The High Cost of Being Fair
A synopsis of the Minneapolis Fed's 1993 Annual Report.
Published June 1, 1994 | June 1994 issue
It's been a little over 30 years since Milton Friedman published Capitalism and Freedom. In this book, which was cited in Friedman's Nobel prize award, he argues passionately and cogently in support of free markets. He stresses that government interventions in markets generally restrict individuals' freedom of choice and impair the efficiency of the economy.
Friedman, and later his critics, pointed out that efficiency is not the whole story. Although free markets generally lead to efficient outcomes, that alone is not sufficient to guide policymaking. Policymakers must be guided by other social objectivesnamely, fairness or equity. Friedman's critics argued that efficient outcomes are not necessarily fair because some individuals can receive too little of the economy's goods or services.
Policymakers, then, can be viewed as facing a trade-off between efficiency and fairness. According to this common view, increasing government intervention in markets leads to more fairness at the cost of less efficiency. But, because government interventions in the economy have been allowed to expand, the public must view the cost of this lost efficiency as low.
However, a lot has happened since Capitalism and Freedom was published. New knowledge and evidence have accumulated on the relationship between economic performance and government involvement in the economy. These new developments suggest that the costs of government interventions typically are higher than formerly thought. Such interventions not only result in one-time losses in economic efficiency, as is commonly thought, but they typically also reduce growth over time.
If the costs of achieving fairness are higher than formerly thought, government interventions to achieve that goal ought to be scaled back. The public must realize that the tradeoff between efficiency and fairness is not so favorable when viewed in a dynamic, or growth, context.
To make my arguments concrete, I examine in the Annual Report just three of the many ways the government intervenes in markets: trade protection, redistributive taxes and transfers, and social security. (Of course, I could have also included government interventions in health care, agricultural price support policies, industrial policies, and so on.) For the purpose of this synopsis, though, just one case is examined redistributive taxes and transfers.
Restoring the balance between efficiency and fairness is simple economically, but difficult politically. Economically, the solution is to scale back government interventions made in the name of fairness by better targeting benefits to the poor and needy. However, politically, that is hard to do. Government programs spread benefits widely to low-, middle- and high-income people in order to buy support for the program. But there is no clear rationale for the government to intervene in the name of fairness and distribute benefits to middle- and high-income people. People in these income classes must be convinced that such interventions are not in their collective best interests. Until they are, politics suggests that the government's role in the economy will continue to grow.
The cost of government interventions in theory ...
The public demands fairness ..
By almost any measure, the government's role in the economy has been growing. For example, the ratio of total government expenditures to gross domestic product has risen steadily in the last 30 years, from less than 28 percent in 1963 to more than 34 percent in 1993. And even these figures vastly understate the government's role in the economy because they exclude mandates, regulations, tax subsidies and other types of interventions. The government's role has expanded even though economists since the time of Adam Smith have agreed that, except in special cases, private unfettered markets are the most efficient way of delivering goods. So why the expansion?
The short answer is that the public wants to be fair. Admittedly, some interventions can be attributed to special cases. Examples include interventions in decreasing cost industries, such as price controls in the cable television industry; interventions because of externalities, such as pollution abatement programs; and interventions in certain private information, insurance environments, such as the mandate of automobile insurance for all drivers. But these special cases cannot explain the extent of the expansion. Rather, the increase in government interventions reflects a dissatisfaction with the ability of markets to provide fair outcomes. Departures from free trade are one example. Concessions under the North American Free Trade Agreement (NAFTA) to individual industries such as sugar beet growers, textile producers and truckers were justified because it would be unfair to cause workers in these industries to lose their jobs or receive less income. Recent changes in the income tax structure are another example. The Clinton administration's 1993 tax bill was justified on the grounds that it was taking income from those who had profited (unfairly) from the 1980s tax cuts and giving the proceeds to the less fortunate. And finally, the greatest expansion in federal government expenditures over the last number of years was in entitlements, which exist primarily to give more income or services to the poor or unfortunate; that is, they owe their existence to the public's support of the goal of fairness.
