Inequality measurement and tax/transfer policy

International Tax and Public Finance https://doi.org/10.1007/s10797-021-09695-w Inequality measurement and tax/transfer policy Patricia Apps1,2 · Ray Rees1,3 Accepted: 16 August 2021 © The Author(s) 2021 Abstract We provide a critique of the standard methodology for inequality measurement, which makes welfare comparisons between households by deflating household income and consumption with an equivalence scale. We argue that this leads to support for tax/transfer policies that significantly disadvantage low to middle income households and second earners—predominantly women. Its main limitations are that it takes an overly-simplistic approach to household production, bases its welfare measurements on joint household income, and has no theory of the family household. We point the way to an alternative procedure by presenting a theoretical model of the family household that derives duality-based welfare measures. In the light of current data limitations we propose, as a second best, primary earner income as a superior base to joint income for across-household welfare comparisons in policy formulation. We also emphasise the importance of taking the family life cycle into account when making such comparisons. We use the Australian income tax system and Australian income and tax data for a detailed comparison of the standard approach with our proposed alternative. Keywords Inequality · Equivalence scales · Tax/transfer policy · Families JEL Classification D13 · D31 · H21 · H24 · H31 * Patricia Apps Ray Rees 1 The University of Sydney Law School, Sydney, Australia 2 IZA, Bonn, Germany 3 LMU and CESifo, Munich, Germany 13 Vol.:(0123456789) P. Apps, R. Rees 1 Introduction The use of equivalisation indices to deflate measures of household income and consumption in empirical studies of the family household has become widespread and routine, although some economists have argued strongly against it.1 In practice a number of widely used equivalence scales exist. Their aim is based on an assumed need to take account of the variations in size and composition of households and economies of scale in the household consumption process when making welfare comparisons across heterogeneous households. Equivalence scales in general are constructed on the basis of some calculation of the “needs” of individuals of different ages. Then with each household in the sample is associated a number of “adult equivalents”. The idea of economies of scale is reflected in weights of less than one for adults beyond the first and smaller weights for children.2 By deflating a household’s total income by the equivalence index and assuming that income is equally distributed across adult equivalents within the household,3 a single number is obtained, which, it is assumed, characterises the standard of living of each adult in the household and is directly comparable across households. For example the widely used OECD “square root” scale4 deflates household aggregates, such as gross and disposable incomes and total consumption, by the square root of the number of individuals in the household. Another typical example is the “Oxford modified” scale used by the Australian Productivity Commission.5 A scale of 1 point is used for the first adult, 0.5 for each additional person aged 15 years or more, and 0.3 points for each child under 15 years. If, for example, a household with two adults and two children had a joint income of 2.1 times that of a reference single person household the two households would be considered equally well off. A number of other scales that use a similar procedure, but with different numbers, have been proposed over the years. It is not difficult to be critical of this type of homogenisation procedure as a way of dealing with household heterogeneity. Our aim in this paper is to focus more directly on the connection between inequality measurement and the formulation of tax/transfer policies. Perceptions of the ranking of households in terms of which household types are better and which worse off will obviously be influential in determining the support for a particular policy. For example, we show below that equivalence scales based on total household income lend support to joint rather than individual income tax systems.6 1 For example Pollak and Wales (1979), Atkinson (1970) and Atkinson et al. (2017). Browning et al. (2013) criticise the standard procedures from the standpoint of the family household. 2 See Apps and Rees (2001) for a different approach to estimating child costs. 3 This assumption has been widely criticised in the family economics literature. See for example Lise and Saetz (2011), who show using UK data that within-household equality is rejected. 4 See, for example, OECD (2019) and Sila and Dugain (2019). 5 Report of the Australian Productivity Commission (2018). 6 In a companion paper to this, Apps and Rees (2018), we show that an optimal individual incomebased tax system is superior on grounds of both equity and efficiency to an optimal system based on joint 13 Inequality measurement and tax/transfer policy One important source of support for this view is the belief that, controlling for family composition, equilibrium household income and individual wellbeing are comonotonic: one necessarily increases with the other as we move through the equilibria of a given set of households, or, in other words, a ranking of households in terms of equivalised household income corresponds to a ranking in terms of individual wellbeing. Although in the standard household model in which single individuals divide their time between work and leisure this seems unobjectionable, in a world of couple households with considerable heterogeneity in second earner labour supplies it is no longer true in general. Moreover, the equivalisation procedure, when based on standard demographic variables, assumes that the components of the household type vector7 are fully observed, and therefore rules out consideration of the implications of the fact that important components of this vector may not be observable, or, more accurately, not currently available in existing datasets. This has to do with the absence of a conceptual framework for family household decision taking of the kind we provide in this paper. The simple assumption of “economies of scale” applying in some way to household consumption processes does not do justice to the complexity of realistic household production functions. It confuses two aspects of household production that have long been well understood: first, the presence of non-assignable goods, often referred to as “household public goods”;8 and secondly, the significance of joint production in household production processes.9 The critique of the Becker model of household production by Pollak and Wachter (1975) emphasised the importance of multi-activity production functions characterised by significant joint production,10 Footnote 6 (continued) income, for a popu (...truncated)