Inequality update

Writing at The American Prospect, Liam Malloy and John Case argue for the implementation of a Pigouvian tax to reduce income inequality, which the article's subheading declares to be "America's most outrageous problem." For those not familiar with the term, a Pigouvian tax is one used to reduce something deemed to be harmful, with pollution often provided as a classic example. The logic at the heart of the tax is, as the authors note, "if you want less of something, tax it."

This is exactly correct, and a point more of our friends on the left should reflect on amidst their cheerleading for higher taxation. Just as a tax on pollution will reduce pollution, so will a medical device tax (such as the one imposed to help fund Obamacare) reduce the production of medical devices, incomes taxes will reduce income, sales taxes will reduce product sales and so on.

Of course, in order to implement a Pigouvian tax one must first identify a problem the tax would help mitigate. Seeking to spell out why income inequality should be a candidate for a Pigouvian tax, the authors list what they believe to be three deleterious effects. The first:

As the economy grows, the rich get nearly all the gains. The United States enjoyed an economic Golden Age from the end of World War II to about 1973. During that time, despite the fact that the top marginal tax rate never dropped below 70 percent (and stood at more than 90 percent until the early 1960s), growth in real gross domestic product (GDP) per capita averaged close to 2.5 percent a year. There is a widely held—and mythical—belief that the United States has been in the midst of a great stagnation ever since. The minuscule increase in the median household income, about 0.4 percent per year, supports this myth. 

But the economy has not stagnated. Output per capita has risen more than 90 percent since 1975, or an average of 2.1 percent per year. That’s less than the figure for the Golden Age but not much less. The difference is that since the 1970s, virtually all the gains have gone to those at the top. The average income of the top 1 percent has tripled, while the median household income has increased by less than 20 percent. 

The skewing of the income distribution, in short, imposes a cost on the vast majority of people. From 1975 to 2008, the median income of U.S. households rose by a total of $8,000 (in today’s dollars). Had the distribution remained the same as it was in the postwar years, the increase would have been $40,000. Instead of its current level, $50,000, the median income of U.S. households today would be $86,400.

The authors appear to believe it is rather damning that median household incomes have not  increased at the same rate as economic growth, but it unclear why it should be regarded as such or any kind of surprise. After all, no one is entitled to a certain slice of GDP, but rather only those who produce it. For example, the authors cite the growth in output per capita in the US, but that does not mean the growth in output has been uniform.

Imagine a village of 10 people, each of whom produces 10 units of output, for 100 units total. Now imagine that two of the villagers adopt some new technology that enables them to double their output to 20, thus pushing up total production in the village to 120 units. While per capita output has grown by 2 units per person, or 20 percent, eight of the villagers are no more productive than before, so why should we expect their income to have grown?

Beyond the theoretical angle, there are more practical problems with this line of argument. Unmentioned by the authors, for example, is the fact that household size has declined since 1973 from 3.0 to 2.6 currently. Thus, not only have incomes grown (albeit modestly), but they are being spread across fewer people.

More important, however, is that income is only a means to an end -- an improved standards of living -- and on that count one would be hard pressed to make the case that society is only 20 percent better off than forty years ago. Almost across the board, be it health care, housing, or even grocery stores, quality has increased. Not only has quality gone up, but many goods are also cheaper. Take for example, the telephone. In 1973, here's what a $35 phone ($175 in 2011 dollars) looked like:

Today, for only $25 more one can purchase (with contract) an iPhone 5 that includes not only the ability to make voice calls from almost anywhere (with long-distance included), but other features such as a camera and video camera, access to a wealth of information, alarm clock, music and even the ability to watch broadcasts over the cellular network in near high-definition quality:

Screen capture from my iPhone

The iPhone is a particularly useful example, because although its development only generated monetary benefits for a relatively small number of people (Apple executives became fabulously wealthy, while stockholders and other Apple employees benefited to lesser extents), literally millions have people have seen their quality of life improved by the device (and millions more by smartphones in general). Although it may not show up in the form of additional income for most people, society is undoubtedly better off.

This story has replayed itself across the economy, with small numbers of individuals gaining disproportionate monetary rewards while society broadly benefits in ways perhaps not captured by median household income. Jeff Bezos has become extremely wealthy through the founding of Amazon.com, while the rest of us benefit by both increasing the range of products available and saving us a trip to the store. John Mackey's founding of Whole Foods has earned him tens of millions of dollars while the rest of society benefits in the availability of improved choices at the grocery store and increased competition that has led other stores to upgrade their own offerings. While we may not directly share in the financial rewards, we have all benefited from the work of these individuals. To say that "the rich get nearly all the gains" is flatly wrong, or at the very least deceptive.

