Reducing inequality on the cheap: when legal rule design should incorporate equity as well as efficiency.

• Author: Liscow, Zachary

NOTE CONTENTS INTRODUCTION I. REDISTRIBUTION BASED ON INCOME A. Equity-Informed Distribution of Entitlements and the "Zero Distortion" B. Contrasting Alternative Equity-Informed Legal Rules C. Factors that Affect the Value of Equity-Informed Legal Rules 1. How Effectively Income Can Be Redistributed Based on Group Membership 2. Elasticity of Group Membership 3. Timing of Income Transfers and Behavioral Responses 4. Economic Incidence 5. Bargaining Costs 6. Importance of Helping the Poor Versus Horizontal Equity II. REDISTRIBUTION BASED ON NON-INCOME FACTORS A. Tagging B. When Insurance and Transfers Are Unavailable or Not I-Efficient CONCLUSION INTRODUCTION

At least since the majority in Lochner v. New York (1) found that bakers' hours could not be limited by the government, many scholars have argued that legal rules should not try to affect the distribution of income. What many consider the decisive argument in favor of this position is the idea of "double distortion" offered by Louis Kaplow and Steven Shavell: using legal rules to affect the distribution of income merely simulates income taxes, distorting income just like a tax but also distorting the behavior regulated by the legal rule. (2) As a result, they argue, all redistribution should take place through the income tax code, and none should take place through legal rules. The argument is especially sweeping given the scope of what a "legal rule" can be: regulations on bakers hours, tort laws, methods of conducting cost-benefit analysis, or any "rules other than those that define the income tax and welfare system." (3)

Kaplow and Shavell's analysis supports what is perhaps the central tenet of law and economics, namely that legal rules should be designed based on their efficiency consequences. (4) That is, legal rules should lead to behavior that maximizes "wealth," the sum of individuals' willingness to pay for the externalities, goods, and services produced by an economy. (5) But traditionally, economists have sought policies that maximize not wealth but rather "social welfare," the sum of individuals' utility, (6) and utility often increases more when a resource is distributed to individuals, especially the poor, who are not the ones most willing to pay for it. In other words, equity, or distributing resources to individuals whose utility is most increased by receiving the resource, matters for utility too. In the classic trade-off between efficiency and equity in social welfare maximization, "distortions" to the wealth-maximizing outcome resulting from deviating from the "efficient" rule must be traded off against improvements in equity that result from the "distortion." Kaplow and Shavell's "double distortion" argument, however, eliminates this trade-off for legal rules. In their world, taxes should be the sole means of promoting equity.

Kaplow and Shavell's argument has been criticized from inside and outside of law and economics. In particular, Chris Sanchirico and others claim that equity should be taken into account when designing legal rules. (7) Kaplow and Shavell themselves acknowledge that their argument does not always hold, but they do relatively little to explore exactly when this is or to define the optimal policy under those circumstances. This Note seeks to map the territory between the two sides by answering two questions: (1) When exactly does the double distortion argument not hold? (2) What should policymakers do at such times? This Note argues that, within traditional economic understandings of welfare maximization, legal rules should consider equity for two reasons. (8) First, legal rules may be more efficient than income taxes at redistributing income from the rich to the poor. While this Note does not advocate for more redistribution, as income inequality increasingly becomes part of the political dialogue, finding efficient ways of reducing income inequality may be increasingly important. (9) Second, features other than income are often desirable bases for redistributing income, and legal rules may be institutionally better-equipped than taxes--or the only option--to redistribute based on such non-income features.

To understand why redistributing through legal rules may be desirable, the starting point is the so-called marginal cost of public funds, the cost of redistributing through taxation. That is, redistribution through legal rules may be inefficient and costly, but so is redistribution through taxation. The most-cited economics article estimating the efficiency costs of taxation shows that about a third of each marginal dollar of taxes is lost as waste. This is primarily because a tax on labor discourages working, and a tax on capital discourages investment. (10) I will call this empirical result the "one-third rule." If the distortion from departing from the "efficient" legal rule does not exceed approximately one-third of the amount redistributed, changing the legal rule is more efficient than raising taxes. (11) As a result, even an "inefficient" legal rule could be optimal so long as it reduces the amount of taxation.

