Economics 2: income distribution, public goods and the state

by George Hatjoullis

GDP is often thought of as the income of a nation. Strictly speaking this is better covered by GNP. The profits from Nissan’s operations in the UK go back to Japan whilst BP’s profits come back to the UK. However, GDP is a better concept for dealing with employment in the UK so we will continue with the blurring of these two concepts. You may as well get used to it as it happens all the time in the press. The issue of interest in this lesson is Income Distribution.

Individuals claim their share of GDP via money. They earn money by selling their labour to those that own the means of production. If they earn enough they can save and they too can own some small part of the means of production by investing their savings. The owners of the means of production earn claims on GDP in the form of profits. One way of looking at income distribution is to measure the amount of GDP accruing to those offering their labour for sale and the amount accruing to profits. [Of course, the elephant in this room is the state but we will come to this shortly].

This labour/capital division of GDP is beloved of marxists but is somewhat misleading in a modern economy. Labour owns quite a bit of the means of production. Pension plans, ISA, Insurance policies etc are all invested and grow in line with profits. Even bank deposits are a form of ownership. The depositor is a creditor of the bank and has a claim on the assets of the bank. It is more useful to think in terms of individual income from working and income from investment. This is particularly important for the pension debate. Individual income from investment is determined by the distribution of wealth as well as the rate of profit. It is the unequal distribution of wealth that is of most concern.

Now introduce the state. The economic function of the state is to organise the production of public goods and to affect the distribution of income. A public good is one from which no individual can be excluded from the consumption thereof, and consumption of by one individual does not reduce the amount available for consumption by some other individual. Pure public goods are rare but one can see that many activities of the state have elements of public good.

The collection and removal of sewage is an interesting example of a public good. An effective sewage system eliminates a lot of highly contagious diseases. Everyone benefits and any one person benefitting does not diminish the capacity of others to benefit. Indeed it enhances everyone’s capacity to benefit because there are less contagious diseases lurking. Anyone that doubts this should check the main problems that emerge when the sewage systems break down in war, earthquake and flood disaster. It is the indiscriminate nature of contagious diseases that has encouraged the wealthy and politically powerful to fund such developments. Note the state can outsource the provision of public goods.

Public goods involve externalities. The state does not produce clean air but it can act to stop those that pollute it from doing so or at least make sure that they pay a charge for doing so. Externalities arise when the private activity does not take into account the wider public benefit or disbenefit from an activity. The state can interfere to adjust the private economic activity to account for public benefits and disbenefits. Of course, externalities are in part subjective and different countries perceive the need for state interference in different ways. European countries typically see widespread externalities from universal healthcare. The USA does not.

State activity must be funded and the act of funding redistributes income. Whether this is necessarily the case is a fine academic point. In practice it is always true. Some pay more and some benefit more from state activity. The state may also act to achieve a particular distribution of income. Income distribution may also be deemed to involve externalities. The state funds itself via taxes and borrowing (one could view borrowing as a tax on future generations). The structure of taxation affects the distribution of income [note that users charges for state provided goods are simply taxes as they are not market determined].

In principle all economic activity could be ordered by the state. However, as the demise of the Soviet Union and rise of capitalist China testify, this is not a sustainable approach. Market directed economic activity seems to be the most effective way of organising such activity that the human species has come up with (so far). Market activity is dominated by two emotions; fear and greed or, if you prefer, risk and reward. Basically, individuals are driven to provide goods and services in order to gain claims on GDP. They finance their activities by borrowing (leverage) or by promising to share the profits (equity). The activities are risky and this may drive how they finance their activities. Borrowing means keeping more of the gain and the risk, whilst equity involves sharing both. Successful (and lucky) people end up with lots of claims on GDP, whilst unsuccessful people end up in dire straits. A distribution of wealth emerges which may or may not be deemed desirable, usually depending upon in which part of the bell curve one finds oneself.

For many economists income and wealth distribution is a political issue and not a legitimate matter for economic theory. For political economists it matters very much. The issue usually centers on whether income distribution affects the growth rate of GDP. Given that activity is all assumed to be driven by risk and reward, income and wealth distribution logically must impact the rate of growth of GDP. In other words, the size of the cake is not independent of the distribution of the cake. The interaction of size and distribution ought to be the main focus of behavioural economics. One should also add that not all activity is necessarily driven by risk and reward in practice, nor merely to acquire claims on GDP. Some people just like doing what they do and are happy to be paid ‘enough’. However, happiness is not a concept with which economic theory has come to grips.

So to recap:

1. GDP/GNP is divided between those selling their labour and those owning the means of production but the two do overlap.

2. The state affects income distribution in its role in the organisation of the provision of public goods and as a matter of policy.

3. Income and wealth distribution may interact with the growth of GDP. The distribution of the cake is not independent of the size.

4. Cake is not the only thing people care about.