The efficiency-equity trade-off
Introduction
There is one large part of the public sector that seems to be outside of the scope of public management. The vast and often highly costly programmes which transfer money to people do not appear to bend themselves to the logic of public management with its focus upon efficiency Social security is not about the provision of goods and services but concerns citizens’ rights, so-called entitlements. Few question the justice inherent in entitlements, but what is contested is the size of the transfer payments as well as how they are to be financed.
If entitlements belong to the domain of social justice, then deliberating about these rights requires a theory of justice. Yet, such a theory is not available in the social sciences, as the concept of justice remains an essentially contested notion.
However, transfer payments may be examined from another angle, namely economic efficiency in a macro-sense. What are the costs to the economy of large transfer payments, either on the income side (taxation) or on the expenditure side (subsidies)?
Could it be the case that entitlements are inversely related to economic efficiency in the sense of total output? A number of hypotheses in both expenditure and taxation theory have suggested that this is the case. Here, we find the Okun efficiency-equity trade-off, the Laffer curve, the leisure-work reaction curve and the excess burden argument from tax wedges. If some of these hypotheses are correct, then a government distributing entitlements must take into account the costs of redistribution, which may go prohibitively high. Let us look at what is involved here.
If it is true that income redistribution runs into conflict with economic efficiency, lowering total output, then why do governments operate such programmes? We must search for the basic rationale of all the transfer programmes that loom so large in the budgets of rich countries. Brian Barry suggests that justice implies that governments redistribute in order to achieve equality. Director’s law suggests another answer (Stigler, 1970).
Income redistribution
Wagner’s Law about the impact of affluence upon public expenditure seems particularly applicable to transfer payments. Whereas poor countries are largely unconcerned with this type of public expenditure, the case is entirely different in rich countries. In the OECD set of countries, all governments pay huge sums of money for income maintenance. And the share of the GDP going to income maintenance is rising, slowly but seemingly inexorably.
The Wagner effect, or the positive elasticity to spend publicly any increase in GDP, seems to make sense in relation to income maintenance. Even poor countries must pay for basic state necessities, such as public goods and infrastructure. But only rich countries can afford income maintenance programmes. In his original statement of his hypothesis about the future size of government, Wagner actually separated the need for infrastructure from the need for income maintenance, although he argued industrialisation and urbanisation would increase both kinds of expenditures (Wagner, 1877–1901).
Yet, Wagner’s Law has its limits. The so-called welfare societies have a much lower level of income maintenance than the welfare states. And whereas the latter employ pay-as-you-go schemes, the former have introduced more actuarial principles. Affluence is a necessary but not a sufficient condition for huge income maintenance programmes.
Income maintenance is a concept that covers a variety of programmes. What is characteristic is that they constitute rights, i.e. they are part of public law, meaning that governments must respect them even when they face financial difficulties. Entitlements can only be changed through law, and this has happened in the 1990s because governments have found the task of paying for all promises made in income maintenance too burdensome.
Transfer programmes give money to many groups of people, collected in principle by means of taxation. Some countries employ only taxes, while other countries also use social security charges. Income redistribution arises when transfer programmes are not based upon so-called actuarial principles, i.e. rules that guarantee that what one person pays in he/she can also collect. Thus, public income maintenance which is based upon pay-as-you-go schemes is not an insurance scheme.
Public maintenance schemes build upon the fundamental separation between the income side of the public household and the expenditure side of the same household. Although governments have tried to limit the gap between what a person pays in and what he receives, it remains the case that income maintenance is basically a pay-as-you-go system where there are winners and losers.
But who is money being transferred to in public redistribution schemes and from whom is it coming? The naïve opinion is that money is taken from the rich and given to the poor, but income maintenance schemes do not operate that way.
Much of the money in these programmes concerns redistribution from and to the same individual, i.e. they constitute redistribution over the life cycle of the
The efficiency—equity trade-off 95 same individual. One and the same person pays into the system during certain years but takes out from the system at other periods of time.
Now, there is in principle no limit to the demand for income maintenance.
The remuneration could always be made more generous and programmes could always be extended in various forms. In addition, real life developments push expenditures upwards due to demographic changes. The situation is such that governments have reason to be worried about the transfer payments.
Expenditures for income redistribution have increased much faster than the GDP, and more rapidly than the allocative expenditures. Transfer payments are today larger than allocative expenditures in most OECD countries. Sometimes one type of income maintenance is left outside the entitlements, namely poor relief, because in some countries it is more a discretionary expenditure than a right. However, when included in the income maintenance sector, then the redistributive branch of government becomes clearly larger than the allocative branch almost everywhere.
If it is certain that income maintenance costs more and more not only directly but also indirectly, then it is uncertain what the outcomes of transfer payments are. There are two problems involved. First, there is the excess burden question, i.e. whether the true cost of transfer payments is significantly larger than the nominal cost. Second, there is the problem of the effect of redistribution, i.e.
whether such schemes really lead to more income equality.
