His loss might be everybody's loss.

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The Cost of Redistributing Wealth

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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I’d like to explain how most modern economists think about wealth redistribution. If you discuss welfare, taxes or inequality with an economist, you’re bound to run into a concept called the equity-efficiency tradeoff. It’s the idea that there’s a fundamental tradeoff between the size of the economic pie and the equal distribution of said pie. 

Suppose you’re a really rich person. You have $50 billion in wealth, though it fluctuates day to day depending on the financial markets. But even if the markets take a tumble, you will still have enough to buy almost anything you want -- mansions, private jets, super yachts. You can afford to give hundreds of millions to political causes, universities or charities each year without putting a noticeable dent in your net worth. 

Now suppose some hacker comes and steals $10,000 out of one of your brokerage accounts. Unless you have a very careful accountant, you probably won’t even notice the theft. The difference it would make in your purchasing power would be negligible. The loss would be no larger than what you probably suffer a hundred times a day from the random movements of the markets. 

Now suppose that hacker, in the tradition of Robin Hood, decided to give the stolen $10,000 to a poor man in a slum in Baltimore. That $10,000 is probably as much as the poor guy earns in a year. Suddenly, his yearly salary is doubled and his risk of having to sleep in a homeless shelter is dramatically reduced. He could even use the money to take some night school classes and buy himself a better future, if he is so inclined. 

In other words, $10,000 makes only a tiny difference to the well-being of our multibillionaire, but it would make a huge difference to the well-being of the average American poor person -- to say nothing of the average poor person in India or Nigeria. 

This difference in the marginal value of wealth -- the value of each additional dollar -- is a key part of modern economics. It underlies our theory of risk and our theories of labor and leisure. But it also has implications for what we think of as human welfare -- the total well-being of the species, or the nation. A given number of dollars creates more well-being in the hands of the poor than in the hands of the rich. 

So should we just redistribute all the wealth until everyone has an equal amount? Even if you think that doing so would be morally acceptable, you would have good reason for caution. Although rich people might not notice one or two random thefts from their bank accounts, they will most definitely notice the systematic appropriation of their wealth by the government. That systematic appropriation, of course, is called taxation. 

When you tax people, you usually cause them to reduce the amount that they do the thing that is subject to the tax. That’s not always true -- if you tax people’s labor, they may work less because of the decreased value of an hour of work, or they may work more because they’re poorer than they were before. But in general, taxation reduces economic activity. Taxing investment reduces investment, and taxing consumption reduces consumption. 

Only a few kinds of taxation don’t result in a decrease in economic output. One example is land taxation -- since the amount of land is constant, you can tax it without worrying that supply will fall. Even then, you have to be very careful how you separate the value of the land from the value of human development of that land, which can be reduced in response to taxes. 

Anyway, the basic message is that the more the government tries to shift income around, the less total income there is to distribute. The more equal you force your society to be, the poorer it gets. 

This is sometimes known colloquially as “Okun’s bucket,” after economist Arthur Okun, who once likened redistribution to moving wealth from one person to another with a leaky bucket. You manage to move some from one place to another, but along the way you lose some from leaks. 

Modern empirical techniques have allowed economists to get a better idea of how big the leaks are in the bucket. For example, a recent paper by Nathaniel Hendren looks at the earned income tax credit, food stamps and housing vouchers. He finds that for every dollar redistributed from rich to poor with those programs, anywhere from 34 cents to 56 cents leaks out and is lost. 

This is how economists think when they consider redistribution programs like the ones mentioned above. They don't normally consider moral questions, like whether it’s ethical for the government to confiscate one person’s income in order to give it to another. When they do attempt to wade into the moral side of things, the result is often ham-handed and awkward. 

Thus, economists typically leave questions of justice to the philosophers and politicians. Mostly, they focus on trying to quantify the tradeoff between equality and efficiency. That may seem a bit heartless, but to many economists, it feels like the most objective way to approach questions of redistribution. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net