Notes on Alesina and Angeletos on ‘Fairness and Redistribution’ Econ 594ER October 29, 2007

Social spending and beliefs AmericansEuropeans

How are multiple equilibria sustained? Can we explain differences in beliefs w/o relying on differences in ‘economic fundamentals’ or on persistent distortions in beliefs? Equilibrium 1 –taxes are higher, individuals invest and work less, and inequality is lower –a large share of total income is due to luck which is why income redistribution is desirable and this sustains the equilibrium Equilibrium 2 –taxes are lower, individuals invest and work more, and inequality is higher –a larger fraction of income is due to effort rather than luck and this sustains the equilibrium Authors do not try to explain how these equilibria are reached (probably through cultural evolution in belief), but argue that different beliefs are sustainable Previous literature –Rawls (1971) and Mirrlees (1971) model fairness as demand for insurance –Piketty (1995) agents form beliefs only based on their experience –Benabou and Tirole (2005) multiple beliefs arise because agents bias their own perceptions to offset procrastination (presumably in investment?)

Experimental evidence of luck & fairness Fehr and Schmidt (2003) –Dictator games: people give away some of endowment even though they could keep it all –Ultimatum games: players suffer monetary loss to punish ‘unfair’ behavior –Gift exchange games: players reward ‘fair’ actions –Public good games: players punish free riders Key: Results are sensitive to how endowments are allocated –Hoffman and Spitzer (1985) and Hoffman et. al. (1985) show players more likely to make unequal offers in ultimatum games when endowments are ‘earned’ –Clark (1998) finds that player in public goods games vote for less redistribution when endowments depend on performance rather than being randomly assigned

Framework of the model y i depends on talent, investment, effort, and random noise\luck (η i ) Government imposes flat tax rate to generate funds for a lump sum redistribution transfer Individuals get common disutility from unfair social outcomes (Ω) Ω is basically the aggregate difference in utility from the income one gets (y i ) and what one deserves (ŷ i ), where y i – ŷ i = η i Definition: An equilibrium is a tax rate and collection of investment and effort choices that maximize the utility of the median agent

Key assumptions and results Fairness and the signal-to-noise ratio –RHS is ‘signal to noise’ ratio in pre-tax income; numerator is ‘earned’ denominator is ‘luck’ –Optimal tax rate decreasing in signal to noise ratio –E.g., if tax rate =1,100% of income is from luck Signal-to-noise ratio is endogeneous –Heterogeneity in talent or willingness-to-work increases signal –Luck increases noise –Signal-to-noise ratio decreases in the tax rate, reflecting distortionary effects of taxation Optimal policy and multiple equilibria –Demand for ‘fairness’ leads to higher taxes and multiple equilibria –The ‘high-tax’ equilibrium is sustained by a self-fulfilling low signal-to-noise ratio

Comments Critical assumption is that, with less governmental intervention, ‘luck’ has less of an influence on outcomes. –Q: Is the logic correct? Don’t lucky results increase with effort and investment? What happens when we allow for intergenerational wealth transfers? –Signal-to-noise ratio depends on policies chosen by past generations –Authors say that a society that has history of high distortions will tend to have inherited wealth, which makes it more likely to have aggressive redistribution in present –Q: Is the logic correct? Is this consistent with empirical evidence?