“I too have long considered the relationship between equality and efficiency to be non-linear, instead of just a simple trade-off. Too much equality isn’t good since it reduces incentives, but neither is too much inequality. I would say the relationship is of an inverted-U type where moving to both extremes – too much and too little equality is bad for the economy. The trick is to find an optimal point which reduces the level of inequality where it offers more opportunities for everyone, but also just enough for it to continue to drive incentives. More on that in my next blog post.”
in 1975, testifies of this relationship where greater economic equality
necessarily to some extent implies lower efficiency of the economy. In other
words, lowering inequality comes at a cost of lowering efficiency. He develops
a very interesting argument in which he acknowledges this trade-off, but
also proposes a set of policy interventions that would increase both efficiency
and equality – such as policies aimed at attacking inequality of opportunity,
like racial and sexual discrimination in the workplace (which were arguably
even greater back in the 1970s than today) and barriers of access to capital.
So in a way even though he implies a linear relationship between equality and
efficiency, where one is necessarily sacrificed in terms of another, he clearly
sees that when inequality is too high, it can also act as an impediment on efficiency.
Okun emphasizes on several occasions that he is a stern believer in the market
system, but also that some rights (like the right to vote) should not be bought
and sold for money. In other words, he believes in the enormous efficiency of
the market system (he devotes an entire chapter emphasizing the benefits of the
“mixed” economy model vs the socialist economic model), but is also concerned with the moral implications of why some of our basic human rights cannot have a price tag
attached to them. The reason why is very
eloquently summarized in following sentences: “Everyone
but an economist knows without asking why money shouldn’t buy some things. But
an economist has to ask that question”. Hence the first chapter.
he also uses his famous “leaky bucket” metaphor to emphasize the inequality-efficiency
trade-off. Here’s a brief explanation: say you want to tax the richest families
for a certain amount of money (e.g. $4000 per family) and then redistribute this
money to the poor so that each poor family gets $1000 (the ratio of poor to
rich is assumed to be 4:1). Now imagine you are carrying all this money you
took from the rich in a leaky bucket, so that each poor family will necessarily
receive less than a $1000. What’s the cutoff value of money the poor would
receive for you to consider the transfer efficient? There is basically no wrong
answer here – it depends on your preferences for redistribution. Some people
would accept 10 or 20%, some 60% (like the author), some almost 99%. The point
that the leaky bucket experiment is trying to make is that each redistributive
action will necessarily come at some cost in efficiency. But we as a society
must accept this in order to lower economic deprivation that not only hurts the
economy, but it can also infringe on our principles of democracy.
considerable amount of attention to the problem of too much power in the hands
of certain interest groups and how they might use it to bias the budget (and much more) in
their direction. He cites oil producers, farmers, teachers, union workers, gun lobbies,
you name it. Specifying the intensity of their preferences through money is a perfectly
legitimate manifestation of their democratic right to fight for their interests.
However by doing so they necessarily channel public resources to the hands of the
few, at the expense of an unorganized majority which lacks enough interest to engage
(just as Mancur Olson taught us).
that this discussion seems so contemporary, yet Okun wrote it back in 1975!
Furthermore, he lays out other facts about 1975, where he complains about the
“unacceptably” high levels of wealth and income inequality: “The richest 1 percent of American families
have about one-third of the wealth, while they receive about 6 percent of
after-tax income.” Today that figure is much higher – it is about 18% of
total income. In the books on inequality I’ve read so far, the 1970s were the
golden age! But according to Okun, it was still too high. Even in the decade when top income tax rates were
75%, America still had the inequality problem.
This can only confirm
Okun’s hypothesis that the US has always sacrificed equality for efficiency.
Inequality in the US has been and probably always will be higher than in Europe
– but that is precisely because of the innovation-driven, trial-and-error,
cut-throat capitalism of the US versus the welfare-state, cuddly capitalism of
Europe. And that’s fine. But the fact is that inequality in neither of these
has to be this high. Hence the final chapter where he proposes a set of
standard policy measures (some of them quite good, focusing equality of
opportunity) designed to combat the “alarmingly” high inequality of the 1970s
(sic!), without sacrificing efficiency.
Building up on Okun: The trade-off reexamined
We start from the bottom-left corner with the Gini index at its theoretical 0 level, implying perfect equality (each person having the same income). Clearly for that level of equality efficiency (measured as either total factor productivity (TFP) or GDP p/c growth) is also around 0, since no one has any incentives to produce and to innovate given that all rewards are equal. Even at slightly lower levels of equality (after introducing some inequality), efficiency does not increase, assuming that it takes time for agents to pick up the signal that there is now a possibility to work more in order to get more. Then as inequality stats to increase, the level of economic efficiency increases even more as the relationship becomes reinforcing – more people see that their innovation, talent or extra effort will be significantly rewarded so they expand their activities which creates upward pressure on both inequality and efficiency. Until it reaches a point of maximum economic efficiency for a given level of inequality. As I’ve pointed out in the graph this is not necessarily at the Gini=0.3, it could be either higher or lower than that – this needs to be verified empirically. After that global maximum of the curve, the relationship turns negative – more inequality beyond the efficiency-maximizing level slowly but steadily decreases economic efficiency until society descends into close to perfect inequality (a Gini=1 means one person has all the income), where again there are no incentives to produce, innovate or create new value, given that all of this new wealth will just fall into the hands of the selected few (like in a stationary bandit dictatorship).
Finally, given that my graph above is a mere theoretical construct, one should really consult the actual data to see whether or not it holds. I intend to do just that in the next few years.
