The Great Economic Divide Makes Everyone Poorer
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The Fiscal Times
December 20, 2011

The argument that the rich should pay a larger share of our tax bill than the poor does not rest upon fairness alone. As Robert Frank explains in his book The Darwin Economy, requiring the rich to pay a larger share allows us to have more goods and services than we would have with a more equal tax structure – we can make everyone better off – and this improves economic efficiency.

To see how this works, imagine four families sharing a large, jointly owned backyard area. The families would like to install a swing set, slide, etc. for their children to share. The set costs $1,200, and they need to figure out how to pay for it. One of the households is fairly well off and would be willing to pay up to $800 for the swing set. But the other three families struggle to make ends meet, and each is only willing to pay $250. These families really want the swing set – even more than the well-to-do family – but even $250 is a squeeze on their tight budgets.

If everyone is asked to contribute equally to the swing set, $300 each, it won’t get purchased since that is more than the poorer households are willing to pay. But there are arrangements that will work. Suppose, for example, that the wealthy family offers to put up half, $600, leaving the other three families to share the remaining $600, or $200 each. The wealthy family gets a swing set for $600 even though it would have been willing to pay up to $800 for it – economists say this family enjoys $200 in consumer surplus. The less wealthy families also receive $50 in consumer surplus since each household gets the playground equipment for only $200 even though it would have paid $250.

Thus, if we insist upon equal contributions from everyone, we forego the opportunity to make all of the families better off – to give each family goods and services for a price less than their full willingness to pay. In economic terms, allowing unequal contributions increases efficiency.

Now let’s change the example slightly. Let the families all live on the same block, share a common, city-owned area, but they hardly know each other and have very little interaction. Even though the city would let them install the playground equipment if they can come to an agreement on how to pay for it, the trust and knowledge that is needed to reach an agreement is not present. Each household might worry, for example, that the others will misrepresent their situation in order to shift the cost elsewhere.

This is where government has a role to play. Nothing has changed in this example except the ability of the individuals to come to an agreement. They still want the playground equipment, and they have the same willingness to pay as before. Thus, if the government were to install the equipment and then send the families differential tax bills – the rich family is charged $600 and the poorer families $200 each – everyone is made better off just as before.

This is, of course, an argument for the government provision of certain types of goods through a tax structure that requires the wealthy to pay a larger share of the bill based upon efficiency rather than equity grounds, but here’s the problem. This only works if the rich and the poor live in the same neighborhoods, share the same roads, use the same parks, attend the same schools, and so on. In an increasingly divided economy and society – as in the US in recent decades – the opportunities for mutually beneficial arrangements diminish. If the wealthy do not attend the same schools, live in the same areas as the poor, have special lines at airports, shun public pools, have their own tennis courts, golf courses,  and parks, if they have helicopters to avoid city traffic, their own security arrangements independent of the police – the list goes on and on – then these opportunities  are lost.

In the example above, suppose that the wealthy families live in a separate area, each on its own large piece of property rather than being distributed among the population. Remember that the wealthy family was only willing to pay $800 for the $1200 swing set, so it won’t be purchased (to make it simpler, assume no cheaper swing sets are available). And, unfortunately, since the poor households are only willing to pay $250 each, four together cannot cover the full price either. The kids will go without.

Now, if wealth disparities continue to grow, then the wealthy household may eventually be able and willing to purchase the swing set for its private use, but even then, the equipment will sit idle most of the time instead of being shared by the children of four households. In addition, the wealthy households are likely to resist having their money taxed away to provide swing sets for the poor since they get no benefit from that type of spending. And it’s the same with spending on roads, schools, and so on.

The more divided our society becomes, and the divisions are growing, the less shared experience we will have. The rich live in one world, the poor in another, and mutually beneficial arrangements between the two groups fail to occur.
And we are all worse off because of it.

University of Oregon macroeconomist Mark Thoma writes primarily about monetary policy its effect on the economy. He has also worked on political business cycle models. Thoma blogs daily at Economist’s View.