Income Inequality and Redistribution in Five Countries

By Nardi, Mariacristina De; Ren, Liqian et al. | Economic Perspectives, Summer 2000 | Go to article overview

Income Inequality and Redistribution in Five Countries


Nardi, Mariacristina De, Ren, Liqian, Wei, Chao, Economic Perspectives


Introduction and summary

Policymakers designing or changing a country's tax and transfer system aim at redistributing income and supporting the living standards of low-income families, while at the same time encouraging work effort and economic self-sufficiency. Indeed, there is a tradeoff between redistribution and efficiency: Economic theory suggests that transferring more income to the poor tends both to reduce their work effort and to distort the economic decisions of those who are taxed to provide the revenues that are being redistributed. There are several reasons why a government might want to redistribute income. Some of these are linked to the fact that people face different opportunities and different outcomes.

The government might want to provide insurance to its citizens against different outcomes, for example, sickness or unemployment, because in some cases private markets cannot work well. Moreover, not everybody enjoys the same opportunities in life; for example, people from poor family backgrounds are at a disadvantage relative to those from wealthier backgrounds, and transfers are a way to partly offset these differences. [1]

For historical and social reasons, different countries put different weights on the costs and benefits of redistributing income. Traditionally, Anglo-Saxon countries have a relatively low degree of government intervention in the economy and place more emphasis on incentives, while in many European countries, we see relatively more government redistribution, greater provision of public goods, and more emphasis on equality of opportunities and outcomes. Our goal in this article is to look at different countries, study their redistribution policies, and discuss the effects of the redistribution/incentives tradeoff. Since we want to look at countries that display different degrees of government intervention, we pick countries belonging to both traditions. We focus on a small number of countries to study these issues in detail: the U.S., Canada, Germany, Sweden, and Finland. Our country choices are also limited by the availability of comparable data.

The link between the distribution of income and taxes and transfers is a complex one. Households in each country decide how hard to work, when to retire, and how much to consume and save, taking into account the incentives and disincentives provided by the structure of taxes and transfers in their country. Therefore, the distribution of labor income is itself endogenous and the actual measure of taxes and transfers depends on the labor and saving decisions of the households. Moreover, the distribution of labor income depends on the distribution of human capital, and the government, for example, by subsiziding education, can have an impact on it. [2]

We focus on distribution of income across working-age households in these five countries because we are interested in labor income (earnings) inequality, abstracting from normal retirement decisions. In fact, at some age most people are retired and their labor income drops while their gross income is supplemented by social security payments, pensions, and other income sources. Looking only at households of working age, however, we ignore another important aspect of redistribution: social security transfers to older people.

We study income inequality in these five countries and use different income measures to compare the redistributive consequences of taxes and transfers. We also discuss their likely effects on the households' labor, early retirement, and savings decisions. The distinction between transfers and taxes is interesting because transfers are typically not just connected to income, but may be means tested (both asset and income based) or based on a specific condition (for example, being unemployed or a single parent). Taxes are typically not related to means testing and depend much less on specific conditions. They rely mostly on income as the screening signal. …

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