Economia e Finanza Pubblica

1. Economia e Finanza Pubblica Pietro Navarra Settimana #1: Libertà e redistribuzione

2. Outline • The redistribution paradox in democratic systems • 2. The size of redistribution differs across countries. Why? • 3. Literature review on preferences for redistribution and welfare speding • a) social mobility and redistributiuon • b) distributive justice and redistribution • c) other economic, social and political motives for redistribution • 4. Why are some sources of inequality justifiable and others aren not? • Autonomy freedom (AF) is our answer • 5. A theoretical model of AF and redistribution • 6. The empirical investigation

3. The redistribution paradox The framers of US constitution supported the extension of suffrage only to property owners. They believed that if all citizens were given the vote, the right to property would have likely been overturned In modern democracies political rights are distributed equally. Income distributions are such that the median income is generally lower than the average income. In these circumstances a majority of voters (i.e., the poorest 50%) may be expected to impose a transfer scheme that redistributes all income to the mean History tells us that this expectation proved to be false and the existence of universal suffrage did not lead to the expropriation of the wealth from the rich by the poor. Why did this happen? Why does inequality persist in democracies? Why does not the majority of citizens with incomes below the median vote for extensive welfare systems?

4. The redistribution paradox Explanation 1 (efficiency): full income equalization is not carried out through political action in democracies since large scale wealth expropriation would produce adverse dynamic effects for the entire economy This perspective is based on the hypothesis that significant redistribution of income from more to less productive economic agents would be inefficient. This fact would cause an overall reduction of working incentives and a decline of national income with the associated consequence that the wealth of the majority would inevitably fall (Meltzer and Richard, 1981) Further, if the rich have an exit option by moving to another jurisdiction, this would tend to limit the available resources and ultimately the scope for redistribution (Epple and Romer, 1991)

5. The redistribution paradox Explanation 2 (efficiency): more egalitarian distributions of income are unlikely to be associated with investments in education, innovation and economic growth (Perotti, 1993; Fernandez and Rogerson, 1995). Voters understand these unfavorable effects of income equality on economic development and choose to attenuate their requests for higher redistribution Explanation 3 (public choice): the notion that democracy expresses the will of people is considered naive (Buchanan and Tullock, 1956; Olson, 1965). Small groups are better equipped in swaying policy choices. They generally enjoy better economic conditions and offer larger per-capita gains that better mobilize their members. Democratic policy makers are captured by such organized groups to the detriment of larger and often disorganized groups (Peltzman, 1976) – Economic power often translates in political power (Breyer and Ursprung, 1998)

6. The redistribution paradox Explanation 4 (collective action problem): the concept of voters ignorance due to the fact that for the vast majority of voters the costs of acquiring information about the legislative process and the effect of this acquisition on their welfare are much higher than the expected beneficial effects (Olson, 1957; Popkin, 1991; Bartels, 1996) Poor and less educated persons have a lower propensity in spending time and money to acquire information about the policy formation process (Rosenstone and Hansen, 1993) The media, which to a larger extent influence the political opinion of voters, are owned and/or closely controlled by economically powerful groups which are interested in maintaining a relatively unfettered process of wealth accumulation (Chomsky and Herman, 1988; Zaller, 1992)

7. The redistribution paradox Explanation 5 (electoral competition): the way in which competition is faced by opposing parties may constitute another interesting possible explanation for why democracy does not allow full redistribution of wealth from the rich towards the poor Electoral competition is never based on a single issue, but rather it is characterized by parties confronting themselves on multi-issue platforms amongst which many are of non-economic nature (Roemer, 1998) If political competition takes place within a context in which a non-economic issue play a salient role, the party representing the poor may advocate a softened down redistribution policy

8. Redistribution across countries • Although income inequality is justifiable in democracies and the poor majority does not expropriate the wealth from the rich minority, governments redistribution policies differ in different countries • Why some countries spend more in welfare and others less? Does individual preferences for redistribution help explain differences in welfare spending across countries? • we describe economic, social and political motivations that explain the cross-country heterogeneity of social expenditure • we examine the effects of people's beliefs about social mobility on the distribution of income and their effect on individuals’ preferences for welfare transfers we analyze the consequences fairness concerns on individual's attitudes toward inequality and redistribution

