The primary aim or goal, for any economy, is to be efficient. However, the term efficiency in economics is often used loosely. At the most precise level, it means Pareto-efficiency — a situation in which no individual can be made better off without making another individual worse off (IMF policy paper, 2014). To this effect, the extent or the margin of making one better off has indeed made several others far worse off than before. Here, we will be assessing the methods undertaken to correct this.
The rise in inequality can be credited to a various number of factors, including, but not limited to the globalization of factors and product markets, declining top marginal income tax and the increasing bargaining power of top earners. In order to offset this rising inequality, governments have undertaken redistribution policies; where the money is redistributed to the marginalized section of the economy. Although this seems like the utopian solution, redistribution may cause more harm than good when we talk about long-term growth prospects. This stems from the problem of growing fiscal debt ratios of economies. Hence, the only win-win solution would be to solve the problem at its very roots and have a more focused approach by employing budget consolidation over redistribution policies.
Income redistribution policies and growth are correlated. Empirical evidence and studies do suggest that this may be a positive correlation; where income redistribution has positive effects in the sphere of social equality and economic stability, when invested in the areas of education and health. On the flip side, however, countries which have invested in redistribution policies in the past have noted lower or stagnant rates of growth, although there are exceptions to this case. It would be fair to weigh in social, political and economic changes in the environment of the various economies over the years, but it is suggested that higher redistributive policies will retard the growth of the economy and create the backward bend of supply of the labour curve. This, in fact reduces efficiency and thus has a negative impact on future prospects. Transfer payments discourage the recipients from earning income now and from investing in their potential to earn future income. Hence, the economy will be poorer than before, and in the long run, individuals will choose not to invest or work, as their spending is covered by the taxpayers who are funding their transfers.
The logic of redistribution iterates that positive impacts are created in the economy when the government regulates and redistributes the income in the economy among its people. When the government is out to provide benefits in terms of government spending to those who cannot afford it or have less disposable incomes, the benefits they receive in monetary terms will almost immediately be converted into spending. This expenditure could be viewed as creating a multiplier effect in the economy and thus accelerating growth. The flip side of this argument, which was highlighted by Prof. Dorfman, is that, “If the government seeks to provide redistribution of income from the money raised in the form of taxes, the spending power of the individual who pays the taxes are exactly reduced by the amount the other gains from the redistribution of the taxpayer’s money”. This individual can neither spend nor save this money. This can be viewed along the same lines as the ‘Broken Window Fallacy’ argument.
Moreover, it is also argued that the individuals belonging to the lower-income bracket possess a higher marginal propensity to consume. It is not necessary for economies to operate under this narrative; even if they do, it can be understood that despite the money not being spent, it is definitely saved. When money is saved, it exists and is circulated in the financial system, and can thus be lent to generate interest or be similarly used for multiple other purposes. Hence, in the long run, the aggregate change in the economy from income redistribution, despite it being a short-term solution, remains unchanged or is in the negative.
Economies of the world are facing high fiscal debt ratios, and if a policy of income redistribution is taken, it most certainly would worsen the situation rather than help to reduce said debt. Hence the government must favour budget consolidation packages over redistribution policies. Budgetary consolidation, if not accompanied by improvements in the progressivity of overall tax and social transfer systems may have adverse effects on inequality. Depending on whether consolidation is concentrated, expenditure reductions can improve equity. It is important that the fiscal instruments which are set up in place are used with considerations to the adverse effects of inequality, and hence, in effect, it is important to have certain restrictions in place. The aforementioned can be enforced using methods such as strengthening social safety nets, which can greatly enhance the capability of governments to protect vulnerable households during adjustment.
Tax and transfers play a key role in reducing income inequality (OECD, 2012). The primary contribution of taxation to reducing income inequality is through its financing of redistributive spending measures in a way that it does not harm growth. To begin with, make the income tax systems more progressive. For example, in economies where a flat rate is used, there may be scope for more tax progression at the top. Since the mid-1990s, 27 countries—especially in Central and Eastern Europe and Central Asia—have introduced flat tax systems, usually with a low marginal rate. The top personal income tax rate must, however, be set with care.
In conclusion, budgetary consolidation policies which are set up must be consistent with the overall macroeconomic objectives of the economy. A design of fiscal consolidation policies should enhance efficiency, and with others, there may be a need to mitigate a trade-off. Nevertheless, along with consolidation, the demand shrinks in the short run. On the flip side, this period can be kept short by employing appropriate policies, so that growth, in the long run, does not face any negative effects. On the whole, as budgetary consolidation aims for the consistency of the macroeconomic policy of the economy in the long run and its objective is to reduce income inequality, it is preferred as a solution over that of income redistribution.
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