Leaky Buckets and Doing Good With Other People's Money

Many people see government as the way to ensure a fair distribution of wealth, basically by taxing the wealthy and giving something to the poor whether it is cash transfers or aid in-kind. Right now, I won't address the moral considerations or the problems of interpersonal utility comparisons. I will address some of the inefficiencies stemming from incentives and administrative costs.

First, you need to acquire the resources by taxing from someone who makes a higher income(or wealth) to give it to someone with a lower income(or wealth). An income tax creates a disincentive for producing and the capital gains tax reduces incentives for investing. Both result in a smaller amount of production now and in the future. Just how much is a question for the econometricians.

With a complex tax code like in the United States, incentives are in the tax code to invest in one thing as opposed to another. For example, municipals bonds are tax free at the Federal level and often at the state level. While this keeps rates low for municipalities, it diverts capital away from other uses. In absence of tax incentives for municipal bonds, more corporate bonds may be bought reducing the cost of borrowing for corporations. The price of lost innovation and production is really unknown with just this one example from the tax code. With a political system like ours, the tax system is bound to stay complex. Of course, nobody wants to pay taxes. So, we must have a government agency enforcing the tax code, investigating tax payers, and dispensing penalties. None of this is done for free. While I do not know what productive use an IRS agent would have outside of government, there may be one.

On the other side, welfare programs of all kinds have administrative costs. These programs need to set conditions for who receives payments and enforce that the truly deserving and needy get these benefits. None of this comes for free. As a parallel to the taxation side, the disincentives of welfare function in similar ways. Somebody who receives benefits knows that their benefits will be reduced if they work more. For some the psychological benefit of working and producing outweighs this loss of handouts. However, at the margins it can have an effect.

We have seen that transferring from the rich to the poor does not come free and this must be taken into account in the structure of tax and welfare systems alike.