The equity efficiency trade-off

    Economics is the study of trade-offs between different uses of scarce resources. Firms continuously trade off current benefits from the distribution of dividends against future benefits from retaining these profits and reinvesting them in the business. Managers and workers trade off the career fruits of long and hard working hours against the joys of leisure time. Consumers trade off the utility that could have been attained by buying good X or Y for the utility derived from purchasing good Z instead.

    Arguably, the most important, and certainly the most hotly debated, economic

trade-off is the political choice between equity and efficiency. Conventional wisdom

suggests that more equity leads to less efficiency, because equalisation of income and wealth among individuals can reduce work incentives, as well as the aggregate level of savings and investment .Conversely, unrestrained market forces result in inequitable outcomes or, in the famous words of Arthur

Okun, ‘dollars transgress on rights’.

    Economists have attempted to check the link between equity and efficiency empirically.This entails finding satisfactory measures of the two concepts. Efficiency is usually measured by reference to average GNP per capita.

    Measuring equity is trickier. Economists associate equity with an even distribution of income and wealth among individuals. The main measure of income distribution is

derived from the Lorenz curve, presented in Diagram 1.

    The Lorenz curve plots the cumulative share of income and wealth in ascending order against the cumulative percentage of population. In Diagram 1, for instance, 80 percent of the population receives only 50 per cent of the total income, while the richest 20 per cent enjoy the remaining 50 per cent of the pie. The poorest fifth of the population receives a mere 3 per cent of national income and wealth. This Lorenz curve thus depicts a society with considerable inequality. A country with perfect equality of income and wealth, where each individual controls the same amount of material goods,exhibits a straight Lorenz curve, called the ‘line of equality’.

    The more strongly the Lorenz curve diverges from the line of equality, the greater

the degree of inequality. This can be captured by a simple measure. The Gini coefficient is the proportion of the area delimited by the line of equality and the Lorenz curve, relative to the total area between the line of equality and the horizontal axis. The index can take values between 0 and 1, where 0 means perfect equality and 1 represents complete inequality.

    Diagram 2 shows Gini indices for a selection of high-income countries. The upper

bars represent the distribution of disposable income among individuals. The lower

shaded bars show what level of income inequality would have prevailed in

the absence of government redistribution through progressive taxes and welfare

benefits.

    Two important conclusions can be drawn from Diagram 2.

1. Market forces alone produce highly unequal income distributions. The ‘before redistribution’Gini indices for the 10 sample countries are contained in the range

0.33_–_0.44.

2. Post-tax distributions are much less unequal than pre-tax distributions. The ‘after

redistribution’ coefficients lie in the range 0.20_–_0.34. Tax and welfare payments

reduce inequality to a significant extent. 

    Wealthy countries tend to be more equal in overall income distribution than poor

countries._2 The UK, however, has experienced deteriorating inequality in recent years.Up to the 1980s its Gini coefficient was 10 points below the US level; by the 1990s the gap had fallen to only 5 points._3 Equity and efficiency do not necessarily conflict. The 10 countries in Diagram 2 are all among the world’s very richest and some are quite egalitarian. In developing countries, higher inequality in income or land ownership tends to be associated with lower growth. It is argued that big income and land ownership differentials reflect underinvestment in education, divert government efforts from investment and growth promotion towards the abatement of social conflict, and reduce the majority’s incentive to save and invest.

    The relationship between equity and efficiency depends to some extent on individual attitudes and culture. In some societies, income inequalities are condemned less, and financial work incentives valued more, than in others. A political philosopher stated that ‘the combinations of equity and, say, economic growth attainable in a competitive market economy full of individualistic materialists might be rather different from those attainable in a co-operative economy run by and for ascetic altruists’._5 A poll conducted in 1990 showed that only 29 per cent of Americans thought it was the government’s job to reduce income differentials, while 60_–_70 per cent of Germans and Britons, and over 80 per cent of Italians and Austrians, were of that opinion._6 The debate continues.