Question

Why does Okun think there is a trade-off between equality and efficiency? Is he right? If  Okun is right: How much leakage would you accept? Justify your position.

Answer 1

Forty years ago, Arthur Okun proposed an interesting thought experiment in his book Equality and Efficiency: The Big Trade-Off. He imagined the redistribution of income like moving water in a bucket with holes in it, and then posed this question: How much water would you be willing to lose as the water moved from the rich to the poor? In other words, how leaky of a bucket would you tolerate before you would stop redistributing income?

The last decades have seen a significant and sustained increase in (within-country) income inequality in many advanced and emerging market economies, with a notable exception for some developing countries in Latin America and sub-Saharan Africa that have had historically high-income inequality. By some estimates, income and wealth inequality in some countries are near their highest levels since the nineteenth century after more than 40 years of declining inequality following the Great Depression. You might think that raising $1 in government revenue simply requires taking $1 from a person through taxes. But that’s not true—the person from whom you take the $1 reacts to the change in their income, resulting in unintended consequences. A person who has their taxes raised, for example, might work less because their incentive to work—has declined. Getting $1 in government revenue requires taking more than $1 from the person being taxed as they are making less income. This means the cost of raising $1 in additional tax revenue is greater than $1. At the same time, if less than 100 percent of the value of a program goes to the beneficiary then providing $1 of benefit increases their income by less than $1.

Inequality matters for growth and other macroeconomic outcomes, in all corners of the globe. One need look no further than the role inequality is thought to have played in creating the disaffection that underlies much of the recent unrest in the Middle East. And, taking a historical perspective, the increase in U.S. income inequality in recent decades is strikingly similar to the increase that occurred in the 1920s. In both cases there was a boom in the financial sector, poor people borrowed a lot, and a huge financial crisis ensued. The recent global economic crisis, with its roots in U.S. financial markets, may have resulted, in part at least, from the increase in inequality. With inequality growing in the United States and other important economies, the relationship between inequality and growth takes on more significance.

Income distribution and growth sustainability

The duration of a growth episode is related to differences in country characteristics and policies. The quality of economic and political institutions, an outward orientation of an economy, macroeconomic stability, and human capital accumulation has long been recognized as important determinants of economic growth. And we found that they matter for the duration of growth episodes too. We argue that income distribution may also - and independently - belong in this pantheon of critical determinants of growth duration. At the level of simple correlation, more inequality seems associated with less sustained growth.

Okun presents an engaging dual theme: The market needs a place, and the market needs to be kept in its place. As Okun puts it: Institutions in a capitalist democracy prod us to get ahead of our neighbors economically after telling us to stay in line socially. This double standard professes and pursues an egalitarian political and social system while simultaneously generating gaping disparities in economic well-being. Today, Okun’s dual theme feels incredibly prescient as we grapple with the hot-button topic of income inequality.In his foreword, Lawrence H. Summers declares: On what one might think of as questions of “economic philosophy,” I doubt that Okun has been improved on in the subsequent interval. His discussion of how societies rely on rights as well as markets should be required reading for all young economists who are enamored with market solutions to all problems.