October 3, 2017/IMF
Prepared by Vitor Gaspar, Paolo Mauro, and Tigran
Poghosyan
INTRODUCTION
Public discourse on inequality has become more prominent in recent years, rekindling interest in methods to assess the implications of policies not only for total economic output but also for its distribution. Against this background, it is worth re-emphasizing some lessons from the “old masters” in economics who addressed this topic a few decades ago—including Arthur M. Okun and Anthony B. Atkinson in the 1970s. Their lessons—on how to elicit people’s views on inequality and how to summarize societal welfare using a monetary indicator encompassing both average incomes and their distribution—remain relevant for fiscal policymakers today. As emphasized by Pigou (1920) in the quote above and De Graaff (1957), a satisfactory theory of welfare must recognize that welfare depends on both the size and the distribution of national income. Indeed, an intuitively appealing, single indicator combining both efficiency and equity considerations may be used not only to gauge the wellbeing of countries but also to rank different policies. This primer summarizes the old masters’ contributions and applies them to recent data on income distribution for a large sample of countries.
Although the theory of welfare is a mature, well-developed field in academia, its practical application is not commensurately frequent or systematic. This primer seeks to encourage more widespread use by policymakers of the tools developed by welfare theory. Rather than attempting a comprehensive review of the plethora of methods to elicit people’s attitudes toward income redistribution and to conduct analysis based on social welfare functions, the primer provides an in-depth, step-by-step refresher on two specific tools chosen because of their simplicity and intuitive appeal: Okun’s “leaky bucket” and Atkinson’s “equallydistributed-equivalent income.” By doing so, it illustrates both the potential benefits of systematic welfare analysis and the types of assumptions needed to undertake it. The next section outlines a few seminal contributions by influential economists of the past to the analytical methods for the joint assessment of equality and efficiency. Section III presents empirical illustrations based on recent data for a panel of countries and calibration of the impact of a hypothetical tax-and-transfer scheme in a general equilibrium setup. The last section concludes.
THE “OLD MASTERS” ON ASSESSING EQUITY AND EFFICIENCY
A joint assessment of equity and efficiency requires a method to elicit people’s views on the relative importance of these two aspects of well-being, and a way of putting the two together into a single measure.
Economic welfare is best promoted by a minimum standard raised to such a level that the direct good resulting from [..] the marginal pound transferred to the poor just balances the indirect evil brought about by the consequent reduction of the [national] dividend—A. C. Pigou, 1920
A. Eliciting Observers’ Aversion to Inequality: Okun’s “Leaky Bucket” Exercise
To devise a measure combining both total income in an economy and its distribution across households, a necessary first step is to establish the relative weights of those two components. To that end, Okun (1975) proposed a thought experiment capable of eliciting people’s attitudes toward the trade-off between equality and efficiency: Okun asked the reader to consider five families: a richer one making $45,000 (in 1975) and four poorer ones making $5,000. Would the reader favor a scheme that taxed the rich family $4,000 and transferred the proceeds to the poorer families? In principle, each poorer family would receive $1,000. But what if 10 percent leaked out, with only $900 reaching the recipients? What would the maximum acceptable leak be?2 The leak represented not only the administrative costs of tax-and-transfer programs (and, one might add, potential losses due to corruption),3 but also the fact that such programs reduce the economic incentives to work.