Estimating Equivalence Scales for Tax and Benefits Systems
When comparing, say, the welfare derived from income by a family that is comprised of two adults and three children to that of a single adult, it is necessary to take into consideration the relative needs of the respective households. The most common means by which applied studies in economics currently relate the needs of heterogeneous income units is through the use of equivalence scales. Despite a considerable research effort, however, almost every aspect of equivalence scale specification remains controversial. What characteristics should equivalence scales take into account? Should the scales apply an additive or multiplicative adjustment to income? Is the assumption of base independence valid?1 How should a reference unit be selected? Is it reasonable to assume that there is no inequality within an income unit? What criteria are most sensible for selecting a functional form? And, arguably most important, do the cardinal relations implied by equivalence scales permit income units to be compared in terms of underlying welfare? All of these questions remain largely unresolved. This paper is concerned with estimating the relativities that are implicit in tax and benefits policy. Using observed tax and benefits payments to estimate equivalence scales may mitigate some of the criticisms to which alternative scale specification criteria have been subject. For example, most econometric estimates of equivalence scales used for distributional analysis are based on consumer demand behaviour. Pollak and Wales (1979, p. 216) have notably criticised this methodology on the basis that “the equivalence scales required for welfare comparisons are logically distinct from those which arise in demand analysis”. The central difficulty is that demand analysis fails to provide a basis for making cardinal comparisons of welfare between households, and so equivalence scales that are estimated from expenditure data necessarily depend upon exogenously imposed value judgements. In contrast, part of the intuitive appeal of equivalence scales based on a country’s transfer system is the perception that such relativities embody a social consensus; that the tax and benefits system, being an observable instrument of government, can be used to infer the value judgements made by government when acting in its role as administrative agent for society. Comparison of the relativities that underlie taxation with equivalence scales based on the costs borne by heterogeneous income units could also provide a useful means for evaluating the adequacy of associated provisions made by transfer systems. Alternatively, the equivalence scales implicit in transfer systems could be used to compare the provisions made through time and/or between countries. Such equivalence scales could also play a role in the tax design process itself. In view of the fact that the redistributive systems of many countries are comprised of numerous different tax and benefit schemes, it is difficult to ensure that the overall system does in fact achieve the desired redistribution. Information about implicit scales — which may on reflection be found to differ from the values held by policy makers — can be useful in suggesting that certain features of the tax system need adjusting.
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