December 10, 2006

World inequality

BeckerPosner 2 entries Grouping confidence 1.00

Becker December 10, 2006 Opening 88 comments

World inequality--BECKER

A recent UN report on world inequality of wealth attracted widespread media coverage. The Report finds that the richest 2 percent of adults own half the world's assets, which clearly indicates a very skewed world distribution of assets. When put into context, however, the inequality in wealth appropriately defined is not nearly as large as the report might suggest, and wealth inequality in the world has almost surely become smaller over time, not larger as some in the media reported.

The UN Report was prepared by very good economists, and does a commendable job in what it tries to do. That is to measure the value in 2000 of the world distribution of physical and financial assets, net of any debt--this is usually called net worth. The authors had direct wealth data for countries that have more than half the world's population, and an even larger share of its wealth, and they infer wealth in countries missing from their data. Their results do show both considerable inequality in assets, and a long tail at the upper end of asset holdings--called skewness in statistical language. The report does not even attempt to show what happened to world inequality over time, even though some of the media reports that it demonstrates that inequality greatly increased in recent decades.

World inequality in wealth is to a large extent determined by inequality across nations. Comprehensive data on what happened to the distribution of assets in the world over time are not available, but the income data show a sizeable decline, not increase, in world income inequality since 1980. This is mainly but by no means entirely due to the remarkable rate of growth in incomes in two quite poor nations, China and India, which contain about 37 percent of the world's population. Studies also show that both the number of and the fraction of the world's population who live on either $1 or $2 of income per day has fallen quite sharply during the past 25 years, again partly due to China's and India's growth.

Earnings, not incomes from physical or financial capital, are the predominant determinant of incomes for the vast majority of persons in the world in rich as well as poor nations. Put differently, human capital, not assets, is the most important form in which people hold their wealth. Human capital is itself determined by education, training, nutrition, and other forms of health investment. Human capital wealth that determines earnings is about three times as large as wealth in the form of physical assets of all types. Such wealth from human capital is much more equally distributed and is much less skewed in its distribution than are assets.

Even earnings and money incomes exclude the contribution of better health to people's "real" income, defined as the incomes that produce wellbeing. World inequality in health among countries has declined greatly since 1960 when measured by life expectancy at various ages, even thought the AIDS epidemic in Africa has largely eliminated the gains in life expectancy in that continent after 1970. Inequality in "full" income among countries has declined much more rapidly than inequality in per capita GDP since 1960, where the growth in full income is defined as the sum of the growth in GDP plus the value placed by individuals in different countries on the improvements in their life expectancy--for definitions and various results on world inequality, see the article by Becker, Philipson, and Soares in the American Economic Review, March 2005.

Income inequality within the United States and many other countries has indeed grown a lot since 1980, in part due to much greater returns on education and other human capital, and in part due the somewhat related growth in incomes at the upper end that Posner discusses. This widening inequality appears to be largely due to technological and other changes, such as globalization, that have increased returns to persons with more education and other human capital, including high-end abilities. However, inequality in life expectancy has fallen within most of the developed countries as a result of more equal access to health care---in the U.S. due mainly to the growth since 1970 of Medicare and Medicaid. So while inequality in full income probably also grew, and perhaps substantially, it grew more slowly than did inequality in earnings and incomes on assets.

My discussion should not be construed as complacency about the inequality found within countries like the United States, or among countries. For example, America should do a much better job of providing a way for able young persons from more disadvantaged backgrounds to finish high school and go to college--the past 25 years have been devastating for persons with little education. This is not an easy problem, but head start and related early childhood programs seem to be effective, legalization of drugs would reduce the temptation for inner city youth to drop out of school to sell drugs, and I also support greater competition among schools. Unlike Posner, I do not support the estate tax because it brings in little tax revenue relative to the large costs involved in legally avoiding this tax--through trusts and the like-- and also in illegally evading this tax (see my more extended discussion of the estate tax in my post on May 15, 2005).

Many other poor countries should be following China and India's example and open up their economies to competition and world trade, so that they too can grow faster. Similarly, the rich countries have to reduce their restrictions on imports of goods produced by developing countries, and by countries that want to be developing.

To conclude, it is worth remembering that world inequality in "real" incomes has declined, not increased, a lot during the past 25 years. Much more can be done to equalize opportunities both within and between nations, yet it is unwise to concentrate attention primarily on inequality in assets. This is one component of inequality, but it is by no means the major determinant of inequality in wellbeing.

