Universal suffrage exists in almost all democratic societies, providing every adult with equal political rights at the ballot box. These societies invariably have market economies. The distribution of income among working adults is always dispersed and typically skewed to the right-hand side. This is because the income of individuals at the lower end is bounded below at zero, but the income of high income individuals can be unbounded and many times above the median level. It would seem logical that by virtue of the tyranny of the majority vote, such societies would adopt income redistribution policies to transfer resources from the rich to the poor.

 

A relatively simple way to accomplish this is the negative income tax proposed by Professor Milton Friedman. The negative income tax goes beyond the progressive income tax in the scope of its redistribution effects. The progressive income tax merely provides lower tax rates for low income individuals and households. The negative income tax provides them with a cash supplement; in principle the lower the income, the higher the effective income supplement.

 

The regular fixed cash supplement provided by the Macau government to every resident is a form of negative income tax. Last year Hong Kong adopted it as a one-off. But other than these two examples, the negative income tax has not been adopted by any democratic government.

 

Why not? Why have democratically constituted governments, and their leaders, rejected the negative income tax as an income redistribution tool? One cannot fail to notice that the governments in Macau and Hong Kong are not really democratic according to the criterion of universal franchise at the ballot box.

 

Misallocation Lowers Efficiency

 

Students of economics learn early on a simple proof that shows why a subsidy-in-cash is always better from the  perspective of the recipient than a subsidy-in-kind. Let’s say the recipient is given a subsidy of $10,000. If this is in cash, he or she may choose to spend $8,000 on housing and divert $2,000 to other things that are more valued. But if the recipient is given a subsidy-in-kind of housing valued at $10,000, which comes in “one piece” and is indivisible, there is no choice or flexibility.

 

Alternatively, the recipient may prefer to spend $12,000 on housing but be obliged to consume the “one-piece” subsidy-in-kind worth only $10,000 and use his remaining income to consume something that is not his preferred choice. Both situations are sub-optimal because people are forced to spend resources on their less preferred choices.

 

The lesson here is that economic inefficiency arises from the misallocation of resources. This is a cardinal sin in economic policy because it is could be avoided by changing policy from an in-kind subsidy to an in-cash subsidy. When people are given cash subsidies and allowed to choose freely, then benefits are maximized and resources are not wasted through misallocation. 

 

Another implication of this lesson, which is often not taught until one has been an economics student for several years, is that for every public policy that provides a subsidy-in-kind rather than a subsidy-in-cash, some resources are wasted. The accumulation of policies that provide subsidies-in-kind leads to ever increasing amounts of resources wasted over time. The economic potential of a city or country is compromised and its growth rate is progressively reduced.

 

Those who take the study of economics seriously should be very troubled to observe that almost all public policies take the form of subsidies-in-kind rather than in-cash, including housing, health care, education and training, transportation, food, clothing, social services, public utility services, and so on. Within each of these broad categories one can find numerous finer categories of specific subsidies-in-kind. For example, within health care one can find subsidized dental check-ups for children, cataract replacements for the elderly, breast cancer check-ups for women, and so on. The collection of policies that is adopted varies from city to city and country to country, but  almost every society we observe opts for subsidies-in-kind.

 

Why, then, is this less efficient choice preferred? Why do societies systematically choose policies that harm their longer term economic prospects? If societies are systematically choosing bad policies over good ones, there must be a good reason for it.

 

Two possible reasons can be dismissed very quickly. First is the argument that economics is wrong and has been for over 200 years. This is simply not credible. Anyone who can prove that subsidies-in-kind is better than subsidies-in-cash will surely win a Nobel Prize, but this has not happened.

 

Subsidy-in-kind Stimulates Demand

 

Second, it has been claimed that the purpose of subsidies-in-kind is to force people to consume what policy makers believe is best for them rather than provide people with cash and let them decide how to spend it. The implication is that “big brother” knows what is best for the people, a highly dubious and quite undemocratic presumption. But then why not offer cash coupons that can only be used for designated services, such as housing rental coupons, tuition vouchers, food stamps and the like? They would have the same effect of targeting consumption of the designated service. The preference for subsidies-in-kind over cash or coupon subsidies must have a deeper reason.