10. The theory: Degree of openness A country's redistributive scheme is the government's response to exogenous income shocks deriving from the degree of openness of its economy: a country with a large exposure to international trade is more vulnerable to large economic instability

11. The theory: Religiosity Religion and welfare spending are substitute mechanisms against adverse life events. Therefore, high religiosity is expected to be associated with low redistribution and vice versa

12. The theory: Fractionalization Group fragmentation in the population along racial and/or ethnic lines may affect welfare spending. People of different races, religion and ethnicities look at each other with some suspicion and may feel less generous in terms of welfare

13. The theory: Fractionalization

14. The theory: Political explanations PR systems produce more redistributive spending since parliaments under PR are fragmented. Fragmentation leads to multi-party coalition governments that are conducive to large and more persistent public deficits

15. The theory: Income People's preferences for redistribution are driven by the net pecuniary gain accruing to single individuals from redistributive taxation: if an individual is a direct recipient of a transfer program she favors it and viceversa (Roberts, 1977)

16. The theory The basic "workhorse" political economic model for preferences for redistribution is Meltzer and Richards (1981). It is a static model in which individuals care only about their consumption (income) and have different productivities The only tax and transfer scheme allowed is given by lump sum transfers financed with a linear income tax. The median voter theorem aggregates individual preferences and captures a very simple political equilibrium Consider a standard utility function with the usual properties: where one unit of labor is inelastically supplied and the individual productivity is

17. The theory Assume that the government uses a linear income tax t on income to finance lump sum transfers and that there is a wastage equal to per person which capture the distortionary cost of taxation. Using the government budget constraint, which establishes that every one receives the same lump sum transfer, and defining the average productivity, one can write: Equation (2) simply states that consumption is the sum of after tax labor income (the first term) plus the lump sum transfer obtained by the government (the second term) reduced by the waste of taxation (the third term)

18. The theory The equilibrium tax rate is the one that maximizes consumption for the voter with median productivity The distance between average and median is, in this model, the critical measure of inequality The tax rate (and therefore the level of the lump sum redistribution) is higher the larger the difference in productivities (or income, in simplified versions of the model like this one) between the average and the median voter

19. The theory The difference between the self-reported income and average income in society as a measure of the individual's net loss from redistributive taxation: countries with higher individual incomes display lower levels of welfare spending (Meltzer and Richards, 1981)

20. The theory: Discounting income flows People's preferences for redistribution points to the individual’s net pecuniary gain from redistributive taxation: if he is a direct recipient of a transfer program she favors it and viceversa Taxes and redistributive schemes are in place for lengthy periods of time. Individuals are both interested in today's income after taxes and future incomes. Therefore, we would expect that people are likely to maximize a multi-period utility function in which income at further stages will be properly discounted In this context, people's beliefs about of social mobility play a crucial role in shaping their attitudes toward redistribution. Individuals whose income is currently below the average entertain the hope that they or their children will someday move up in the income ladder and oppose high taxes for the fear of hurting their future selves or their children

21. The theory: Discounting income flows Hirshman (1973) tunnel effect: He emphasizes the important role played by the expectations about individuals’ own future incomes on their attitudes towards current income differences In assessing whether government should reduce wealth inequalities, people do not only take the status quo into account, but they also consider their prospects about future welfare Poor people who view themselves on a rising income trajectory may well oppose redistribution because they soon expect themselves to be further up the income ladder (and would eventually have to pay for the government's redistribution). This mechanism might also be at work in the reverse direction, i.e., the rich persons may favor redistribution because they expect to be poor in the near future

22. The theory: Discounting income flows Hirshman's contribution gave rise to a related literature analyzing the impact of the `prospects of upward mobility' (POUM) on people's demand for redistribution (Benabou and Ok, 2001) Both the `tunnel effect' and the POUM hypothesis reflect clear selfish-centered motives underlying agents attitudes towards equalization policies, without any altruistic concern.Yet, they do not clarify what determines their optimistic (or pessimistic) expectations about future incomes Why do (do not) people believe in their prospects of upward mobility? Why do (do not) they trust the working of social mobility? Why do (do not) they think it is fair and just? What are the determinants of people's beliefs about the social mobility process?