Efficiency versus equity
The new management philosophy has one main objective for the public sector reforms that it recommends, namely to raise efficiency in the provision of goods and services. The number of means employed to enhance this goal is considerable and covers, besides privatisation, incorporation of public enterprises, the introduction of internal markets, the employment of the purchaser—provider separation, contracting out, the use of massive contracting whether provision is inhouse or outhouse, bench-marking, restructuring of ministries, use of executive agencies, increased use of user fees, etc.
Focusing not upon the means but upon the single objective efficiency, one may raise a question that appears to contain a few puzzles about public sector reform in the 1990s. First, what is nature of that key objective, efficiency, which is so much focused upon? Second, why are other objectives that have figured prominently in the public sector never mentioned, especially equity? Finally, one may enquire into the outcomes of public sector reform, relating the objectives concerning efficiency and equity to the actually accomplished results. One would, of course, want to know what are the signs, if any, that efficiency has increased as well as whether equity has been affected at the same time, either increasing or decreasing.
Talking about efficiency in the public sector, one may either take a micro- perspective, focusing upon how quantities, qualities and costs have developed within one sector or even within one ministry, department or production unit.
Or one may take a macro-perspective, attempting to make an overall assessment of public sector reform with a measuring rod like macro-efficiency, meaning the maximisation of output. Below, we will pursue the macro-perspective, and in particular focus upon the argument about a trade-off between efficiency and equity.
Relevance of a distributional perspective on taxes and expenditures
The public sector allocation of goods and services cannot be approached only from the efficiency perspective. Such goods and services are distributed to consumers or citizens. Distributional matters are unavoidable when one looks at public finances. The minute that a supply of goods and services is forthcoming, one can ask: who gets what, when and how?
Each allocation of services has a distribution of these attached to it, but there is in addition the large set of transfer payments, i.e. the income redistribution branch of government, or as it is also called: social security. In advanced countries, social security is larger than public resource allocation on both the income and expenditure sides. Redistribution can be in kind or in money.
Moreover, allocation and distribution interact, meaning that certain efficient outcomes may not be satisfactory from a distributional point of view—the equity perspective—or the other way around. The possibility of an efficiency-equity trade- off arises not only in the income maintenance programmes, but also in the allocative programmes. What, then, is the equity perspective that may compete with the efficiency norm?
Distributional criteria in relation to the public provision of goods and services (in kind) or in relation to transfer payments (in money) are not easily specified.
From an efficiency point of view, there are the user fee criteria of various kinds:
charges, benefit taxes, which mean that people who get the goods and services pay in full for their utilisation. From an equity point of view, there are need or want criteria as well as rights criteria so that distribution of the goods and services is not in accordance with the willingness to pay but on the basis of criteria derived from social justice theory.
When needs, wants or rights are employed, then the allocation (in kind) or redistribution (transfer payments) is basically paid for by means of taxation schemes based upon the ability to pay. Taxation has immense distributional implications, as the choice of a finance scheme faces alternatives, which relate to the kind of good or service allocated in the public sector. Benefit taxation seems reasonable in relation to divisible goods and services (mainly private goods) whereas ability-to-pay taxation would be more appropriate in relation to indivisible goods and services (mainly public goods). Redistribution in the social security system can be paid for by means of a benefit approach or the ability-to-pay approach, where the latter allows much more interpersonal redistribution whereas the former is more conducive to intergenerational redistribution for one and the same person.
The efficiency—equity trade-off 97 The widespread employment of schemes for ability to pay in combination with public resource allocation entails redistribution in kind. It seems impossible to satisfy by means of a realistic mechanism the Wicksell requirement for efficiency in the public sector, where MB=MC for all individuals over all goods and services, when there is lots of allocation paid for by means of the ability-to- pay approach. It is true that benefit taxation schemes enhance the Wicksell requirement, but not all benefit taxation schemes fully implement the rule that the individual who benefits also pays the cost for the good or service that he/
she consumes (Wicksell, 1967).
Actually, a number of efficiency reasons could be used against benefit taxation.
Many public goods cannot be sold due to the free rider problem. Some goods and services should not be priced at all, because enjoying them carries hardly any marginal cost, such as roads. Finally, pricing goods and services the consumption of which leads to positive external effects may lead to an under- supply of these goods.
Moreover, an equity argument against benefit taxation could be stated, as government sometimes wants to make certain goods and services freely available to groups with needs that would not be properly looked after, if prices were used to cover the entire cost for these goods and services—redistribution in kind or true merit goods. Government would definitely want to do so, if groups were entitled to help in these respects.
Transfer payments are often considered to be entitlements which people have because they are citizens in a country. The concept of an entitlement is critical in social justice theory and cannot be derived only from the efficiency framework, focusing upon Pareto-optimality. Entitlements play a major role in welfare state theory as well as in nationalism (Miller, 1997).
Ability-to-pay taxation is the income type that governments predominantly use to pay for the provision of goods and services in the so-called soft sector.
