Friday, September 10, 2004

Poverty and Inequality

Just Left has an interesting post on income equality.
No Right Turn has already noted that the survey quoted is too old to reflect the actions of the current Government, but I'm more concerned with the wider issue of the relevance of income inequality.

I pointed out in comments to Jordan's post that real poverty can be measured by looking at what people would spend an extra dollar a week on if they were given it. If people are strict economic rationalists then they will use whatever money they have on their most important needs first. A really poor person will not be able to meet all of even their most basic needs (eg feeding their children adequately) and would therefore spend their additional dollar on these basic needs. Better-off people will have already satisfied the basic needs and would spend the money on something less critical (eg put it towards a home computer and internet connection to help the kids learn more). The very rich will only have entirely frivolous things (eg always drive the latest model Porsche) left to spend the money on. In economic terms we call this the "Marginal Utility of Expenditure" and it will generally (more or less) fit a single falling curve when plotted against income.

If a society had a fixed amount of income to distribute then the falling marginal curve would imply that everyone should get an equal share. Any person with more than their share would have a lower marginal utility than anyone with less than their fair share and, in consequence, redistributing income from the person with the most to the person with the least will lead to a net increase in "total utility". Real societies don't have fixed amounts of income to distribute and, in practice, redistributing income from high to low earners will act as a disincentive to earning and reduce total income. Policy therefore needs to strike a balance between maximizing utility of income by redistribution against the loss of income by disincentivisation.

I was interested to see that at least one commentator thought it OK to tax a (rich) person so that a poor person could feed their children adequately but not just because "his marginal utility is higher than mine". I accept that the latter phrase lacks the emotional appeal of the former but it is really just another way of saying the same thing (for a large enough difference in marginal utility). I would assume that the commentator means that they are only willing to be taxed so as to help really poor people rather than everyone with higher marginal utility.

Of course the need to balance disincentives against redistribution ensure that we would never take taxes off any taxpayer to help everyone who was on a higher marginal utility - that would be tantamount to complete equalisation. Whether, however, we can set a threshold level of poverty (or marginal utility) is another matter. The difference in marginal utility between the very rich and someone just above the threshold may be greater than that between an average taxpayer and the poor.

Suppose we have a society of three people (A,B and C) earning 0, $500 and $1000 respectively per week and suppose that we need at least $300 per week to sustain an "acceptable" standard of living (ie threshold marginal utility corresponds to $300 per week on the standard curve). We must redistribute at least $300 to A and can raise this only by taxing B and C. Suppose we adopt a flat tax of 20% and take $100 from B and $200 from C. B might now argue that he now has only $400 and that he would have had $300 had heearned nothing. His effort in earning $500 has left him only $100 per week better off. If we took the whole $300 from C then B would be left better off by $200 than A and C would be $200 better off than B - but which is the fairest? In neither case is C's money actually going to B. Pragmatically the second solution is likely to cause the least "disincentivisation" (both B and C keep 40% of their earnings) and also gives higher total utility.

Jordan also talks of inequality from the point of view of an inclusive society and appears to contest Rodney Hide's suggestion that we would all be better off in a society where everyone had more money even if it meant greater inequality. I beg to differ. The thing about Rodney's suggestion is that it has nothing to do with the real choices facing us or that we faced in the recent past. The poor did not just become relatively worse off compared to the rich in the late 80s and early 90s they became worse off in absolute terms. The increase in the gap between rich and poor may have resulted in part from the propensity of the rich to "leverage their wealth into income" as one commentator suggested but Occam's Razor would suggest that active government policies of cuts in top tax rates, benefit cuts, reductions in government services, the ECA and cuts in minimum wage rates probably had more to do with it.

My main problem with the concept of relative (ie distributional) poverty is that I don't believe that the poor (or anyone else) measure their perceived position against some statistical median. Surely the only real people they can measure themseves against are those with whom they most commonly come in social contact - their family, friends, workmates and neighbours. In most cases these people are likely to come from a similar income group to themselves. An unemployed factory worker in Otara is unlikely to come in contact with a stockbroker in Remuera and how, therefore, will he feel socially excluded by the disparity in their incomes?