23. The theory: POUM hypothesis A departure from the basic model is one in which the ranking of individuals in the income ladder can change, i.e. a model where we allow for social mobility, (Benabou and Ok, 2001) Individuals care about not only current but also future income. If redistributive policies are long-lasting, future income prospects matter in determining current preferences for redistribution We need at least two periods in the utility function: where the second subscript indicates the periods

24. The theory: POUM hyoithesis Individual income is now perturbed by shocks to individual productivity , where the properties of these shocks are discussed below The budget constraint for the consumer (ignoring discounting) is: which generalizes (2). Note the assumption that the tax rate is decided at the beginning of period 1 and is fixed for period 2 Also period 2 income is uncertain so individual i has to vote based upon his expectation about his income relative to average and median income of period 1, which are known, and of period 2, when his position in the income ladder is unknown

25. The theory: POUM hypothesis Prospects of upward mobility should make somebody below the median of today’s income be more averse to redistribution than otherwise In principle, this effect could be counter-balanced by the prospect of downward mobility, but Benabou and Ok (2001) show that, under certain conditions, prospects of upward mobility (POUM) reduce the demand for redistribution relative to the basic Meltzer-Richards case The POUM hypothesis highlights that social mobility deeply interacts with preferences for redistribution

26. The theory: POUM hypothesis Individuals discount their future income so as to take into account their perceived chances to move up the income ladder. As they discount future income, if they expect to escape poverty, they won’t like redistribution

27. The theory: Opinions about inequality A more radical departure from models in which individuals care only about their income/consumption is the one in which the utility function includes some measure of income distribution: where is individuals’ consumption, some measure of income inequality and the summation is taken from the present "p" to a final period (possibly infinity). In other words, consumption depends upon a host of standard variables (like labour supply or productivity) and inequality This argument in the utility function captures the fact that individual i does not care about inequality per se but only about its effect on her consumption flow

28. The theory: Opinions about inequality • Two observations: • The dependency of consumption over inequality might be much richer if the model were made dynamic: current consumption may depend on past inequality or even on expected future inequality, but the basic qualitative argument would not change • Different individuals may care differently about different measures of inequality, a very important theoretical consideration that will be very hard to take into consideration empirically • What would be the sign of the first derivative of that function, i.e., the sign • of at different levels of ?

29. The theory: opinions about inequality In particular, is it possible that even the “rich” may be affected negatively by inequality so that, purely for selfish reasons, they would vote for redistribution? Two arguments have been suggested to justify a negative derivative for the rich: Externalities in education. Assume that the average level of education in a country increases that country’s aggregate productivity and that education has positive externalities. Also assume that more inequality implies that more people are below an income level that does not allow them to acquire an Education. Then, even the rich may favor some redistribution because they would also benefit from an increase in the average level of education

30. The theory: Opinions about inequality Crime and property rights. A largely held view is that more inequality leads to more crime, and therefore, by reducing it, the rich would have to spend less on security, since generally their property would be safer Incentive effects. More inequality has an aggregate social value. In fact one may argue that more inequality creates incentives to work hard and exercise more effort for most people below the top. The strength of this incentive effect is, of course, a very hotly debated empirical question Whether channel 3) dominates or not on the other two is of course critical in determining the relationship between inequality and economic efficiency. If channel 3) dominates there is a trade off between equality and economic efficiency; if channel 1) and 2) dominate there is no such a trade off

31. The theory: The role of fairness Individuals may have views about what constitutes a justifiable level of inequality. One way of expressing these preferences that would be useful for our discussion is as follows: where represents the ideal level of inequality for individual i and his/her weight on deviations from it Needless to say, the quadratic specification is used only for convenience of exposition. The first term in the utility function is the same as in the previous section

32. The theory: The role of fairness Much of our empirical discussion will be on what determines and for different individuals. From a theoretical standpoint, we could characterize various possibilities:

