Income Mobility, Ratchet Effect, and Optimal Level of Redistribution

Abstract

This paper hypothesizes that individuals are more sensitive to how their relative position within the various income classes change over time than to their relative position within a class at anyone point in time. If the poor perceives no foreseeable escape from poverty, a strong sense of inequity is likely to develop. This creates several important socio-economic problems, including increased crime and social instability. Other problems arise, however, as macro-economic activity is affected by changing individual behavior. Little is known about the relationship between the degree of income mobility and individuals' behavior. The purpose of this paper is to give some insight into how individual behavior changes when degree of income mobility changes. The results of my analysis suggest that policy which increases the degree of income mobility can promote the equity in anticipated utility while reducing the level of redistribution. When income is redistributed through the social security system, this policy promotes capital accumulation and economic growth.