This is not to say there aren't areas where progress has lacked, or life has become more expensive. For example, one big reason why income has shown only middling growth is because of the growing cost of health care, forcing companies to shift money that otherwise would have been used to increase wages to pay higher insurance premiums for employees. The cost of college has also soared, as well as housing in many parts of the country, leaving families and individuals feeling increasingly stretched thin. What this cries out for, however, is not punishing the rich or corporations (recall that the health insurance industry is not particularly profitable), but rather paring back government interventions that promote these trends (the health care sector is rife with government distortions, while housing supply in major cities is frequently held back by regulation).

Finding ways to increase the incomes and standards of living of all citizens is a conversation well worth having, but it is a distinct one from income inequality.

This brings us to the next argument (which seem to echo remarks made by then-Senator Barack Obama in 2008):

Many talented people focus narrowly on getting richer, to the exclusion of activities that might be more beneficial to society. The greater the number of very rich people, and the bigger their share of the pie, the more it seems that getting very rich is both feasible and desirable. For young people, going where the money is becomes more attractive than a career in science, education, or public service. As late as 1986, only 18 percent of Harvard graduates planned any sort of business career. In 2011, the figure was 41 percent, including 17 percent going into finance.  

The new incentives affect the behavior of anyone with a decent shot at getting rich. CEOs of large corporations expect astronomical compensation packages. Wall Street executives pursue riskier lines of business in search of higher profits than they could earn through traditional banking or brokerage. Doctors and lawyers have an incentive to train for lucrative subspecialties, leaving a shortage of general practitioners and public defenders. All these brain drains impose costs on everyone else.

Or, just maybe, salaries act as price signals, telling graduates where their talents are most needed. Is there any indication the country suffers from a lack of teachers or bureaucrats? Would the country have been better served if Steve Jobs had opted for a job teaching calligraphy instead of running Apple? If John Mackey had gone to work at the Agriculture Department? Frankly, yet another argument in favor of smaller government is that it would free up smart minds to think of new innovations or businesses, which seems a better use of their talents than dreaming up new regulations.

In any case, where is the evidence that the public sector is having difficulty filling its ranks? If anything, the opposite seems to be occurring:

In 2009 alone, 16 percent more young college graduates worked for the federal government than in the previous year and 11 percent more for nonprofit groups, according to an analysis by The New York Times of data from the American Community Survey of the United States Census Bureau. A smaller Labor Department survey showed that the share of educated young people in these jobs continued to rise last year. 

“It’s not uncommon for me to hear of over 100 applications for a nonprofit position, sometimes many more than that, and many more Ivy League college graduates applying than before,” said Diana Aviv, chief executive of Independent Sector, a trade group for nonprofits. “Some of these people haven’t been employed for a while and are happy to have something. But once they’re there, they’ve recalibrated and reoriented themselves toward public service.” 

...Renewed interest in public service is visible across the country. Applications for AmeriCorps positions have nearly tripled to 258,829 in 2010 from 91,399 in 2008. The number of applicants for Teach for America climbed 32 percent last year, to a record 46,359. Organizations like Harvard’s Center for Public Interest Careers have been overwhelmed — and overjoyed — with the swelling demand from talented 20-somethings.

The authors are perhaps more on point with their critique of the salaries of doctors, lawyers and Wall Street CEOs, but let's recall that specialists in the medical profession are highly paid because of the incentives provided by Medicare, the law profession is crying out for deregulation and Wall Street is both highly regulated and subsidized by government bailouts. In short, none of these phenomena are the work of the free market.

Again, the authors may well have identified real problems, but  it is not at all clear how any of them would be solved by higher tax rates, and in fact actual solutions appears to lie in less government. 

We are then brought to the final critique:

As a group, the rich can use money to pursue political power and influence well beyond their numbers. Despite fundamental principles such as one person, one vote, the wealthiest Americans have always wielded disproportionate political influence. Today they can make unlimited, anonymous donations to “super” political action committees. They can play a huge role in financing nearly every campaign for federal office. Senators and representatives, faced with the need to raise an average $9 million (Senate) or $1.5 million (House) for each race, spend up to four hours every day cultivating the well-to-do. Nor is the problem confined to elections.  

Generously financed lobbyists do their best to ensure that regulatory and tax policies at every level of government don’t interfere with the opportunity to make—and keep—a ton of money. “Another vicious circle has been set in play,” writes Joseph Stiglitz in his new book The Price of Inequality. “Political rules of the game have not only directly benefited those at the top, ensuring that they have a disproportionate voice, but have also created a political process that indirectly gives them more power.”

Little wonder, then, that disaffected citizens on the right, on the left, and in the middle—whatever their views on inequality—believe that the very rich and organized business interests have hijacked America’s political process. The danger, of course, is that the trend is self-perpetuating. In their book Why Nations Fail, Daron Acemoglu and James A. Robinson show that sustained economic growth depends on open and inclusive political institutions. But when a moneyed elite so dominates the political order, it can rewrite the rules to forestall change and maintain a perch on top of the economic ladder. Acemoglu and Robinson quote Woodrow Wilson, who said during the last period when inequality threatened democracy: “If there are men in this country big enough to own the government of the United States, they are going to own it.”