... But what's fairness?
Although policies seek to achieve fairness, there's a surprising lack of agreement among both economists and non-economists on what fairness really means and on how important it is relative to other social goals. Yet most defenders of government interventions in the name of fairness do tend to hold some similar views. They typically agree that fairness does not require everyone to get the same size slice of the economic pie, but they argue that market outcomes are often unfair because some people get too little. Defenders also agree that fairness is not all that counts. They argue that efficiency, or the size of the pie, counts too. However, between two systems producing the same size economic pie, they agree that the one with slices of more equal size is better.
Costs are small initially ...The defenders have a strong case. Under unfettered markets, individuals would be rewarded according to their contributions to the economic pie. The rewards for some, however, would be too small to afford them a minimal standard of living. Changes in the reward system under unfettered markets could also be very harsh. Since industries decline as they become obsolete or non-competitive, workers in those industries would lose their jobs. Since the public appears to demand fairer outcomes, government intervention is seen as a desirable way to bolster the standard of living of low-income individuals and to protect the jobs of individuals in threatened industries.
But the defenders of this type of intervention recognize that interventions incur costs. As economist Arthur Okun (1975) put it many years ago, there is a tradeoff between equity and efficiency. Efficiency is generally best served under unfettered markets. In a market system, prices signal how to allocate resources, and rewards provide individuals with the proper incentives. Government interference in markets alters the price and reward structure and causes inefficiencies.
The tradeoff is easily seen in an extreme case. Suppose initially that a market economy generates a wide distribution of income. Suppose next that the government intervenes by taxing all individuals earning above the average (or mean) income and transferring the proceeds to those whose income is below the averagein essence making everyone's income the same. Individuals would then have little incentive to work because they would get the same income whether they worked or not. In this case, total income, or the size of the economic pie, would shrink considerably.
In actual practice, though, the loss of efficiency from interventions is typically seen as modest. That is a major reason for their proliferation. Okun likened government redistribution schemes to leaky buckets that carry water from the haves to the have-nots. Although some water is lost in transit, the task is still worthwhile because the unfortunate end up with more than they had before (1975, pp. 91-106). Empirical studies generally confirm that the costs of such interventions are small. For instance, a recent study done by the Congressional Budget Office (CBO) finds that removing the barriers to trade with Mexico would lead to little gain in output in the United States (CBO 1993, p. 23). It follows that the existence of these barriers costs little in terms of lost efficiency. Similarly, another study finds that the tax distortion costs of the U.S. redistributive income tax system are no larger than the compliance and collection costsa modest 5 percent to 10 percent of revenues collected (Slemrod 1992, p. 46).
... But huge over time
Although I have no quarrel with the argument that some government interventions are necessary to provide adequate income or services to the poor and unfortunate, I do quarrel with the common assessment of their costs. If resources are being taken from one group and given to another based on the income of each, the redistributions necessarily distort. That is, these interventions necessarily alter the reward structure and thereby alter incentives.
The common view of the costs of these distortions to incentives, such as that in the two studies above, is based on an essentially static, or point-in-time, analysis. However, interventions based on fairness not only lead to static distortions, but they also can reduce growthan effect that can only be measured over time. Such interventions typically reduce the rewards to innovation and investment in human and physical capital. The costs of underinvestment in developing new methods, new skills and new equipment can become staggering. It is possible that the recipients of the government's redistribution schemes eventually would be better off without them: A small slice of a big pie could eventually exceed an equal slice of a small pie. That is essentially what happened under Eastern European socialism, leading to the fall of communism. Although this brand of socialism was intended to promote fairness, the economic pie in this part of the world became relatively so small that the middle class there became worse off than the poor in capitalist countries.
Restraining government interventions made in the name of fairness could lead to more growth by encouraging more innovation and investment. More growth is desirable because it can provide larger slices of the economic pie for everyone in the society.
