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Inefficiency from Inequality

June 8, 2011

There is a long standing principle in mainstream economic thought that efficiency and equality are mutually exclusive.  I cannot give that argument justice but it must hold that efficiency creates inequality or that equality creates inefficiency.  The only way I can consider the later argument working is if equality creates incentives to underproduce which is an argument that has been made.  I disagree with it but I’ll talk on that later.  The former argument is that efficiency creates inequality.  I’m sure this argument has been made as well but I am unfamiliar with it.  Instead of dealing with the argument directly I desire to explore how the two can be compatible.

Part of the question of compatibility between the two is the measure of fiscal multiplier.  A fiscal multiplier is how much the GDP changes relative to the amount of money spent by a government.  What fiscal multipliers are is a subject of much debate amongst economists with no consensus.  Generally direct spending is given a multiplier greater than one and tax cuts are given a multiplier less than one.  This means that a dollar taxed and spent by the government generally has the impact of growing the economy when these are the case.

In general when adjustment in fiscal policy are made the net impact on GDP is the multiplier of the spending divided by the multiplier (in absolute value) of taxes used to fund the spending times the amount spent.  When this number is greater than one the economy as a whole benefits from spending: ie. the spending is more beneficial than the taxes are harmful.  Different taxes and different spending have different multipliers and the problem is these are hard to measure.

A study was done in response to the stimulus spending in 2009 (http://www.nber.org/papers/w16759.pdf?new_window=1 via http://tpmcafe.talkingpointsmemo.com/2011/02/22/washington_wrecks_the_economy_more_evidence/ via http://www.tinyrevolution.com/mt/archives/2011_02.html) that shows that spending on infrastructure likely has a multiplier of at-least 1.5 and spending on direct aid to the poor has a multiplier of at-least 2 at-least in a recession.  These are large figures and larger then a tax raise that has a multiplier of less than 1 or slightly greater than 1.  This would directly suggest that at-least in a recession that taxing the wealthy and spending the money on the poor helps boost society’s GDP.

The question remains is why would there be such a disparity between the three aspects.  The answer is revealed in spending habits.  Someone who is getting by week to week or month to month is largely spending all of the money he or she earns while someone who has the luxury of a substantial savings or other wealth reserve has the ability to fund this reserve.  The poor spend more money than the rich as a portion of income.  Since it is the cycle of production and consumption that drives GDP, the poor are more efficient drivers of GDP then the rich are.  Thus increasing equality drives short term efficiency in GDP growth.

Important to the notion of economic efficiency is the question of what an economy is supposed to do.  An economy is supposed to provide goods and services to a population.  I will make the further claim that necessary goods need to have a higher priority than luxury goods.  Since the spending power of different segments of a population determine what production occurs, greater equality leads to production more balanced with humane priorities.  This leads to the conclusion that increased equality creates efficiency in an economy.

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From → Economics

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