The business sector is not problematic from this aspect, as it can in principle be fully financed by means of charges or user fees—benefit taxation. However, no government has ever accepted the proposal to put a price tag on all its goods and services, if it were at all feasible from a practical point of view, in order to arrive at the Wicksell efficiency condition, or MB=MC also for the public sector.
As already underlined in Chapter 3, various forms of taxation are placed upon different people and objects on one occasion in order to pay for a bundle of goods and services as well as transfer payments that on another occasion are distributed to a variety of people. Thus, arises the gulf between payment and utilisation, which remains a typical feature of any public sector, i.e. especially the soft sector. Decisions about financing are taken on separate occasions from decisions about spending.
The inverse law of concentration of benefits and diffusion of costs appears very much true of the public sector, especially the soft sector. Benefits tend to be concentrated on certain groups of people whereas costs tend to be spread out upon all groups of people. In the social security system this seems almost to be
unavoidable in a modern public sector, given that they are founded upon the pay- as-you-go idea instead of upon only an actuarial mechanism.
Distributional aspects of public sector services
When goods and services are claimed to be in the public interest or the national interest, then they should benefit in principle each and everyone. Yet, one could argue that so-called public goods like defence or Rule of Law benefit some groups more than others, although they would be in the public interest. However, it seems exaggerated to emphasise the distributional implications of the allocation of all kinds of goods and services, especially pure public goods or common pool goods. Only in relation to the types of goods and services in the public sector that are not classified as pure public goods, such as infrastructure, environment and education as well as health and social care, the question, who gains by it, seems highly relevant.
Semi-private or semi-public goods and services do not provide benefits that are entirely for one group of people. Society as a whole—each and everyone practically—benefits from good communications, a clean environment and a high average standard of living of the population with regard to education, health and social care. There are externalities involved, meaning that private utility is smaller than social utility. Yet, some groups benefit more than others.
The distributional consequences of the allocation of services in the public sector appear in a clear manner in relation to goods and services which are characterised by full appropriability and very little jointness, such as education, health care and social care. On the other hand, benefits tend to be less concentrated on certain groups and more widespread in their distributional implications when goods and services are characterised by considerable jointness such as with communications or positive externalities such as with various aspects of the environment. Yet, one can argue that distributional consequences occur everywhere, in roads for instance there are groups that are favoured such as motorists or people who use trucks and buses primarily.
Urban areas favour their populations concerned with the protection of the environment in a very wide sense of that concept including all kinds of pollution, clean water and sewage.
Distributional implications of social security
As we move to the core of the redistributional branch of government, viz. social security, distributional considerations loom really large. Both on the payments side and the expenditure side social security is very much focused upon redistribution. Social security in an advanced country costs so much that it is vital to establish the distribution consequences of such large flows of money.
Several welfare states have devised special forms of taxation—social security charges—in order to pay for the immense expansion of the transfer payments system characteristic of the last twenty years. A key question is whether the
The efficiency—equity trade-off 99 person who pays these charges is the same person who benefits from the transfer payments as well as whether there is proportionality in the system.
Transfer payments include a number of items of expenditure: pensions, unemployment benefits, sickness insurance, maternity leave, child allowances, accident and handicap insurance, student support, social care, etc. Due to a combination of political pressures and demographic changes, the total sums of money passing through social security have skyrocketed. There is little demand for a reduction in the size of these programmes, as they are considered to be entitlements.
Obviously, much social security is the transfer of money from one person to the very same person with only a difference in time. The same person pays social security charges during his active time in occupational life and then collects much of the same money when he/she is no longer active occupationally However, social security is not the same as insurance.
First, social security is obligatory, as the social security system covers people by means of public law regulations. Individuals have to pay the social security charges and they are entitled to the social security payments. Second, there is no guarantee whatsoever of proportionality, or any automatic relationship between the amount paid and the amount received. There are losers and winners in the social security system meaning that some people pay more than they receive whereas other people receive more than they pay.
The rationale of social security is more concerned with equity than efficiency.
Although for reasons of opportunism or negligence not all people would buy insurance against the unfortunate and unpredictable events that might hit them during their life time, social security is motivated less by consumer myopia and more by the argument that many people cannot afford such insurance.
Since the income and wealth distribution among people is always more or less skewed, there is a need for state intervention after markets have distributed resources in accordance with the basic criterion that factor (labour, capital, land) payments are equal to their marginal contribution or value:
(MP) Factor compensation=Marginal productivity
In principle, people who are not working will receive nothing when (MP) is applied. Thus, there is a demand for state intervention in the distribution of income and wealth after markets have been in operation. This is ex post redistribution.
Yet, there is also an argument in favour of ex ante redistribution stating that equity requires that there is equal opportunity for each and everyone. Markets should start their operation of rewarding the talented and punishing the unfortunate from a starting-point that is just—i.e. there should be equal opportunity.
Thus, social justice requires state intervention both before and after the operation of markets. To make things more complicated still, justice is also employed as a criterion for the evaluation of market operations, requiring inter alia contractual honesty and the mutual fulfilment of obligations.