33. The theory: The role of fairness Individuals’ views about an acceptable level of inequality are often intertwined with a (possibly vague) sense of what is "fair" and "unfair." People feel that there is a difference between wealth accumulated, for instance, by playing the roulette tables in Las Vegas and wealth accumulated by working one’s way up from an entry-level job to a higher-level one with effort, long days at the office and short hours of sleep Suppose that individuals’ income is due to a combination of effort (e) and luck (l), so that:

34. The theory: The role of fairness The overall measure of income inequality can now be decomposed in and , the inequality in the distribution of the effort and the luck parts of income, respectively. Therefore: that is the overall inequality is a function of inequality in income derived from effort and luck So far, we assumed that individuals had an ideal level of Q and no preferences over its two components. But individuals might have preferences defined over the two components for a sense of fairness, i.e., one is more entitled to retain the sources of his/her effort than income acquired by chance

35. The theory: The role of fairness We could rewrite the utility function of individual i as follows: Where for some, and perhaps all, i. These inequalities capture the fact that a lower level of inequality induced by luck is deemed more desirable than inequality induced by effort Possibly , if individuals feel more strongly about deviations from optimality for one or the other type of inequality

36. The theory: The role of fairness What is luck and what is effort is, in practice, an issue on which people may strongly disagree: Is being born smart purely luck? If so, how do we disentangle success in life that results from some combination of effort and intelligence? Being born in a wealthy family is luck, but what if the wealth accumulated by our parents is the result of great effort? The terms effort and luck need to be interpreted broadly. By effort, we mean all activities that require "pain“ or a utility cost for the individuals, while luck represents all those factors that deliver income to the individuals without any pain or loss of utility to obtain it

37. The theory: The role of fairness Social policies that depend on people’s views about luck and effort may in turn create incentives for individuals to put forth more or less effort and therefore generate endogenously different shares of luck-dependent and effort-dependent income Alesina and Angeletos (2005) construct a model that is meant to capture a low redistribution (US-style) equilibrium and a high redistribution (European -style) equilibrium In the US equilibrium, taxes are low, people invest more in hard work, and a higher fraction of income differences amongst people is due to effort. In the European equilibrium, taxes are high, effort and labor supply are low, a larger fraction of income differences is due to differences in luck, and therefore, high taxes and large redistributions are desirable

38. The theory: The role of fairness Individuals support redistribution owing to a sense of justice: redistribution should take place to the benefit of those citizens whose low incomes are due to bad luck, rather than to those whose low incomes are due to lack of effort.

39. The theory: Distributive justice Studies on the effects of income dynamics on people's attitudes towards inequality have undergone a research path that stresses the role of individual's perceptions about fairness in social mobility Piketty (1995): individuals support redistribution not only to improve their own financial situations, but owing to a sense of justice which entails that citizens should be compensated through redistributive taxation. However, this redistribution should take place only to the benefit of those citizens whose low incomes are due to bad luck, rather than to those whose low incomes are due to lack of effort These sociotropic preferences are based on the concept of `moral reciprocity', i.e., people are willing to transfer income to others conditionally on the guarantee that the latter are not free-riding on the system (Putterman, 1996)

40. The theory: Distributive justice The idea that the demand for redistribution depends on people’s preferences about others income and opportunities has been empirically validated in the economic literature Fong (2001 and 2003) shows that the dynamic of income distribution and the equality of opportunities as opposed to equality of results enter in the individual's utility function Alesina and La Ferrara (2001) demonstrate that a person's attitudes toward equalization policies depend on her opinions concerning the determinants of income. Individuals who think that wealth is determined by social acquaintance, family history and/or other similar privileges, rather than talent, education, merit and ability, are more favorable to large redistribution

41. The theory: Distributive justice • Benabou and Tirole (2006) explain why people tend to believe that the world is just and individuals get what they deserve despite the fact that the world is not so just. They analyze their theory’s implications for social mobility and redistribution • If enough individuals perceive that economic success is highly dependent on effort, they will represent a pivotal voting-block demanding low redistribution. Given the relationship between beliefs, political outcome & policy choice, two equilibria emerge: • the `American Equilibrium’ characterized by individuals' belief of living in a just world that drives the process of social mobility and leads to a demand for relatively laissez-faire public policies • the `European Equilibrium’ characterized by a view of social and economic interactions that carry with them unjust income • dynamics which lead to a more generous welfare state

