Optimal Progressivity of Redistribution with Frictions to Knowledge Diffusion

Abstract

Benabou (2002) strengthens the so-called Efficient Redistribution Hypothesis (ERH) by demonstrating how income redistribution can promote growth and welfare by mitigating economic waste from resource misallocation that is caused by credit market frictions to production, which is subject to diminishing returns. We ask how the presence of knowledge externality in private education technology and social frictions resisting knowledge diffusion changes the optimal progressivity. In the model, the distribution of human capital of the parent's generation determines the stock of nonrival knowledge through a process of diffusion which is subject to communication frictions. The output cost of inequality and the optimal progressivity increase with the degree of knowledge externality and hence with social returns to education, if and only if, frictions to diffusion outweigh frictions to production. If the inequality augmenting neighborhood effect of parental human capital is relatively large, compared to the inequality mitigating impact of the economy's stock of nonrival knowledge, then the ERH fails with low communication frictions. However, if frictions and social returns to education are large, irrespective of its local or global origin, then even with endogenous growth led by constant returns to capital, the ERH survives.