Constrained Income Redistribution and Inequality : Legal Rules Compared to Taxes and Transfers

A widely accepted result, associated with Louis Kaplow and Steve Shavell, is that it is more costly to use legal rules to redistribute income than to use the tax and transfer system (the income-tax only result). An assumption behind this result is that if a legal rule is changed to eliminate its income-redistributive effects, the tax and transfer system can be adjusted to counteract the effects of those changes on the distribution of income. A number of commentators have questioned this assumption, suggesting that political constraints may limit the ability of the tax and transfer system to adjust to changes in legal rules. They conclude that legal rules should sometimes, or always, be designed to redistribute income.Building on this critique, this paper considers how adding political constraints on redistribution changes the income-tax only result. After examining what we know about the effectiveness of the tax and transfer system in redistributing income, the paper considers a political constraints that limit adjustments to the tax and transfer system, in each case examining the implications for the income-tax only result. It concludes that adding political constraints strengthens rather than weakens the result. There are two key considerations.First, legal rules may be regressive as well as progressive. To the extent that the wealthy control the political system and seek to redistribute wealth upwards, allowing the use of legal rules may make it easier for the wealthy to do so because redistribution using legal rules is less transparent than redistribution via the tax system. Second, allowing the use of legal rules to redistribute may lead to tit-for-tax strategies when coalitions change, with coalitions that favor less redistribution enacting regressive legal rules and coalitions that favor more redistribution enacting progressive legal rules. The net result is a loss in the effectiveness of legal rules with unclear effects on the distribution of income. The income-tax only approach mitigates this effect