... And in practice
The ability to raise both efficiency at a point in time and growth over time by restraining government is not just a theoretical possibility. It's a real option. The next section illustrates how government interventions get started, how much damage they actually do and how they could be scaled back.
Redistributive tax and transfer policies
Redistributive taxes and transfers is one of the areas where government interventions made in the name of fairness could be scaled back to promote higher growth. It is generally observed that in the 1980s the rich got richer and the poor got poorer (McKenzie 1992). The government responded with changes to federal income tax and transfer policies (following the 1986 tax reform) to counter this increase in income disparity (CBO 1994, pp. 54-57). In 1993, for example, marginal tax rates were raised significantly on higher-income families and the earned income tax credit was greatly expanded for lower-income families. These changes were defended based on fairness arguments.
Standard economic analysis recognizes that these changes, especially to higher marginal tax rates, had costs in terms of lower efficiency. Higher marginal tax rates on the wealthy were seen as distorting investment decisions by encouraging the use of tax shelters. A more progressive tax system also was seen as reducing the supply of labor, primarily that of households' secondary income earners. However, these costs were seen by policymakers as low relative to the benefits of a fairer income distribution, and so the policy changes were enacted.
The standard measures of redistribution costs understate the true costs because they fail to include the cost of lower growth. The costs are measured under the assumption that the income distribution is staticthe same individuals are either unemployed or working at the same jobs year after year. Costs to redistribution, then, are thought of in terms of how they affect individuals in given income classes. (These classes are usually defined by quintiles, which each contain one-fifth of the population.)
Recent research indicates that the static assumption is false and provides a new way to think about the income distribution. Suppose income quintiles are hotel rooms and individuals are the occupants (Sawhill and Condon 1992). Standard analysis assumes the same individuals are in the same rooms year after year. But, in fact, recent studies indicate that a significant amount of room-changing is occurring over time. It is reported that in both the 1970s and 1980s "some three out of five adults changed income quintiles. A little less than half the members of the bottom quintile moved up into a higher quintile, and about half the members of the top quintile fell out of that quintile" (Sawhill and Condon 1992, p. 3).
A US Treasury Department study (1992) finds that a significant degree of household mobility over time is explained by the life cycle pattern of earnings. In their early years individuals typically invest in acquiring skills and furthering their education and thus earn low incomes. In their later years they earn progressively higher incomes as they realize the returns to their investment in human capital.
Thus, for many people, progressively higher marginal tax rates represent reductions in the rate of return to their human capital. In their early adult years they must sacrifice income to invest in their human capital by taking time to study and train. They are willing to invest because they foresee an adequate return in terms of higher future income. Progressively higher marginal tax rates reduce the return to their human capital investment by removing progressively larger chunks of their future income.
There is good reason to believe that people's career decisions are affected by changes in returns; that is, they go where the money is. For example, one study reports that in the 1980s there were large increases in the relative supplies of most of the types of workers whose relative wages increased (Bound and Johnson 1992). Another study finds a large enrollment response to a change in the return to higher education (Blackburn, Bloom and Freeman 1991). These and other studies suggest people respond to rewards as theory and common sense suggest. Thus lowering the returns to investment in human capital will lower the amount of time and effort people put into training and education.
The argument that redistribution lowers growth depends on the existence of significant mobility across income classes, as is true in the United States. In the United States, progressive taxes are mainly just higher taxes on the same individuals as they move through their careers, causing them to invest less in their human capital. The argument need not hold for other countries which have little mobility across classes. For those countries, taking money from the few rich and giving it to the many poor could allow the poor to invest more in their human capital, such as schooling, thus raising total human capital investment and growth. But, again, in the United States, where schooling is available to all and mobility is high, this possibility seems remote.
