Are people inequality averse, and do they prefer redistribution by the state?

Abstract

We link life-satisfaction data to inequality of the pre- and post-government income distribution at the regional level, to estimate the degree of inequality aversion. Three different inequality measures are used. In addition, we investigate whether a reduction in inequality by the state increases individual well-being. We find evidence that Germans are inequality averse. Inequality reduction by the state does not increase well-being. On the contrary, inequality reduction imposes an excess burden on middle-income earners. The paper uses data from the German Socio-economic Panel Study (GSOEP) from 1985 to 1998.

Introduction

Most industrialized countries redistribute income from rich to poor. Revenue from progressive income taxation and payroll taxation is distributed to individuals through both monetary and non-monetary transfer payments. Redistribution policy reduces income inequality, from the perspective of the pre-government income distribution, and results in a more equal post-government income distribution. Table 1 shows the extent of income redistribution by the state for selected OECD countries. Inequality is measured by the Gini coefficient. It can be seen that Northern European countries reduce income inequality by about 50%, and Germany does so by 35%. Even in the United States, the reduction of pre-government inequality through redistribution is about 25%.

Economic theory advances a wide range of hypotheses to explain and legitimize redistribution by the state. For convenience, we summarize the main hypotheses with reference to three arguments as follows. The first is an efficiency argument. Individual preferences might be better satisfied by institutions such as the state if private transactions are affected by market failure. The second argument is related to self-interest. Redistribution policy is driven by elections, group pressure, rent seeking, and so on. A popular model is that of the median voter. Another is the theory of Rawls (1971). The basic hypothesis of the third argument is that people are intrinsically inequality averse, which means that inequality enters individual utility functions. A possible justification for this is that individuals are altruistic or prefer a more equal income distribution, which then becomes something of a ‘public good’ (see Thurow, 1971, for a discussion). While the underlying motivation is of less interest to economists, whether such preferences provide additional legitimization (beyond efficiency concerns) for political redistribution is of interest.

In this paper, we focus on the third argument. We link survey data from the German Socio-economic Panel Study (GSOEP) on individual life satisfaction to the extent of regional income inequality. In contrast to other recent studies, however, we do not use post-government income inequality to test whether people are inequality averse, because we argue that post-government income inequality is not an ideal indicator. Instead, we decompose post-government income inequality into its constituent parts, namely pre-government income inequality and the extent of redistribution by the state. Thus, we are able to analyze whether people are inequality averse and also whether they support redistribution by the state.

The GSOEP provides information over a period of 14 years for West Germany on individual life satisfaction as well as information on several individual economic and socio demographic determinants of life satisfaction. In addition, the use of panel data allows one to control for unobserved individual heterogeneity. For each year, pre-government and post-government income inequality is computed for 75 regional areas within West Germany. In what follows, Section 2 contains some theoretical considerations and preliminary empirical findings. Section 3 describes our approach to linking satisfaction data and income inequality, describes the data, and explains the estimation methods. The estimation results are presented in Section 4. Finally, Section 5 concludes the paper.