Income Redistribution, Part 2

Last week I published the first of two articles on income distribution. This topic is important for many reasons, one being that the redistribution of income and wealth is the main reason for the welfare state to exist. The welfare state, in turn, is a social and economic system that is entirely contradictory to the concepts of individual and economic freedom. It is a dysfunctional hybrid between the ideologically pure communist central-planning model and free-market capitalism. The socialist ideologues who created the Scandinavian welfare state, such as Ernst Wigforss, Alva Myrdal and Rudolf Meidner, thought that they could get the most of the benefits from socialism while still allowing free-market capitalism to create enough prosperity for all.

This was of course a huge miscalculation. Economists of many walks of life – or economics – pointed to this early on. The foremost early critic of the welfare state was Friedrich Hayek, whose book Road to Serfdom is really a big warning signal to friends of economic and individual freedom of the venomous nature of the welfare state.  Others followed, such as Milton Friedman, but their work was for the most part academic, leaving the public policy field open to statist scholars to advance the welfare-state agenda.

America’s most prominent advocate of the welfare state was John Kenneth Galbraith. He wrote several public-policy oriented books back in the late ’60s and the early ’70s, among which The New Industrial State is a panegyric marketing effort for the Scandinavian model. Not only did Galbraith fervently propose a socialized health-care system, but he also wanted far-reaching structural measures in the economy for income redistribution.

The reason why income redistribution has become a cornerstone in welfare-state promoting policies is that the welfare state, unlike communism, does not distribute consumer goods and services among the citizenry. The goal with socialism – a goal shared by both communists and welfare statists (or social democrats as they prefer to call themselves) – is to eradicate differences between individuals in terms of what they have. This is why, e.g., the Cuban and North Korean governments hand out food rations to people. While the purpose of food rationing nowadays is to divide up whatever bread crumbs the communists are able to produce, the original purpose was indeed to make sure everyone was equal.

This is also why communist governments assign housing, furniture, bicycles and cars to people. In the last decade of East European communism this ridiculous distribution system was unraveling; in Budapest in the ’80s you could find shopping malls reminiscent of those in the West, filled with small shops that sold everything from shoes to appliances. The products were clearly of lesser quality than what we had in the West at that time, but there was no doubt that the communist regimes had begun realizing that the free market was simply much better at satisfying people’s needs.

Instead, the communists looked at transitioning from their rigid, dictatorial system into a more Scandinavian-oriented welfare state. This included income redistribution, but since there were not a whole lot of people with high incomes to take from, and a lot of poor people to give to, they failed to make the leap.

That is fortunate, because by the time Eastern Europe got out of its communist system the Scandinavian welfare state was beginning to show very clear signs of economic arthritis. The Swedish economy was no longer growing at the levels it had back in the ’50s and ’60s. Its inflation-adjusted GDP growth fell below two percent per year. Denmark was having even worse problems and plunged into a full-fledged fiscal crisis. Finland was hit by a double whammy: the true costs of its welfare state combined with enormous losses in exports as the Soviet Union collapsed.

In the cases of Sweden and Denmark there was no doubt that the slow growth was directly related to exceptionally high taxes. These taxes, in turn, were used to finance very elaborate income redistribution systems. With slower growth the higher incomes grew less than what the welfare state needed, while more people remained in income brackets where they were eligible to receive redistributive entitlements.

In short:

  • to pay for the welfare state, government needs to raise taxes;
  • as taxes go up the private sector finds way to cope and still produce jobs that pay reasonably well;
  • there is still a large tax base available for government to tap into in order to finance all the entitlements it has handed out;
  • as taxes increase, though, the private sector reaches a point where it can no longer adapt, but instead goes into a state of stagnation;
  • when the private sector stagnates, so does the tax base – and the welfare state is hurled into a state of fiscal crisis.

In other words, political efforts at redistributing income between citizens eventually open up the fiscal whirlpool that has swallowed Greece, Spain and Portugal and is now sucking down Italy and potentially even France.

There are philosophical reasons why income redistribution is wrong. I will leave them for a future article. For now, let us conclude that from an economic viewpoint, income redistribution does not work. It harms the entire economy, erodes prosperity and creates perennial deficit problems.

Bottom line: you cannot combine free-market capitalism with any form of socialism. Either you embrace capitalism and freedom, or you learn to live with the atrocities of socialism.

It’s really that simple.