The limitations of decentralized world redistribution: An optimal taxation approach

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Abstract

A centralized scheme of world redistribution that maximizes a border-neutral social welfare function, subject to the disincentive effects it would create, generates a drastic reduction in world consumption inequality, dropping the Gini coefficient from 0.69 to 0.25. In contrast, an optimal decentralized (i.e., with no cross-country transfers) redistribution has a miniscule effect on world income inequality. Thus, the traditional public finance concern about the excess burden of redistribution cannot explain why there is so little world redistribution.

Actual foreign aid is vastly lower than the transfers under the simulated world income tax, suggesting that voluntary world transfers – subject to a free-rider problem – produces an outcome that is consistent with rich countries such as the United States either placing a much lower value on the welfare of foreigners, or else expecting that a very significant fraction of cross-border transfers is wasted. The product of the welfare weight and one minus the share of transfers that are wasted constitutes the implicit weight that the United States assigns to foreigners. We calculate that value to be as low as 1/2000 of the value put on the welfare of an American, suggesting that U.S. policy is consistent with social preferences that place essentially no value on the welfare of the citizens of the poorest countries, or that implicitly assumes that essentially all transfers are wasted.

Introduction

In May, 2002 rock star Bono and the former U.S. Secretary of the Treasury Paul O'Neill toured Africa together. At each stop they publicly aired their different views on the need for and effectiveness of foreign aid. Bono insisted that more aid is needed to lift Africa out of desperate poverty, implying that it is largely the mendacity of developed countries that prevents more aid. Secretary O'Neill argued that much aid has done little to reduce poverty, owing in large part to waste and corruption.

This high-profile tour generated wide media coverage of global poverty and global income inequality. But the same debate has been ongoing for many years. Gross disparities of income across countries1 have drawn attention to the small amount of resources transferred from the rich countries of the world to the poor countries, and have given rise to calls that the rich countries devote much more of their resources to foreign aid. For example, Sachs (2001) has called for the United States to double its aid budget and devote the funds to disease control, primary education, clean water, and other vital needs of impoverished places.

That voluntary, decentralized cross-country transfers might fall far short of what a centralized scheme motivated by the pursuit of social justice would imply is no surprise. To the extent that the well-being of the poor is a public good from which residents of all rich countries derive pleasure, the equilibrium outcome will be inefficient because of the free-rider problem. Alternatively, some donors might derive utility not only from the well-being of the recipient, but also from the act of giving itself.

The unwillingness of the United States and other developed countries to substantially raise their foreign aid may also reflect one or both of two other factors: The citizens of rich countries place a very low value on the welfare of the citizens of poor countries, or they may shy away from transfers because of the large efficiency cost that would plague such efforts. This cost may have two sources. One is the concern expressed by Secretary O'Neill and others that the funds would not reach the targeted groups due to waste and corruption. Another type of cost relates to the traditional concern of public finance economists that the process of taxing the well off and transferring the proceeds to the less well off causes disincentives. The economic cost of these disincentives limits the optimal amount of cross-country transfers that would be undertaken even by a policymaker with egalitarian impulses to redistribute from the globally rich to the globally poor.

In this paper we adapt the predominant perspective in public finance by presuming that the rationale for redistribution is neither altruism nor the “warm glow” of giving, but rather the pursuit of social justice. Following this tradition, we assume that the social desirability of alternative distributions of welfare among the world's population can be assessed in terms of a Bergson–Samuelson “social welfare function” defined over the utility (further assumed to be a function only of income) of the population under study. This function is assumed to be both anonymous and Paretian. From this public finance perspective, it is clear that the problem of global redistribution has the same structure as the problem each country faces – trading off in the pursuit of social justice the efficiency costs of a progressive tax system against the more equal distribution of welfare it achieves. In fact, most countries achieve some degree of redistribution through their own tax-and-transfer system. Clearly, the extent of overall world redistribution is small relative to world inequality because cross-country transfers are minimal. The question of whether these minimal transfers are at least approximately optimal and what the optimal transfers would be requires further investigation, however.

In this paper we explore this question quantitatively as follows. We first calculate each country's optimal redistributive policy, assuming that each country sets its tax system to maximize a concave social welfare function of individual utility levels, knowing that the tax system will influence individuals’ choices. Then each country will set its own tax schedule that is more or less progressive based on the distribution of incomes (more precisely, the ability to earn income) within that country. Even though the social welfare function is concave, the desire to redistribute is constrained by the economic cost of the marginal tax rates the redistribution requires. Using data on income inequality and assumptions about utility functions that imply how responsive behavior is to taxation, we calculate the optimal income tax system in each of 118 countries and characterize the amount of redistribution that these decentralized systems produce.

