Efficiency, inequality, and the costs of redistribution

Efficiency is a word that most people would associate with economics. The field is primarily about making the most efficient use of resources. For a set use of resources to qualify as efficient to economists, however, it must pass certain requirements. There are several different definitions of efficiency, but one widely accepted in the economics world is the so called Kaldor-Hicks principle. This principle is what Harvard University economics professor Nathaniel Hendren was working off of when he wrote his new National Bureau of Economic Research working paper on the inequality deflator—the subject of yesterday’s Value Added.

Looking at how economists think about efficiency can help us understand how rising inequality may be inefficient. Back in 1939, economists Nicholas Kaldor and John Hicks stated that an outcome is efficient if a person made better off by a change in economic circumstances could compensate a person made worse off by the change. Think of opening up domestic markets to freer international trade. If the winners from reduced tariffs in those markets could compensate the losers in those same markets from the move then opening up those markets would result in a more efficient domestic economy, according to the two economists.

The losers of the new arrangement will accept this new state of the world because they could receive compensation that makes up for their losses. The Kaldor-Hicks principle posits that maximizing total economic surplus could allow the winners to compensate the losers.

Now there’s a very important word in the definition of the principle that might slip by: could. Under the Kaldor-Hicks principle an outcome is efficient if the winners could compensate the losers. They don’t actually have to do it for the new outcome to qualify as efficient. So the winners of newly opened markets don’t have to compensate the workers who have lost jobs. They could, but they don’t have to in order for the situation to be efficient.

And here is where Hendren’s new paper has an important point. The Kaldor-Hicks compensation principle assumes that the compensation from the winners to the losers is a simple lump-sum transaction. But we know that redistribution of any economic surplus is distortionary (how much so is up for debate), which means compensation has other economic costs.

If inequality is high enough, for example, then the amount of distortion needed to compensate the losers might be high enough to make everyone worse off. Conversely, Hendren shows that an extra dollar of surplus flowing to a low-income person would benefit everyone in the economy by reducing distortionary taxation. The benefit of reducing this taxation depends upon how distortionary you believe taxes to be. Hendren provides a range of estimates in his paper that are worth exploring in their own right.

Talk of compensation principles and deflators seems like an esoteric topic. And to a certain extend it is. But we need to think deeply about how we define what outcomes are efficient, especially in this era of high and rising inequality.