To the extent that the gap between the aspirations and reality of our disadvantaged can be blamed on unrealistic expectations rather than unacceptable reality, we should look for the cause of those aspirations. In my view it is not to be found in the real or perceived lives of our affluent but in the prevalence of commercial mass media and an advertising industry that devotes obscene amounts of money to selling the single message that "your life sucks". Perhaps our nostalgia for the "good old days" owes more than a little to the non-commercial TV we used to have. Perhaps the "cultural colonisation" that commercial TV and its associated consumerism-gone-mad has brought us cuts deeper into our society than we realise.

What is important is that we retain the most important of our Kiwi values. That we respect the human and civil rights of all citizens and that "participation" in our society does not have a price tag or come with first and second class versions. A decent, inclusive society need not mean that any person may (regardless of their talents) freely choose their walk in life or that people from different walks of life should enjoy the same disposable income. Rather it means that we should all alike walk tall and that all should be valued alike regardless of circumstance or fortune, and that influence, justice, freedom or equality should never be for sale. Whenever I hear the BRT or local Chamber of Commerce bemoan the "Tall poppy syndrome" I feel a surge of hope. Kiwis know how to honour real heroes (Edmund Hilary, Fred Hollows, Peter Jackson) but we also know that an oaf with money is just a rich oaf. If we can hold on to this a little income inequality may not matter.


Blogger Nigel Kearney said...

I don't agree with the conclusions from the example you gave. You're contrasting two tax structures:

1) A 20% flat tax
2) A 60% tax on all income above $500 per week

Although you didn't spell out 2, it's the most obvious way to achieve the outcome you're seeking without taxing B at all.

2 gives the 'least disincentivisation' only if B is considering quitting his job and going on the dole. If B is considering anything else such as working longer hours, taking another job or expanding his business, then 1 is less of a disincentive. B gets to keep 80% of any extra income instead of 40% - a huge difference.

11 September 2004 at 11:56 AM  
Blogger Greyshade said...

Nigel. Of course it's looking at two different tax structures. With only three cases I didn't give enough information to unambiguously identify the tax structure. The scheme I had in mind for Paln 2 was actually a "Universal Marginal Rate) structure where everyone gets a $300 rebate (or benefit) but pays 60% on all income. The point I was making is that there is no unambiguous basis for saying that either structure is "fairer" or that (under either plan) C's taxes are supporting B. The disincentivisation argument depends on whether you look at B's upside or downside or whether you look at A (who only has an upside). The disincentive impact of tax rates goes up disproportionately when the rate approaches 100% and therefore (imho) a flat "effective tax rate" is likely to be the least disincentivising. This is one of the arguments for a flat tax.

A flat nominal tax rate is, however, a fiction if it's achieved by ignoring benefit abatement (or any other charge levied on income). Should A decide to get a job paying $500 pw (in my example) under Plan 1 he does not lose $100 pw of this money (the nominal tax), he loses $400 (tax + benefit abatement) and incurs an effective average rate of 80% which is getting dangerously close to confiscatory.

11 September 2004 at 12:44 PM  
Blogger Sock Thief said...

I met up with a friend from school the other day who is an accontant. Essentially he gives advice on how to minimise tax payments. Its one aspect of your analysis that is not emphasised - the fact the the well-off have the ability and desire to do this.

11 September 2004 at 3:32 PM  
Blogger Greyshade said...

Sock Thief:
A fair point, if slightly outside the scope of my original post. I suspect we all have the desie to minimise our tax liability (or maximise our benefit eligibility) but the self-employed or people with investment income have much more opportunity to do so. The solution is usually to make the system simpler and fairer. Most tax avoidance strategies simply make sure thatthe avoider comes out on the right side of an existing anomaly (eg difference between split income and single income couples).

11 September 2004 at 5:32 PM  
Blogger stephen said...

-- I would assume that the commentator means that they are only willing to be taxed so as to help really poor people rather than everyone with higher marginal utility.

That commentator (gosh, sounds posh) was me, and you assume correctly.

In particular, if decisions are being made about who can best use MY income, I'm concerned about who does the deciding.

12 September 2004 at 10:44 PM  
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