 

Subsidies-in-kind programs have many common features that suggest they are adopted primarily for the benefit of the service provider rather than the targeted consumer. Here, service provider can extend to include the public since public support is necessary to get these policies approved in the first place. The public becomes a necessary passive partner in subsidies-in-kind programs. Let me describe what occurs and why.

 

A crucial difference between subsidy-in-cash and subsidy-in-kind programs is that the latter requires service providers. In a subsidy-in-kind program the government can either provide the service directly (an example is public rental housing) or use a third party service provider (an example is subsidized education). Either way the subsidy is given to the service provider rather than the targeted consumer. A subsidy-in-cash is a direct transfer of cash from the government to the targeted consumer and does not require the use of service providers. The public is usually aware that in both cases the targeted consumer is a beneficiary, but it is much less aware that the service provider is also a major beneficiary.

 

This happens because in the absence of a subsidy, there would be less demand for the provider’s services. A subsidy increases demand which increases the incomes of individual service providers in the short run. In the long run, new service providers will enter the industry unless there are barriers to entry. Given free competition, this will lead to the incomes of individual service providers falling back to their original competitive levels. Although the industry will have grown in size, individual service providers will not benefit in the long run unless the subsidies are increased from time to time, providing periodic increases in short term benefits to the service providers.

 

As this scenario plays out, some service providers may abuse the system and pocket the subsidies but not deliver the expected level or standard of service. Given that public subsidies have been provided, people naturally expect the government to regulate the industry to prevent future abuses and ensure or encourage socially responsible behavior among service providers. The outcome of such regulatory regimes inevitably ends up creating some form of barrier to entry to produce benefits for industry incumbents and secure their good behavior. Over time, positive reinforcement among four interacting factors will become apparent: (1) rising levels of subsidy, (2) increasing barriers to entry, (3) improving social responsibility of the industry, and (4) higher levels of income accruing to incumbent service providers.

 

The Passive and Docile Consumer

 

Hence, the adoption of a subsidy-in-kind scheme leads to three types of economic consequences. First, it results in resource misallocation. A cash coupon scheme presents a similar problem of course. Second, the subsidy transfers resources to service providers whether they are government or third parties. Third, in the long run the scheme could trigger regulatory restrictions, leading to barriers to entry into the industry and protection to incumbent service providers, and helping them to organize and cartelize.

 

These developments are not inevitable, but are quite common in most societies. Professor Mancur Olson in The Logic of Collective Action provides a powerful exposition of why typical successful collective action always takes the form of a narrow specialized subsidy-in-kind scheme. His work has been enormously influential among social thinkers in recent decades. The term “rent-seeking” to describe such activities is only beginning to become more familiar in the public media.

 

A crucial finding of Olson is that politicians find it easier to organize service providers to become active enthusiastic partners in lobbying for subsidies than passive docile consumers at large. Consumers consume a great variety of services, but their consumption of any individual service is only a small share of their total consumption. This implies that they seldom have a large stake in a single specific service. On the other hand, the service provider usually has a disproportionately large stake in their service.

 

Service providers fully understand that the larger the subsidy, the greater the demand for their service. They know that demand will be at a maximum if the service is provided for free and at great convenience to the consumer. This explains why teachers are always more enthusiastic than parents for free education, why public utilities and transportation providers support government subsidies on charges, and so on. Service providers are the concentrated major beneficiaries of subsidies-in-kind and consumers are the diffuse minor beneficiaries. The result of this is that service providers are very keen to lobby with politicians for a subsidy-in-kind.

 

Politicians use this to their own ends. An important consideration for a politician seeking election is to have a program of advocacy that contains a list of subsidy-in-kind schemes that appeal to service providers. This list is not random but carefully selected so that the total package conveys a coherent position that is credible to customers. The credibility of a politician is important because customers have only a small stake in what the politician ultimately delivers in terms of promised services, so branding becomes relevant and an easy way to monitor performance. In the retail business branding has become important with customers who typically do not invest a huge amount of time to research a product before making an occasional purchase.