A few points:

• Political views among the country's rich are hardly uniform. While the rich are typically stereotyped as Republicans, there is no shortage of millionaires on the left, ranging from Hollywood to Silicon Valley to individuals such as Warren Buffet and George Soros.

• The notion the rich can simply buy their way to election victory has been disproven over and over again. 

• If the rich are so powerful, why does the US have the highest corporate tax rate in the industrialized world? Do the rich enjoy paying high taxes? Why is the personal income tax rate on the rich higher now than when Reagan left office? 

• If the rich control government, and thus control the rest of us, isn't that a great argument for reducing the size of government?

Despite the numerous and obvious flaws in the arguments employed by Malloy and Case, at least they attempt a detailed critique. The same cannot be said of a recent New York Times opinion piece by Daniel Altman, whose entire argument against income inequality consists of this:

Whether you’re in the 99 percent, the 47 percent or the 1 percent, inequality in America may threaten your future. Often decried for moral or social reasons, inequality imperils the economy, too; the International Monetary Fund recently warned that high income inequality could damage a country’s long-term growth. But the real menace for our long-term prosperity is not income inequality — it’s wealth inequality, which distorts access to economic opportunities.

Thus, the sum total of evidence presented consists of unspecified IMF research (likely a reference to a paper written by Andrew G. Berg and Jonathan D. Ostry that has attracted considerable attention) and a claim that wealth inequality distorts access to economic opportunities, without any elaboration. 

Also writing in the Times earlier this week on income inequality, Eduardo Porter similarly offered up rather thin evidence of its alleged social and economic ills:

This lopsided pattern of development is hurting us, many economists believe. It is undercutting the aspiration that every American should have a fair shot at progress. There is mounting evidence that our vast inequalities may breed instability and blunt the nation’s economic growth.

It's worth noting that the first link provided by Porter only quotes one economist who believes that inequality harms society (Alan Krueger), while the second is much heavier on speculation ("may breed") than evidence, using the word "might" ten times. Like Altman, the link also cites the Berg and Ostry paper, which makes their argument worth exploring in more detail. A relatively short summary of their paper can be found here.

There are at least two important points worth noting: first that Berg and Ostry are fairly equivocal in their findings, using the word "may" or "might" 19 times. Second is that the role of public policy in addressing income inequality is uncertain:

The immediate role for policy, however, is less clear. More inequality may shorten the duration of growth, but poorly designed efforts to reduce inequality could be counterproductive. If these efforts distort incentives and undermine growth, they can do more harm than good for the poor. For example, the initial reforms that ignited growth in China involved giving stronger incentives to farmers. This increased the income of the poor and reduced overall inequality as it gave a tremendous spur to growth. However, it probably led to some increased inequality among farmers, and efforts to resist this component of inequality would likely have been counterproductive (Chaudhuri and Ravallion, 2007). 

Still, there may be some win-win policies, such as better-targeted subsidies, better access to education for the poor that improves equality of economic opportunity, and active labor market measures that promote employment. 

When there are short-run trade-offs between the effects of policies on growth and income distribution, the evidence we have does not in itself say what to do. But our analysis should tilt the balance toward the long-run benefits—including for growth—of reducing inequality. Over longer horizons, reduced inequality and sustained growth may be two sides of the same coin.

Here's an example of what the authors may be describing: government intervention in the US health care system has served to both artificially reduce the supply of doctors (examples: restrictions on the supply of teaching hospitals, licensing) while at the same time it has also driven up demand for medical services, mainly through subsidies and regulations (tax preferences and Medicare, regulations that certain procedures must be performed by doctors instead of other health care professionals) that encourage higher use of doctors than would otherwise be the case. 

The unsurprising result? Bigger salaries for doctors, higher health care costs that act as a de facto tax on worker salaries through increased insurance premiums, and reduced economic growth through health care inefficiencies. In other words, inequality. However, inequality is not the driver of any of the problems described, merely a result. The actual underlying problem is government intervention that pushes up the salary of doctors, exerts downward pressure on the wages of workers and promotes economic inefficiency. 

Again, a discussion should be welcomed regarding win-win policy measures that would both increase worker wages -- thus reducing income inequality (assuming the rich do not get richer at an even faster pace) -- and stimulate economic growth, but this is very different than the one favored by the left, which is primarily focused on achieving greater equality by reducing the fortunes of the rich through higher taxes rather than lifting up those on the bottom. 

Income inequality continues to be an issue regarded by the left as one of the great plagues of American society, and yet one whose dangers they also struggle mightily to explain.