42. The theory: Distributive justice • Alesina and Glaeser (2004) bring this perspective into the data: • in Europe is widespread the belief that birth determines status and the poor are generally thought to be unfortunate, but not responsible for their own conditions. Government intervention through extensive welfare programs is here perceived an effective remedy for enhancing the economic conditions of the poor • Americans believe that they live in the land of opportunity where the poor have real possibilities of escaping poverty out of hard work and personal responsibility. In this context, the role of government aids as a remedy to elevate the economic conditions of the poor is significantly degraded

43. The theory: Conclusions This literature examined the determinants of the extent of redistribution and therefore the causes that lead different countries to support different sizes of the welfare state The message: subjective beliefs matter since they shape people's perceptions about the determinants of income differentials as well as people's attitudes towards inequality and their opinion about the role of the welfare state Why some sources of inequality are justifiable while others are not?

44. Justifying inequality Consider two societies equally unequal in terms of income distribution, but different in the perception regarding the nature and causes of their inequality. People living in society A consider income dynamics fair since effort, skills and commitment are justly rewarded. In society B people believe that economic success is determined by environmental factors such as luck and/or privilege Thus, individuals in society A are likely to be more tolerant of existing inequalities in the income distribution than those living in society B In society A, the belief of living in a just world where the process of social mobility is driven by effort leads to a demand for low levels of income redistribution. In society B the view that income dynamics are unjust because they are based on luck and privilege leads individuals to demand large redistributive schemes

45. Justifying inequality: Autonomy freedom Individuals consider income inequality fair if income distribution is perceived to be caused by factors under their control (effort) and they consider income distribution unfair if it is perceived as caused by circumstances beyond their control (luck and/or privilege) When do individuals control the distribution of income? We argue that the development of a person’s autonomy is closely connected with her ability of making choices that express control over the way her life turns out We argue that the fuller the exercise of a person’s autonomous behaviour, the more the individual is in a position to affect the distribution of income and the lesser her support for redistribution

46. Autonomy freedom: The concept A person is autonomous if she makes choices among relevant options. A set of opportunities is composed by relevant options if the individual could have chosen something different from what she actually choose We refer in this case to autonomous behaviour since to make her choice she has to rely upon her personal and moral qualities, as suggested by J. S. Mill’s interpretation of individuality Such an interpretation of autonomy freedom is formalized in SCT where a literature which measures freedom of choice emerged. In this literature, choosing autonomously is valuable for substantive reasons, i.e., availability of opportunities; and for procedural reasons, i.e., control of the alternative courses of action a person may undertake

47. Autonomy freedom: The measure Information about the extent of AF can be collected through surveys. In particular, there is a WVS question which is appropriate for our purposes: Some people feel they have completely free choice and control over their life, while other people feel that what they do has no real effect on what happens to them. Please use a ten-point scale in which 1 means none at all and 10 means a great deal to indicate how much freedom of choice and control you have over the way your life turns out This question explicitly refers both to "free choice" (substantive motive for valuing choice) and "control" (procedural motive for valuing choice)

48. AF & redistribution: The model We construct a simple labor-leisure trade-off model in which the individual sequentially expresses: (1) her optimal preference for income transfers and (2) the amount of effort to unfold in her work activities The individual seeks to maximize the following quasi-linear utility function: where and l is leisure, y is the amount of income of the individual and S the income transfer, t is her preference for redistribution and M is the average income in society

49. AF & redistribution: The model Three are the sources of income: work effort, e, environmental factors, v, and past income, R In the income generation process, work effort is the individual's choice variable since it is under her control. The environmental factors are those events that, although outside the individual's control, affect her ability to produce income where θ € [0,1] parametrizes income mobility (low θ = high income persistence), so work efforts carried out in the past and past environmental factors have strong effect on current income. The level of AF perceived by the individual is captured by α € [0,1] whose value measures an agent’s belief on the relative impact of effort and environmental factors on the production of income

50. AF & redistribution: The model The individual maximizes her utility function subject to the following time constraint Using the time constraint, we may rewrite the equation for the individual's net income as follows