Economists frequently remind students, the public, and (especially) government policy makers that there is no such thing as a free lunch. If you want something you like, you must give up something else to get it. Tradeoffs are a fact of life and a central principle of economics. One significant tradeoff that societies face is between the conflicting values of efficiency and equity. Efficiency relates to the size of society’s economic pie, while equity relates to how that pie is sliced.
In economics, efficiency means getting the most you can from the limited resources at your disposal. If two companies producing the same product have equal amounts of land, labor and capital – the three primary factors of production – but one company produces 30 percent more goods than the other, the company with the greater output is operating with greater efficiency, getting more for its resources. Equity involves distributing the wealth of a society fairly among all its members.
Government policies often cause conflict between the competing values of equity and efficiency. A progressive income tax system, for example, requires people who earn more money to pay higher tax rates to support government operations, which may include providing unemployment compensation and welfare benefits to the poor. Such policies may strive to achieve greater economic equity, but at a cost of reduced efficiency. Higher tax rates on high incomes reduce the reward for working hard or building a successful business and may result in people working and producing less. Less output shrinks the overall size of the economic pie.
Much of the debate over the competing values of efficiency and equity in economics centers on tax policy. Depending on the actions taken by policy makers, tax policy can increase efficiency at a cost of reduced equity, or provide greater equity at a loss of efficiency. The most contentious debates usually center on the question of equity rather than efficiency. Opponents of higher taxes often condemn proposed tax hikes as socialist measures intended to redistribute income, while critics of tax cuts view them as benefiting the rich at the expense of the poor and middle class.
Former President Ronald Reagan emphasized using the U.S. tax system to increase economic efficiency. In 1980, the year Reagan was elected, the richest Americans faced top marginal tax rates of 70 percent. Reagan argued the high rates acted as disincentives to work and invest; in other words, they reduced efficiency. By the time Reagan left office, the top marginal rates were below 30 percent. Reagan’s critics contended the president cut taxes for the wealthy, taking away government benefits for the poor. As they saw it, Reagan’s tax policy reduced economic equity.
Harvard economist Gregory Mankiw, a former White House economic adviser, concludes in his book, “Principles of Economics,” that economic principles alone cannot resolve the conflict between efficiency and equity. Political philosophy plays an important role, as well, in striking a balance between these two goals.