided cash grants from federal government to states
– States determine details of how policy implemented
– Five-year lifetime limit on benefits for each recipient
• Some evidence that it has reduced welfare rolls.
• May aggravate the condition of the poorest during economic recessions
Means-Tested Benefit Programs
• A means-tested program:– A benefit program whose benefit level declines as the recipient earns
additional income. The intention is to avoid paying benefits to those who can support themselves.
• Administrative structure discourages work
– If benefits are reduced by $1 for each $2 earned, participants in multiple programs may lose more benefits than the income they earn.
• Administrative costs are high
– Extremely expensive to administer.
The Negative Income Tax (NIT)
• Negative income tax:– a system under which the government would grant each citizen a cash
payment each year, financed by a tax on earned income.
• With NIT, low income families receive a cash transfer while high income families pay tax.
• Family with no income would receive the federal poverty threshold
The Negative Income Tax (NIT)
After-Tax Income
Pre-Tax Income
No Taxes
NIT
tax
transfer
$5,000
$5,000 for everyone, tax=10%
$50,000
Negative Income Tax
• Advantages
– Incentive to work is greater than with current mean-tested programs because people are guaranteed to keep at least some portion of what they earn.
– Lower administrative cost because a single program administered through IRS.
• Disadvantages
– Creates an incentive to not work because the NIT guarantees income to all who do not work.
– The political cost is high.
Minimum Wages
W0
L0Employment
Wage ($/hour)
S
D
Minimum Wages
W0
L0Employment
Wage ($/hour)
S
D
unemployed
Minimum Wages
• Effect on total earnings (w*L) is ambiguous because wages increase but employment falls. Whether total earnings increase or decrease will depend on the elasticity of demand for labor.
• Studies show little effect of minimum wage on employment, and if so the loss in total surplus may be small.
L (work-hours/day)
W (
$/h
ou
r)
S
D
10
5,000
5
0
No Minimum Wage
Minimum Wages and Total Surplus
L (work-hours/day)
S
W (
$/h
ou
r)D
5,000
5
10
0
Minimum Wage ($7)
3
3,000
7
L (work-hours/day)
W (
$/h
ou
r)
S
D
10
5,000
5
0
No Minimum Wage
Minimum Wages and Total Surplus
L (work-hours/day)
S
W (
$/h
ou
r)D
5,000
5
10
0
Minimum Wage ($7)
3
3,000
7
Consumer Surplus
L (work-hours/day)
W (
$/h
ou
r)
S
D
10
5,000
5
0
No Minimum Wage
Minimum Wages and Total Surplus
L (work-hours/day)
S
W (
$/h
ou
r)D
5,000
5
10
0
Minimum Wage ($7)
3
3,000
7
Producer Surplus
L (work-hours/day)
W (
$/h
ou
r)
S
D
10
5,000
5
0
No Minimum Wage
Minimum Wages and Total Surplus
L (work-hours/day)
S
W (
$/h
ou
r)D
5,000
5
10
0
Minimum Wage ($7)
3
3,000
7
Deadweight Loss
Earned Income Tax Credit (EITC)
• Clearly, minimum wage increases CS, but decreases TS=CS+PS through decreasing PS.
• An EITC directly transfers cash from employers to workers.
• The form of a rebate on tax return to laborers.
EITC Is a Better Option
• Without minimum wageconsumer surplus is $12,500/day.
• Minimum wage increases this to $16,500/day.
• Goal: bring worker surplus to $16,500/day using EITC
– Introduce an earned-income tax credit of $0.80/hr for 5,000 person hours/day (total of $4000).
– Finance with a $4000/day tax on employers.
• Efficient
– Worker surplus
– Firm surplus
– Both at least as well off as under a minimum wage
Public Employment for the Poor
• Overcomes the shortcomings of the EITC and NIT
– EITC does not help the unemployed
– NIT reduces the incentive to work
• Problems
– “Make-work” programs are not productive
– Increases government bureaucracy
A Combination of Methods• No single method is perfect.
• In reality, we have a combination of programs.
• The social safety net in the United States is complex—Food stamps, TANF, EITC, minimum wage, SSI (disability), Medicaid, etc.
Federal Government Outlays, 2011Billions of
Current Dollars % of Total
National Defense 705.6 19.6%
Individual Payments 2,345.6 65.1%
Social Security 730.6 20.3%
Federal Employees Retirement 181.4 5.0%
Unemployment Insurance 118.6 3.3%
Medicare, Medicaid & Other Medical 913.0 25.3%
Assistance to Students 58.6 1.6%
Housing Assistance 45.9 1.3%
Food Stamps and Other Food Assistance 103.1 2.9%
Public Assistance 188.4 5.2%
SSI 49.6 1.4%
TANF 21.3 0.6%
EITC 55.7 1.5%
Other Public Assistance 61.8 1.7%
Other Individual Payments 6.0 0.2%
Other 551.9 15.3%
TOTAL OUTLAYS 3,603.1 100.0%
