Persistent Distortionary Policies with Asymmetric Information

Why do distortionary policies persist when Pareto improvements are seemingly available? According to a standard textbook argument, an efficient outcome can be obtained by eliminating the distortions, compensating the losers with a lump-sum transfer, and redistributing the gains that are left over. This paper shows that this argument hinges on the assumption of complete information about the losses suffered by the losers. We relax this assumption and show that, in fact, the informationally efficient way of compensating losers may involve the use of seemingly inefficient (but informationally efficient) distortionary policies. We believe that our argument applies directly to policies that generate deadweight losses through higher consumption prices such as trade barriers, immigration restrictions, and minimum wages. Our argument may, however, be applicable to other distortionary policies. We add an informational friction to the textbook “winners compensate losers” argument. In our model, seemingly inefficient distortionary policies persist only as the optimal response to the information constraints. The optimal policy has an interesting form: the winner offers the loser the choice between maintaining or dropping the distortionary policy; if the distortionary policy is dropped, the loser receives a lump-sum transfer. Our explanation relies on the intuition that maintaining a distortionary policy, while creating a deadweight loss, has the benefit that it does not generate a need for compensation. When the policymaker does not know the amount that should be transferred, there is a risk of overcompensating. Compensating with a transfer is expensive because it induces the losers to overreport their losses in order to receive a higher transfer. This implies that the winner typically pays in excess of the actual losses suffered by the losers. The optimal policy trades off the cost of increasing the overpayment versus the deadweight loss generated by the distortionary policy. There have been several attempts to explain the apparent contradiction between the textbook argument supporting lump-sum transfers and the empirical fact that distortionary policies, in some cases, persist. We argue in Section I that this paper provides a novel explanation to the puzzle. In Section II we introduce a very stark model. Dropping a distortionary policy creates winners and losers. The winner’s benefit is (with certainty) greater than the loser’s loss. This is the sense in which the policy is a distortion. We do not model the aggregation of the winners’ preferences and assume a representative winner dictates the policy. We also do not model the reasons why the winners must compensate losers, because it is not the focus of this paper; instead, we assume that a policy must be chosen subject to keeping losers at least as well off as in the status quo. Under our assumptions, with complete information the distortionary policy would always be dropped, since the loser could be compensated with a transfer sufficient to make the change a Pareto improvement. The setup is intended to make it as difficult as possible for distortions to persist. We assume that losses are private information. We believe there are several applications for which this is a natural assumption. When a trade barrier is lifted, for example, displaced home producers might lose jobs and gain leisure. The value of the former might be quanti* Mitchell: Department of Economics, University of Iowa, Iowa City, IA 52245 (e-mail: matthew-mitchell@ uiowa.edu); Moro: Research and Statistics Group, Federal Reserve Bank of New York, New York, NY 10045 (e-mail: [email protected]). We thank V. V. Chari, Tom Holmes, Ray Riezman, Narayana Kocherlakota, and two anonymous referees for helpful comments. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System. 1 This is, for example, the standard argument in favor of free trade: trade barriers generate deadweight losses from higher prices of the traded goods. Under complete information, it would be efficient to drop the barriers and compensate the displaced workers with a lump-sum transfer. The views expressed herein are those of the aothors and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.