Thus, using an "inefficient" legal rule instead of taxation can be an efficient means of redistribution. As such, though a legal rule may be "efficient" viewed in isolation, it may not be efficient in the overall system of taxes and legal rules. So, before proceeding, I need to develop some terminology. I will call the rule that is efficient (i.e., wealth-maximizing based on individuals' willingness to pay) in the narrow "internal-to-legal-rule" context the "i-efficient" rule. That is, the determination of what rule is "i-efficient" ignores the tax system, imperfect private insurance, any desire to redistribute, and social welfare maximization. I will reserve "efficient" for the rule that is efficient for the overall system. The "efficient" rule maximizes wealth, but subject to the constraint that welfare maximization demands redistribution.

With this backdrop, I proceed as follows. In Part I of the Note, I use the example of a factory owned by rich individuals that is polluting on poor individuals to show how legal rules may be a more efficient means of redistribution. (12) When Kaplow and Shavell criticize equity-informed legal rules, they have in mind legal rules that would instruct courts to increase or decrease damages awarded in a case depending on the relative incomes of the individual plaintiff and defendant. Kaplow and Shavell rightly conclude this type of rule does not promote social welfare. However, this Note examines a type of rule that is subtly, but critically, different. Rather than altering damages, as Kaplow and Shavell and Sanchirico consider, legislatures can develop equity-informed rules that, for example, assign different standards of liability depending on the income of litigants who typically bring a certain claim. (13) If these litigants have different levels of income, such a rule can efficiently distribute wealth to low-income groups and promote social welfare. In some cases, by not considering equity, law and economics fails to maximize not only social welfare but also efficiency. In contrast to the previous literature, I describe the distribution of legal entitlements that can entail a distortion of neither income nor the activity regulated by the legal rule--a "zero distortion." (14)

I then relax the assumptions in the main example and describe six factors that make legal rules more desirable as a method of redistribution. In particular, legal rules are more desirable when: (1) there actually are significant income differences between plaintiffs and defendants; (2) group membership is inelastic; (3) responses to a rule change are slow and the income transfers are fast; (4) the economic incidence of a policy is on the desired individuals; (5) parties can bargain at low cost; and (6) redistributing to the poor is more important than violating notions of horizontal equity.

In Part II, I introduce a second, independent reason to consider equity in the design of legal rules: the tax-and-transfer system may be poorly equipped or unable to redistribute based on non-income characteristics important for welfare. In other words, legal rules are institutionally well-equipped to redistribute where taxes cannot. I focus on two particular cases. First, individuals may be "tagged" as low-ability through the harm measured by the legal system, justifying additional redistribution. Second, when private insurance is imperfect and transfers to harmed individuals are unavailable, then the social welfare function may demand that equity be considered in the legal rule itself.

Since there are both income and non-income reasons to adopt equity-informed legal rules, the harm from not adopting such rules comes from two sources. First, without equity-informed legal rules, efficiency is reduced because wealth is lower. Without equity-informed legal rules, the burden on the tax system to redistribute is higher, reducing the amount that society produces, since taxes discourage work and investment. Second, equity is lower because of missed low-cost opportunities to redistribute to the poor and to other groups to which society wishes to redistribute. Thus, in the appropriate contexts, equity-informed legal rules should be adopted to produce a society that is richer and more equitable.

I wish to cabin the discussion in three ways. First, this is a Note on legal rules versus income taxes, not taxes on externalities or other lands of taxes. (15) Second, I will generally stay within the economic mode of analysis, analyzing policies on the basis of their maximizing social welfare and assuming a social planner really can choose between taxes and legal rules. (16) Third, this is a Note about equity-informed legal rules versus a theoretical i-efficient rule, not versus the current law.

Section I.A explains the "zero distortion" distribution of entitlements based on group income in a baseline...