Equality, Participation, Transition: Essays in Honour of Branko Horvat

74 Determinants of Income Inequality
hypothesis), and may be thought to reflect actual income inequality
between individuals better than other income concepts: for example, gross
income does not include direct personal taxes, while final income adjusts,
in an often arbitrary fashion, disposable income for consumption of government
in-kind benefits (education and health).
08 In some cases, gross income is used when personal income taxes are small,
and disposable and gross income are virtually the same.
09 The point was raised by a referee.
10 This explains why equivalence scales vary between the countries and why
there cannot be equivalence scales independent of specific country conditions.
The ‘correct’ scale for a country is a function of the country’s relative
price ratios. Consider the example of housing, assuming, for simplicity, that
a family needs to pay only for housing and food. Suppose that food costs
are proportional to the number of people, while housing is not. For the same
level of housing comfort, a single person in the US might need $800 per
month, and a five-member family $2000. This implies that a five-member
household should be (for the housing purposes) treated as 2½ adults. Food
costs for each household member are, say $300. Then the household of five
would require 5$300$2000$3500 to be equally well-off as the household
of one that has $1100 ($300 for food$800 for housing). The implicit
equivalence scales is 3.18 (3500/1100). Now let housing costs become practically
zero, as they were in the former socialist countries. Suppose that the
costs are now $8 for a single person and $20 for the family of five. While
the economies of scale for the housing alone are the same, their overall
importance is much less now simply because housing costs no longer matter
very much. Thus, a single person would now require $308 and the fivemember
household 5$300$20$1520. The implicit equivalence scale is
now 4.93 (1520 divided by 308), and we are practically in the world of per
capita comparisons. This is exactly the reason why per capita measurement
made quite a lot of sense in the former socialist countries.
11 The expected negative sign of TRANS deserves a further comment. As has
been argued, increased social transfers will tend to reduce the inequality of
disposable or gross income. But in some recent studies (for example, Alesina
and Rodrik, 1994; Persson and Tabellini, 1992) which are concerned with
determinants of social transfers, higher income inequality is shown to lead,
in conditions of wide franchise, to high redistribution. It would hence appear
that inequality and transfers are positively related. The example underscores
the ambiguity with which the term ‘income inequality’ is used. The positive
relationship between income inequality and transfers makes sense only if
one has in mind inequality of market income (before government benefits
and taxes). It is then logical to assume that if market incomes are distributed
unequally, people (that is the median voter) will vote for large redistribution
because they will thereby gain. But both Alesina and Rodrik (1994)
and Persson and Tabellini (1992) use measures of income inequality after
government cash transfers. Consequently, the cross-country relationship
between market income inequality and TRANS may be positive (because
taxes are higher in more unequal countries), while the cross-country relationship
between TRANS and disposable or gross income inequality may be
negative (because transfers paid out of taxes lower inequality). The two