That there is a conflict between fairness, or equity, and growth can be seen clearly in the current US environment. By almost all accounts the income distribution has widened, and that in itself has brought calls for a greater use of redistributive taxes and transfers. However, this widening in the income distribution can be traced primarily to changes in real, or technical, factors. Thus greater redistribution, which mutes the message of markets, limits individuals' response of either investing in the skills or going to the jobs where the returns are highest.
Most studies conclude that the major cause of the widening US income distribution in the 1980s was a growing inequality in real earnings. Tax and other policy changes caused little of the widening. In fact, one study finds that most advanced industrialized countries showed increases, often large, in wage inequality during the 1980s (Davis 1992). Thus other industrial countries experienced similar income distribution changes as in the United States even though their policy courses were very different.
The changes in real earnings, meanwhile, are generally thought to be due to changes in technology (Bound and Johnson 1992). In the 1980s low- skilled jobs suffered a decline in real wages, while high-skilled jobs experienced a rise in real wages. The changes in real wages reflect a higher return to education, training and experience. The most likely explanation for the changes in returns is the use of advanced technology that substitutes for the work of low-skilled workers and at the same time makes high-skilled workers more productive (Bound and Johnson 1992). One study finds that workers who do use more advanced technology get paid higher wages (Dunne and Schmitz 1992). Another study finds that the evolving use of the computer can explain much of the measured technological advance (Krueger 1993).
Since the changes in income distribution were largely technology- induced, the government's effort to dampen the associated changes in the reward structure certainly will slow growth. The market is signaling higher returns to acquiring skills and education. When these signals are clearly received, individuals are encouraged to develop greater skills, such as computer training, and to acquire more schooling, such as a college degree. Higher progressive taxes mute those signals, however, and they decrease the incentives to invest in these types of human capital. This reduction in investment will slow growth.
Public attitudes must change
My argument that the costs of government interventions made in the name of fairness are costlier than commonly thought does not suggest that they should be eliminated. Rather, it suggests that they should be scaled back. Economically, restraining or scaling back government redistributions seems straightforward and easy to do. Politically, it seems difficult. That is why public attitudes toward government redistributions must change first. Economically, all that is required is that programs to redistribute resources be better targeted. The economic rationale for these programs is to provide resources to the poor and needy. No economic rationale exists for providing resources to individuals in the middle- and upper-income classes. Yet that's where most of the money goes. A study of how federal benefits are distributed across income classes finds that the benefits scarcely redistribute income at all (Howe 1991). In fact, over 40 percent of the 1991 benefits went to households earning over the average (median) cash income, which was three to four times the poverty threshold for a family of two.
By making transfers to those who are not needy, the amount of redistribution is much larger than it has to be for fairness. This excess unnecessarily raises the costs to the economy in terms of inefficiency and slow growth. Economically, interventions made in the name of fairness can then be easily restrained by making all benefits means-tested, that is, making sure the benefits go only to people whose wealth and income are below some threshold levels.
Politically, this remedy may be hard to apply. The benefits of government redistributions tend to be spread widely because that is what the public wants. In order to get public support for such programs, politicians find it necessary to distribute their benefits far beyond just the truly needy. Many people have the attitude that if they pay for a program, they deserve some of the proceeds. As long as the public feels this way, there will be little support for reining in government programs and interventions.
The public, however, has it dead wrong. If the government is to intervene based on fairness, its role is to redistribute resources from the middle- and upper-income classes to the poor. Period. People in the middle and upper classes would be much better off if the amount of taxes used for their own benefits was eliminated and they used the increase in their after-tax incomes to arrange privately for their benefits. In this way fairness could still be served, but the government's role and the resulting inefficiencies could be diminished.
Milton Friedman was right to stress the advantages of unfettered markets. Yet his critics also were right to point out that some individuals in society cannot attain an acceptable level of existence without help. The task confronting society is to develop systems that help the poor while interfering as little as possible with the private markets' ability to foster efficiency and growth. That means targeting redistributions carefully. It means the public must become aware of the high cost of extending benefits to those who do not truly need them. It also means that failure to change could cause society to pay an increasingly high cost as time goes by.
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