Then we consider the hypothetical case of a world income tax, where the same tax schedule applies to everyone regardless of where they live, and which therefore allows for transfers across countries.2 We first consider the case where there is no waste (other than excess burden) from cross-country transfers and that the tax setter is border-neutral, meaning that each person's welfare enters the social welfare function the same regardless of where he or she lives. Assuming further that the world decision maker has the same preferences as each country about the tradeoff between the mean and distribution of incomes (i.e., an equally concave social welfare function), and faces the same costs from imposing redistribution, we can solve for the optimal progressivity of the world income tax. The solution depends on the inequality of world incomes, and not on the degree of inequality within countries.

The results of simulating these stylized models reveal that the decentralized tax-and-transfer scheme makes hardly any dent in the world income inequality. This is so even though countries pick progressive tax systems on their own. In contrast, an optimal world income tax would significantly reduce the world inequality of consumption, albeit with a larger efficiency cost and at the cost of a reduction in welfare of citizens of the richest 25 countries. Thus, we conclude that a concern about the excess burden of cross-country transfers cannot justify why foreign aid is so low – what limits these transfers is not the efficiency cost of the redistribution.

Using our methodology the limitations of voluntary, decentralized redistribution can be quantified. In the final section of the paper we address this question by allowing the policy makers in the rich countries to place a lower value on the welfare of the citizens of other countries at any given level of income compared to their own citizens – as suggested by Bono – and/or expect that a fraction of cross-country transfers would be wasted – as suggested by Secretary O'Neill. With our parameter assumptions we cannot distinguish between the Bono and O'Neill scenarios, but we can calculate what the product of that relative value and the share of transfers that is wasted must be in order to generate the current level of cross-country transfers, in the form of foreign aid, given by rich to poor countries.

It is shockingly low. In our baseline case, the level of U.S. foreign aid is consistent with foreigners are on average being valued by the U.S. at just 16% of an average American, with the citizens of the poorest countries weighted by as little as 1/20th of 1%. The latter value implies either that voluntary, decentralized aid produces an outcome that is consistent with the U.S. putting essentially no weight on the welfare of those individuals, or that 1999/2000th of the transfer is wasted, or a combination of both. One reason for this low implicit valuation is that donor countries may view the welfare of the poorest foreigners as a public good, and so voluntary donations are subject to a free-rider problem.

Section snippets

Calculating the optimal linear income tax

Our central analytical tool is a model of the optimal income tax structure, as pioneered by Mirrlees (1971). The idea is that the government chooses an income tax function that maximizes a given social welfare function, subject to an exogenously specified revenue requirement and the constraint that individuals will choose the levels of consumption and leisure that maximize their utility subject to their own budget constraints, which depend on the tax system chosen.

There are three key elements

Results

We are now ready to calculate the optimal income tax systems, first for each country choosing its own tax-and-transfer system, and then for the world income tax. Table 2 shows the results for a subset of countries.

In the focal simulation we assume that the parameter of the Atkinson's welfare function is v=2.0.17 The first and third columns of Table 2 show the parameters – marginal tax rate and demogrant –

Foreign aid and the Bono/O'Neill factor

A striking feature of the hypothetical centralized scheme of world redistribution motivated by the pursuit of social justice, as represented by the optimal world income tax solution, is the large transfers from the rich countries, amounting in the United States to $16,432 per capita. In fact, many relatively well-off countries do provide foreign aid to less well-off countries, and most rich countries contribute to multilateral institutions such as the World Bank that offer assistance to

Sensitivity analyses

In Table 5, we present the results of simulations analogous to those of Section 3, but for different degrees of concavity of the common social welfare function. We consider v=0.5, 2.0 and 5.0. Because v=2.0 is our baseline case, the numbers in this part repeat information shown earlier. A value of v=5.0 corresponds to a much more egalitarian social welfare function, while v=0.5 is a much less egalitarian social welfare function. To save space, we show only the results for the world as a whole

Summary and ruminations

The decentralization of redistribution decisions results in vastly less redistribution than would be accomplished by a centralized scheme motivated by the pursuit of border-neutral social justice taking into account the disincentive effects caused by the higher taxes needed for cross-country transfers. In our stylized simulation of redistribution policy, a decentralized system without cross-country transfers hardly budges the world Gini coefficient of consumption, even though it reduces it for

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    The earlier version of this paper, distributed under the title “Why World Redistribution Fails” (NBER Working Paper 9186), contains tables with results for all 118 countries used in our simulations.

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