Equity

Our discussion of market failures like monopoly or externalities focused on defects in the allocative role of markets—imperfections that can be corrected by judicious intervention. But assume for the moment that the economy functioned with complete effi-ciency—always on the production-possibility frontier and never inside it, always choosing the right amount of public versus private goods, and so forth. Even if the market system worked perfectly, it might still lead to a flawed outcome.

Markets do not necessarily produce a fair distribution of income. A market economy may produce inequalities in income and consumption that are not acceptable to the electroate.

Why might the market mechanism produce an unacceptable solution to the question for whom? The reason is that incomes are determined by a wide variety of factors, including effort, education, inheritance, factor prices, and luck. The resulting income distribution may not correspond to a fair outcome. Moreover, recall that goods follow dollar votes and not the greatest need. A rich man's cat may drink the milk that a poor boy needs to remain healthy. Does this happen because the market is failing? Not at all, for the market mechanism is doing its job— putting goods in the hands of those who have the dollar votes. If a country spends more fertilizing its lawns than feeding poor children, that is a defect of income distribution, not of the market. Even the most efficient market system may generate great inequality.

Often the income distribution in a market system is the result of accidents of birth. Every year Forbes magazine lists the 400 richest Americans, and it's impressive how many of them either received their wealth by inheritance or used inherited wealth as a springboard to even greater wealth. Would everyone regard that as necessarily right or ideal? Probably not. Should someone be allowed to become a billionaire simply by inheriting 5000 square miles of rangeland or the family's holding of oil wells? That's the way the cookie crumbles under laissez-faire capitalism.

For most of American history, economic growth was a rising tide that lifted all boats, raising the incomes of the poor as well as those of the rich. But over the last two decades, changes in family structure and declining wages of the less skilled and less educated have reversed the trend. With a return to greater emphasis on the market has come greater homelessness, more children living in poverty, and deterioration of many of America's central cities.

Income inequalities may be politically or ethically unacceptable. A nation does not need to accept the outcome of competitive markets as predetermined and immutable; people may examine the distribution of income and decide it is unfair. If a democratic society does not like the distribution of dollar votes under a laissez-faire market system, it can take steps to change the distribution of income.

Let's say that voters decide to reduce income inequality. What tools could the government use to implement that decision? First, it can engage in progressive taxation, taxing large incomes at a higher rate than small incomes. It might impose heavy taxes on wealth or on large inheritances to break the chain of privilege. The federal income and inheritance taxes are examples of such redistributive progressive taxation.

Second, because low tax rates cannot help those who have no income at all, governments can make transfer payments, which are money payments to people. Such transfers today include aid for the elderly, blind, and disabled and for those with dependent children, as well as unemployment insurance for the jobless. This system of transfer payments provides a "safety net" to protect the unfortunate from privation. And, finally, governments sometimes subsidize consumption of low-income groups by providing food stamps, subsidized medical care, and low-cost housing—though in the United States, such spending comprises a relatively small share of total spending.

These programs have become increasingly unpopular in the last two decades. As the real wages of the middle class have stagnated, people naturally ask why they should support the homeless or able-bodied people who do not work. What can economics contribute to debates about equality? Economics as a science cannot answer such normative questions as how much of our market incomes—if any—should be transferred to poor families. This is a political question that can be answered only at the ballot box.

Economics can, however, analyze the costs or benefits of different redistributive systems. Economists have devoted much time to analyzing whether different income-redistribution devices (such as taxes and food stamps) lead to social waste (e.g., people working less or buying drugs rather than food). They have also studied whether giving poor people cash rather than goods is likely to be a more efficient way of reducing poverty. Economics cannot answer questions of how much poverty is acceptable and fair, but it can help design more effective programs to increase the incomes of the poor.

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