 

Lobbying Brings Votes

 

The coherence of the politician’s “package” is less important to service providers because their main interest is in the service that he or she promises to deliver. This concentrated interest helps providers to focus on monitoring the delivery of a very specific promise. A politician’s package of clients may well include service providers who are strange bedfellows, but this does not appear to bother them too much.

 

Having selected subsidy-in-kind schemes for their platform, the politician also has to consider how to gain support for them. This takes time and effort and the politician may not have the resources to sustain direct consumer lobbying without on-going media support, nor to organize the large number of individual consumers, who will have diverse and diffuse interests. The only successful cases of individual-level organization have been unions and local village or residential communities. Usually, a large party-like organization with considerable resources is required for success.

 

In contrast, by capturing the support of service providers, politicians can tap their resources to lobby in support of the subsidy-in-kind scheme, as well as capture their vote and leverage on their effort to bring in consumer votes. Investing effort in service providers has a high net return for politicians under many circumstances, not least in winning tightly-contested elections where the vote advantage is usually quite small; adding an additional subsidy-in-kind scheme to their agenda may well tip the result in a politician’s favor, especially if the new scheme can split away votes from the opposition.

 

The genius of Abraham Lincoln in 1860 was to split away votes from the Democratic Party. Until then the Democratic Party had won almost every Presidential election over the previous 60 years with the support of the agricultural vote. The agricultural vote in the south was based on slave labor and in the north on free labor. By standing for an end to slavery Lincoln secured not only the moral high ground, but provided a new source of free labor – an implicit subsidy – for farmers in the north and commercial and industrial interests. It was therefore no surprise to find strange bedfellows within this single coalition. The Republican Party succeeded in capturing and holding onto the Presidency until the Democratic Party rebuilt their support among urban industrial workers in the 20th century after unions gained power in the Great Depression, and in so doing it cleared the way for industrialization and America’s economic rise.

 

However, success in constructing such grand coalitions is rare and often depends on the arrival of circumstances beyond anyone’s control. The typical situation in politics is of a day-by-day tug-of-war over minor coalition scuffles involving the narrow interests of particular subsidy-in-kind schemes. Professional politicians realize that electoral gains are secured by painstakingly collecting pebbles one by one, which is why it pays to invest in concentrated service providers rather than diffuse consumers.

 

In fact, societies that fail to construct such grand coalitions end up accumulating narrow special interest groups that are interested primarily in rent-seeking activities. Professor Olson’s The Rise and Decline of Nations provides an even more audacious critique of why the accumulation of narrow special interests in society leads to divisive redistributive politics and eventual decline. Olson calls this process “institutional sclerosis”.

 

Narrow Interests Matters

 

Hong Kong is in real danger that this political process is accelerating here. The ability to accommodate lobbying for subsidy-in-kind depends on the willingness and ability to accommodate such demands. A sign that this is occurring is an increase in regulations that mandate the transfer of resources among groups of society or from consumers to service providers. Recent examples are minimum wage legislation and discussions of standard hours of work which transfer resources from employers to employees. 

 

Economists have often warned about the negative consequences of these schemes. In turn, they have been criticized for being heartless if not even worse. I know of few economists who did not begin their studies wanting to help the poor, the disadvantaged, the disabled, but most have ended up warning against many schemes proposed to help the weak and unfortunate in society. It is not because they disagree with the aims and goals, but with the methods. Many economists wonder why we don’t legislate to give cash to the truly needy. Why do we always go about it in a roundabout way? The ABCs of political economy tell us this is not the way of politics. If we give people cash to meet their means that will be the end of politics. 

 

At the end of the day politics is mostly about narrow interests. Unfortunately economics teaches us that this is not just a petty nuisance to be dismissed. It is the stuff that can bring down civilizations. How often we all yearn for grand coalitions that can make democracies function so that the way of the philosopher king need not be taken. But this appears to have eluded many nations most of the time. Still it holds out the hope that the path not taken is probably more absurd.

 

References

 

Mancur Olson, The Logic of Collective Action, Harvard University Press, 1965

 

Mancur Olson, The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities, Yale University Press, 1982

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