Posner December 10, 2006 Opening 120 comments

Should We Worry about the Rising Inequality in Income and Wealth?--Posner

Economic inequality is growing in the United States and other developed countries, and also in rapidly developing countries, notably China and India. Becker and I blogged about economic inequality on April 23, almost eight months ago, but indications that inequality is surging at the very top of the income distribution merits a further look, as does the recent study of world income inequality that is the focus of Becker's comment. Recent reports in the media document phenomenal returns to hedge-fund operators, private-equity investors, and other finance specialists, astronomical CEO salaries, enormous returns to software entrepreneurs, a stampede of lawyers and doctors to Wall Street, $200,000 law-firm signing bonuses for 27-year-olds who have clerked for the Supreme Court, enormous philanthropic gifts ($100 million gifts to colleges and universities by alumni are no longer unusual), and soaring demand for products bought only by superwealthy people, such as full-sized passsenger airliners converted at great expense to private airplanes, $40 million homes, paintings costing tens of millions of dollars, and automobiles costing several hundred thousand dollars. There are now almost 800 billionaires in the United States and countless millionaires, and one out of every 500 U.S. households have an annual income of at least $1 million.

Now this is to look only at the top of the income distribution. It is not to consider the income distribution as a whole, let alone poverty. In the more conventional focus on earnings by quintiles, one sees little change in recent years. But since 1980 the percentage of total personal income going to the top 1 percent of earners has risen from 8 percent to 16 percent. It is the top of the distribution on which I'll be focusing.

What are the causes, and what are the effects, of this trend in the income (and of course wealth) of the highest-earning segment of the distribution? Part of it is reduced marginal tax rates, because high marginal tax rates discourage risk-taking. Consider two individuals: one is a salaried worker with an annual income of $100,000 and good job security, and the other is an entrepreneur with a 10 percent chance of earning $1 million in a given year and a 90 percent chance of earning nothing that year. Their average annual incomes are the same, but a highly progressive tax will make the entrepreneur's expected after-tax income much lower than the salaried worker's. Many of the people at the top of the income distribution are risk takers who turned out to be lucky; the unlucky risk takers fell into a lower part of the distribution. It is rich people as a class who are growing relatively richer, not necessarily individual rich persons.

Marginal income tax rates on the wealthy have not declined much in recent years, however; but the income tax rate cuts since 2001 have favored the wealthy. Another and more important factor in the recent wealth surge is a growing return to high IQs; outstanding success in highly complex fields such as finance and software is highly correlated with high levels of intelligence. And increased size of markets as a consequence of increased international trade provides greater returns to successful innovations.

I am more interested in the effects of the increasing incomes of the rich--though one might ask: are there any effects, other than those that are perfectly benign? Even though the federal income tax is increasingly a proportional rather than a progressive tax (though it is still somewhat progressive--the average tax rate for the top 1 percent of earners--24 percent--is roughly twice that for all federal taxpayers), the more skewed the distribution of income, the higher the proportion of taxes that is paid by the rich. And in fact the top 1 percent of earners pay more than one-third of all federal income taxes today, which is a boon to the rest of the population. Very wealthy people also provide patronage for the arts, funds for high-risk ventures (actually, art is one of those ventures), and money for philanthropic enterprises. And there is very little envy of the rich on the part of other Americans, in part perhaps because of the much-derided but very real "trickle down" effect. This is due partly to philanthropy but more to the enormous consumer surplus generated by products such as Microsoft Windows, the brainchild of persons who are now billionaires. It is also due in part to the fact that, given diminishing marginal utility of income, income increases at lower levels in the income hierarchy increase personal welfare more than increases at higher levels do. Moreover, real wealth is a function of improvements in the quality and variety of products and services, and these improvements benefit all classes of the population.

All this is not to say that the existence of a stratum of exceedingly wealthy people is altogether to the good. There are three potentially bad consequences for our society:

The existence of enormous financial returns to IQ deflects high-IQ people from entering careers in which the social returns may greatly exceed the private returns: government service, basic science, and teaching. The quality of both the civil service and the public schools appears to be falling.
Massive philanthropy directed abroad can interfere with a coherent foreign policy. Major philanthropies such as the Gates Foundation do not coordinate their spending decisions with U.S. national goals.
Huge personal wealth may play a disproportionate role in political competition. Personal wealth confers an enormous advantage on a candidate, but also permits a person who does not want to be a candidate to exert an influence on candidates and policies, as in the case of Richard Mellon Scaife and George Soros. The fact that a person is a highly intelligent speculator, such as Soros, is no guarantor of political insight or wisdom; and the fact that a person has inherited a vast fortune, such as Scaife, is no guarantor of ability of any sort. More important, however, heavy campaign spending by the wealthy force nonwealthy candidates to spend increased time and effort on fund raising, which makes a political career less attractive to nonwealthy persons and makes nonwealthy politicians less well informed about policy and more dependent on interest groups than if campaign spending were lower.

Are these consequences serious enough to warrant remedial action? I think not, except that they may provide some grounds for wanting to retain, perhaps even to strengthen, the estate tax. The disincentive effects of taxing estates are much less than those of income taxation.