How Changing Government Spending Affects Inequality

Juan Carlos Suárez Serrato, a friend and co-author of mine, has an interesting brief on government spending, inequality, and policy design. He analyzes “how differential valuations for government services between rich and poor lead to important implications for the link between inequality and the provision of government services.”

In one of the sections of the brief, he uses the matching rates of FMAP to characterize the program’s implicit social welfare weights on different income groups and considers how much federal funding for Medicaid should decrease with state incomes.

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He shows that current FMAP policy comes pretty close to putting full weight on low-income individuals and thus no weight on high-income individuals.

To understand the trade-off that this policy implies, consider two states: Maine and Kentucky. Kentucky has a lower college ratio and thus a higher federal match and a larger transfer of federal dollars per capita. One justification of this arrangement is that since there are more workers with a higher valuation of these services in Kentucky, there is a larger return to overall social well-being to providing more services in Kentucky. A second justification is that the design of current policy doesn’t actually reflect the calculus of weighing the welfare of different types of individuals but rather the result of a political compromise. While we are all familiar with politically motivated spending programs, the formula behind this program has been largely unchanged since its introduction in 1961, making it less susceptible to political manipulation.

He concludes:

The simple insight that different types of workers have different valuations for government services yields important conclusions. First, since low-income individuals have a higher valuation for government services, decreasing the provision of these services is likely to increase inequality in well-being between high- and low-income individuals. Second, to the extent that citizens and policymakers want policies that reduce inequality, understanding how existing spending programs affect inequality is crucial for our decisions to fund them in the future. Finally, while it is often politically unpopular to argue for policies that weigh the economic outcomes of different types of people differently, it is important for us to recognize that the status quo, as described by our current policies, already embeds a trade-off between people’s welfare and that better decisions can be made by addressing this trade-off directly rather than by ignoring it.

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About ozidar

I'm an Assistant Professor of Economics at the University of Chicago Booth School of Business and a Faculty Research Fellow at National Bureau of Economic Research. You can follow me on twitter @omzidar. http://faculty.chicagobooth.edu/owen.zidar/index.html
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