Many economists and other social scientists have tried to explain the rise of the welfare state and to quantify the determinants of social redistribution. The current consensus among researchers is that the pre-tax-and-transfer distribution of income is not a key determinant of the size of the welfare state. This consensus has been formed because various studies have documented a weak link between income inequality and redistribution (Perotti 1996, Persson and Tabellini 2003, Alesina and Glaeser 2004 while Milanovic 2000 provides an exception).
Yet the striking contrast between the US and (continental) Europe illustrates this weak link. Economic theories of the welfare state predict, both on normative and positive grounds, that higher pre-tax-and-transfer income inequality should be associated with more redistribution of resources (Mirrlees 1971, Meltzer and Richard 1981). In reality however, the US distributes less than Europe despite being more unequal before taxes and transfer payments.
Typically, researchers have looked at one dimension of income inequality at a time (e.g. the Gini coefficient or the distance of median income from mean income). In my recent research (Karbarbounis 2010), I start from the observation that different income groups have conflicting goals regarding the redistribution of resources. Since income is strongly correlated with various measures of political participation, in principle a single inequality statistic is unlikely to account for all conflicting preferences regarding the size of the modern welfare state. In other words, when political influence is increasing in income and redistribution responds to the political demands of various groups of voters, we might expect the effect of inequality on redistribution to vary depending on what part of the income distribution is changing.
To empirically investigate the effects of income inequality on redistribution, I use a panel of advanced OECD countries over the period 1975-2001. The key difference from previous studies is that I include three different measures of income inequality in the same empirical framework. Inequality at the bottom of the income distribution is given by the ratio of the gross earnings of the worker in the 10th percentile of the distribution to mean gross earnings. The ratio of the gross earnings of the worker in the 90th percentile to mean gross earnings captures the relative affluence of the rich. Finally, the median to mean ratio of gross earnings measures how median income changes relative to any other income. My measure of redistribution is standard in the literature and includes expenditures on pensions, survivors and incapacity related benefits, welfare programmes for the poor families, housing, unemployment insurance, active labour market programmes, and health.
A number of important econometric issues that arise in this framework are analysed in more detail in the working paper. Here, I just note that the estimated effect of income inequality on redistribution holds constant any persistent political, cultural, or geographical factor that may cause some countries to redistribute more than others irrespective of differences in their income distributions. This is an important point since it is well known that persistent institutions (e.g. electoral rules, form of the government, judicial review, federalism), transmitted cultural characteristics (e.g. trust, social beliefs about fairness, prospects of upward mobility), the inherited ethnic and linguistic composition of a society and its legal origins, all matter for redistribution and can explain why some countries adopt more pro-redistributive policies than others.
The empirical results indicate a statistically significant and economically large effect of all inequality ratios on redistribution. Specifically, I find that a 10% increase in the gross earnings of the rich relative to mean gross earnings reduces the redistribution-to-GDP ratio by 2.25 percentage points relative to its mean value in the sample (about 21%). A 10% increase in the median to mean ratio of gross earnings is associated with a 3.05 percentage point decrease in the redistribution-to-GDP ratio. Whereas, a 10% increase in the relative earnings of the poor is associated with a 2.14 percentage point increase in the redistribution-to-GDP ratio.
This rich activity in the income distribution is consistent with a one dollar, one vote theory of the welfare state. In the one dollar, one vote equilibrium, when a group of voters becomes richer (relative to the mean), redistributive policies tilt closer to its most preferred size of redistribution. Thus, for instance, when the rich become even richer, redistribution decreases which is line with the preference of the rich because with a progressive system of taxes the rich are the ones who pay more taxes. On the other hand, when the poor become richer, redistribution increases which is in line with the preference of the poor because the poor are the ones who are more likely to benefit from increased social transfers like unemployment insurance and pensions.
The one dollar, one vote theory of the welfare state contrasts sharply with the widely used ‘‘one person, one vote’’ institution (where the median class is the decisive voter) and the ‘‘utilitarian’’ model of redistribution (where the government chooses redistribution to maximise a weighted average of citizen’s welfare). A natural explanation for the one dollar, one vote result is that political influence is not uniform across groups of voters and that political participation is increasing in income. Indeed, using data from the World Value Surveys, I show that in all countries of the sample income is strongly correlated with various indices of political participation ranging from signing petitions to discussing politics with friends and from participating in demonstrations to becoming affiliated with political parties. Since money is associated with more power, income inequality has sharply different implications for redistribution than postulated by the median voter theory and the utilitarian model.
The one dollar, one vote result provides an explanation for the increasing difference in the size of the welfare state in Europe and the US. From 1980 to 2001, the growth of European redistribution exceeded the US’ by approximately 2.7%. According to my estimates, this may be because the European poor did not become relatively as poor as the American poor while the US increased redistribution relative to Europe because the American median voter became poorer. These two opposing effects cancelled each other off. However, the growth of the rich’s income relative to the mean in the US exceeded the growth of rich’s income relative to the mean in Europe. According to the one dollar, one vote theory of the welfare state, the faster growth of the rich's income in the US allowed the rich to increaseits political influence and tilt policy closer to its most preferred redistribution which involves a smaller welfare state. As a result, the growth of redistribution in the US lagged Europe’s.
Alesina, Alberto and Edward Glaeser (2004), Fighting Poverty in the US and Europe: A World of Difference, Oxford University Press.
Karabarbounis, Loukas (2010), “One Dollar, One Vote”, forthcoming in the Economic Journal.
Meltzer, Allan and Scott Richard (1981), “A Rational Theory of the Size of the Government”, Journal of Political Economy, 89:914-927.
Milanovic, Branko (2000), “The Median Voter Hypothesis, Income Inequality and Income Redistribution: An Empirical Test with the Required Data”, European Journal of Political Economy, 16(3):367-410.
Mirrlees, James (1971), “An Exploration in the Theory of Optimum Income Taxation”, Review of Economic Studies, 38:175-208
Perotti, Roberto (1996), “Growth, Income Distribution and Democracy: What the Data Say”, Journal of Economic Growth, 1(2):149-187
Persson, Torsten and Guido Tabellini (2003), The Economic Effects of Constitutions, MIT Press