Question

Suppose, in a country, the government decides to start redistributing income from rich households to poor households. The government considers two policy options:

1. Incentivize rich households to donate to the charity of their choosing — for example, the government could match each dollar the household donates to their charity.

2. Enact an income tax on high income households and directly redistribute the tax revenue to poor households.

Considering both efficiency and equity, provide a reason that (a) would be preferable to (b). Provide a reason that (b) would be preferable to (a). Explain.

Answer 1

Incentivizing rich households to donate to the charity is preferred to enacting an income tax on high income households and directly redistributing the tax revenue to poor households due to the following reasons:

• It's the providers of aid — governments, donor organizations, even private individuals donating to a charity — who decide what poor people need most
• A guaranteed "basic income" can be assured

However, sometimes enacting an income tax on high income households and directly redistributing the tax revenue to poor households is preferred because:

• The trend of rising inequality appears to be attributable mainly to increasing returns to well-educated people as a consequence of a shift in the economy to methods of production and distribution that require application of knowledge and intelligence
• Measures to reduce income inequality, especially measures that raise the median household income (as distinct from reducing inequality by leveling down the incomes of the well off, which could have serious disincentive effects), could increase economic efficiency by reducing political pressures for inefficient policies.