Distributional Externalities and the Optimal Form of Income Transfers

Abstract

When preferences exhibit certain interdependencies, redistributive transfers can make everyone better off. However, the optimal form of such transfers depends on the nature of the postulated externalities. Lump sum transfers cannot achieve some Pareto optima if interdependence involves particular commodities. Here, price subsidies or earmarked (voucher) transfer schemes are required. However, if the interdependence relates to the general welfare of recipients, cash transfers are preferable. Preferences revealed in the political process in favor of in-kind programs suggest "particular-commodity" interdependence. But even if this is so, the analysis does not provide a conclusive case for in-kind transfers. Among other things, comparative costs of administering and policing in-kind as opposed to cash programs must also be considered.