Advancing equality

The market incomes of working age Australians (before taxes and transfers) are more unequally distributed than in most other comparable countries. This reflects (inter alia) our relatively low full-time employment to population ratio and relatively high earnings dispersion. Fortunately, we have a well-targeted tax-transfer system which does an excellent job of redistributing market incomes to the poorest 20 per cent. But the redistribution process entails a cost - high levels of welfare dependence and a range of work disincentives at both the tax and social security level.

Are Australia’s high earnings inequalities necessary to adequately reward education, effort and ability? Or are they partly due to market imperfections and if so, are they producing a sub-optimal allocation of resources?

There is strong evidence that Australians of low socio-economic background face formidable barriers to upward income mobility. These stem from early childhood environments: poorer access to health care, education, housing and employment; location disadvantages; “poverty traps” (little financial gain in moving from welfare to work); lesser ability to borrow and lower levels of financial literacy.

These people are “stuck on the basement” not by choice but because they have no easy means of escape. And, since the mid-1990s, the inequalities in education, health, housing, infrastructure and location have been getting wider in Australia because, although cash transfers have been sustained, the poorest households have been receiving a smaller share of government “benefits in kind”, especially in health and secondary education.

This is an issue ordinary Australians can get fired up about. They might care little about inequalities observed in annual income data. But they care very deeply about inequalities of opportunity - the lifetime inability of many to rise up the income stratum. They want governments to do more to level the playing field.

Why then are governments so willing to provide passive welfare support on a large scale yet so reluctant to step up investment in so-called “active” social programs which improve the human capabilities and mobility of people at the lower end of the income spectrum?

As always, the answer lies in concerns about economic viability. Governments wonder if such programs deliver sufficient economic returns in the long term to offset the economic efficiency costs associated with higher tax levels in the early years.

There is no doubt that existing barriers to mobility are impeding economic performance. A child’s achievements in adulthood are due only very partly to genetic endowments; they are at least as much a product of parental environment. People with the “wrong” parents (i.e., with poor cognitive skills and poor attitudes to education and work) find it hard to escape their birth circumstances. As a result, much talent is wasted and society does not make the best use of all its citizens.

Again, even the most deregulated labour markets suffer from imperfect job and geographical mobility and are unable to deal smoothly and efficiently with structural shocks (such as the big reduction in relative demand for low-skill workers).

Because of inadequate and asymmetrical information, there is also a tendency for capital markets to put too high a risk premium on asset-poor, low-income borrowers and people with irregular incomes, even though they might have good entrepreneurial or business skills or the capacity, through education and training, to enhance their employment outcomes. And there is a well-known tendency for free markets to under-spend on merit goods like preventative health care, education, remedial training and public transport.

Active social policies seek to alleviate these market imperfections. In addition they have the potential to generate positive “external” economic spin-offs. For example, by improving social harmony, they can reduce the incidence of crime and, by raising the prospect that everyone will have an equal chance to capture the benefits of economic reform, they can create a more positive climate for further structural change. Not surprisingly, there is now a mountain of evidence showing that such policies not only “make a real difference to people’s lives” but also deliver “healthier economies”.

There is a hitch. Active social programs make substantial initial demands on revenue. This worries economists because of the links between tax levels and work incentives, saving and risk-taking. But these costs can be minimised by observing a few “golden rules”.

One rule is to ensure that new and existing revenue and spending instruments are well targeted and subject to regular review; many existing social spending programs have goals which are not well specified and whose rationale has largely disappeared. Another golden rule is to choose revenue instruments which do not unnecessarily distort economic choices and which have the least impact on economic incentives: there are many special tax exemptions and deductions which fail this test and could sensibly be scaled back.

Governments could also make greater use of income-contingent loans in lieu of outright grants where the activity being assisted has a reasonable chance of yielding good productive returns in the longer term.

Finally, where a new spending program is expected to build up the future stock and quality of human capital, governments should not be afraid to fund some of it out of borrowing. This argument is particularly strong in a country like Australia which starts with an exceptionally low level of public debt by historical and international standards. And if it means crowding out some marginal private investment (in shopping markets, luxury homes, motels, etc) in order to make room for more productive public investment, so what?

The international evidence makes it clear that free markets and lightly regulated labour markets do not by themselves lead to good social mobility outcomes. They need to be supplemented by active social policies. Such policies can win wide community support and generate substantial net benefits for the economy. Truly a win-win in the long term!