Non-tax policies to combat poverty

guest post by  Jean Hindriks

The post on 8 December 2012 about VAT and Children Poverty, made the point that it could be desirable to subsidize energy prices rather than providing transfer in cash to low income family. This reminds me of the principal implication of the so-called tax principle that says, in a nutshell, that society cannot improve redistribution possibilities by using non-fiscal instruments. The question is then why non-fiscal forms of redistribution are so widely used. Governments frequently provide for goods such as education or health services at less than their costs, which may be viewed as redistributive policies. One may expect that a cash transfer of the same value would have more redistributive power than such in-kind transfer programs.   I claim this is mistaken. There are three reasons why such transfers in kind may be superior to cash transfers as achieved through standard tax-transfer programs.[1]

The first reason is political. Rather than voting for a tax-transfer scheme that benefits the poor, I might impose my own preferences and vote for providing certain services such as education, even though the recipient would have preferred another use. Voters may support redistributive policies if in kind but not if in cash with use at the discretion of the recipient. Political considerations dictate that many government provision programs like education, pension and basic health insurance, be universal. Without this feature the programs would not have the political support required to be adopted or continued (see the Obama’ Healthcare bill). For instance, public pensions and health care would be far more vulnerable politically if they were targeted to the poor and not available to others.[2] It should be noted that it is not because some government programs are universal, that there is no redistribution. First, if the program is financed by proportional income taxation, the rich contribute more than the poor. Second, even if everyone contributes the same to the program, it is possible that the rich will not use the publicly provided service. To take an example, consider the public provision of basic healthcare available to everyone for free. Suppose the program is financed by a uniform tax on all households. There exists a private health care alternative with higher quality but at some cost. Since the rich can afford a better quality, they will use the private health even though free public health care is available. These rich households still pay their contribution to the public program and thus the poor households derive a net benefit from this cross subsidization.

The second reason is self-selection. What ultimately sets the limit to redistribution is when it becomes advantageous for higher ability persons to earn lower income by expending less effort and thereby paying taxes (or receiving transfers) intended for the lower ability groups. The limits to redistribution are reached when a person of a given ability would be just as well off earning the income of another with lesser ability. The self-selection argument is that anything making it less attractive for persons to mimic those with lesser ability could extend the limits to redistribution. For instance, if the government could supplement non-linear income tax with differential commodity taxes (as suggested in the earlier post on 8 December 2012), it will do so in certain cases (namely, if the shares of income devoted to the consumption of each good are related the amount of leisure). For our discussion of non-fiscal instruments to combat poverty, the use of in-kind transfers to supplement standard taxation can be optimal. This is an efficiency based argument. Basically, a given degree of redistribution can be more efficiently achieved by using in-kind transfers as a supplement to income taxes. The argument, unlike the non-separability argument just used for differential commodity taxes, relies on differences in preferences among different income groups. Consider two individuals who differ not only in their ability but also in their health status. Suppose that lesser ability means also poorer health so that the less able also spend more on health. Then both income and health expenditures act as a signal of ability. It follows that the limits to redistribution can be relaxed if transfers are made partly in the form of provision of health care (or equivalently with full subsidization of health expenditures). The reason is simply that the more able individual (with less tendency to become ill) is less likely to claim in-kind benefits in the form of health care provision, than he would be to claim cash benefits.[3] To take another example, suppose the government is considering redistribution either in cash or in the form of low-income housing. All households, needy or not, would like the cash transfer. However few non-needy households may want living in low-income housing. They can afford better housing. Thus self-selection arises by which the non-needy drop out of the housing program and only the needy take up. In short, transfers in kind invite people to self-select in a way that reveals their neediness. When need is correlated to income-earning ability, then in-kind transfers can relax incentive and selection constraints, thereby improving the government ability to redistribute income.

A third reason is time consistency. Here the argument for in-kind transfers relies on the inability of the government to commit to its future actions. Unlike earlier arguments for government time inconsistency, it does not arise from a change in government objective over time (e.g. because of election switch) nor from the fact that the government is not rational.[4] The time inconsistency problem arises from a perfectly rational government who does fully respect individual preferences, but who does not have the power to commit its policy in the long run. The time-consistency problem is obvious with pensions. To the extent that households expect governments to provide some basic pensions to those with too little savings, their incentive to save for retirement consumption and provide for themselves is reduced. Anticipating that, the government may prefer to provide public pensions itself. A related time consistency problem can explain why transfer programs, such as social insurance, education and job training are in kind. If a rational government cannot commit not to come to the rescue of those in need in the future (due to ex-post welfarism), potential recipients will have little reason to invest in their education or to undertake job training, because the government will help them out anyway. Again, the government can improve both economic efficiency and redistribution by making education and job training available at less than their cost, rather than making cash transfers of equivalent value.

[1] Hindriks, J, and G. Myles, 2013, Intermediate Public Economics, (Chapter 18 The limits to redistibution),  2nd edition, MIT Press April 2013

[2] De donder P. and J. Hindriks, 1998, The Political Economy of Targeting Public Choice, 95,177-200, 1998.

[3] Blackorby, C. and D. Donaldson, 1988, Cash versus kind, self-selection and

efficient transfers, American Economic Review 78, 691-700.

[4] Strotz, R.H., 1956, Myopia and inconsistency in dynamic utility maximization, Review of Economic Studies 24, 165-80.


About PoRESP

The aim of the PoRESP project is to contribute to the theory of poverty measurement by connecting it with other fields of welfare economics, and to better understand how redistributive policies should be designed to decrease poverty.
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