January 30, 2011
Inequality in Income and Wealth
Inequality in Income and Wealth—Posner
In discussing inequality of income and wealth (I'll use "inequality" to cover both) one could focus on inequality between countries—rich countries versus poor countries—or on inequality of wealth within countries. The two inequalities could change at different rates, even in different directions. I will focus, as does Becker, on inequality within countries.
As he points out, it has grown. This seems to be the result of four forces: (1) a trend away from redistribution—that is, from policies designed to equalize after-tax incomes by combining heavy income taxation with subsidies for poor people; (2) greater competitiveness, in part because of deregulation, more rapid innovation, freer international trade, and a decline in discrimination; (3) the growth in the size of markets (this is related to freer international trade), which increases the returns to excellence and innovation; and (4) an increasing return to IQ because of the changing character of production. The first three points are related to the collapse of communism and the failure of collectivist policies in noncommunist countries (notably the failure of regulation in the United States in the 1970s and the ossification of labor unions despite government support), and the last to the decline of manual labor relative to brain work as economic activity becomes increasingly automated as a result of technological progress. Most commentators on inequality would reword (4) as an increasing return to higher education, but it is very difficult to gauge the value added of a higher education, especially the economic value. Think of such college dropouts as Bill Gates, Steve Jobs, and Mark Zuckerberg. Higher education is indispensable for persons who want to be members of professions, and doubtless helpful for most people who want to go into business, but it will not make up for deficiencies in IQ.
Compare two people, A and B. A does not go to college, and his lifetime earnings are $1 million. B goes to college, and his lifetime earnings are $2 million. In gauging the value added by a college education, one has to control for, among other things, difference in both cognitive and noncognitive abilities (IQ illustrating the first, ability to apply oneself to a task the second). The point is not that B didn't derive a benefit from college. Maybe without college his lifetime earnings would have been only $1 million too. But maybe if A had gone to college, his lifetime earnings would still be only $1 million because he wasn't smart enough, or motivated enough, to derive any benefit from college. The University of Chicago economist James Heckman may well be right that the only hope for many Bs is early childhood intervention.
Thus the question is whether today in America everyone who can benefit from a college education gets a college education. If so, increasing college enrollments would not reduce inequality, though school reform at the high school and elementary school levels might increase the number of persons who can benefit from a college education, although Heckman's research provides a basis for skepticism.
Inequality is self-limiting to a degree; if it generates tremendous envy and resentment, the government will be under irresistible pressure to adopt redistributive policies. (Equality is likewise self-limiting: too much, and it destroys incentives.) Oddly, increased inequality in the United States has not generated much envy or resentment. The principal opponents of inequality are upper-middle-class liberals rather than poor or lower-middle-class people, and they failed to obtain a rescission of the Bush tax cuts for high-income taxpayers. Obama's health care reform is the only major redistributive measure adopted in the United States in recent times, and its major redistributive component is an expansion in Medicaid, which the states (which pay half the cost of Medicaid) are busily trying to undermine by reducing the medical treatments for which Medicaid will reimburse providers of health care.
If I am correct that inequality is not influencing public policy in the United States—is just not a political issue—then I don't think there is an inequality "problem." There is just the facts that in the United States a small fraction of the population has an enormous share of the nation's income and wealth and, at the other end of the income distribution, there are many very poor people. Are the rich a "problem"? I don't think so. All their money is either spent on consumption or invested, and either way it is economically productive; it's not as if the rich hoarded their wealth in the form of gold bars. The rich influence elections by their campaign contributions, but they would have the same influence with much less money, because it is not the absolute level of a rich person's campaign contributions that sways elections but the level relative to contributions by other rich persons supporting competing candidates.
Warren Buffett warns that without stiff inheritance taxes (which the United States does not have), we will find ourselves in the grip of an "entrenched plutocracy" (according to the Economist article that Becker cites). I don't understand that concern. The heirs of the rich spend their money on consumption or investment, just like their parents; dissipate it rapidly, if they're dumb; but in any event do not by virtue of having inherited a lot of money block the upward striving of others.
Poverty is a problem, but if the rich are not a problem, then the problem of poverty is not a problem of inequality. It looks like a problem of inequality only because the wealth of the wealthy seems an obvious source of money to alleviate poverty. But it is not that taxing the rich would alleviate poverty, but that taxing the rich and using the tax revenues to raise the incomes of the poor would alleviate poverty. Inequality should be a non-issue in the United States—and to a considerable degree it is.
Bad and Good Inequality-Becker
The Economist in its January 20th issue has an excellent discussion of many issues related to inequality within and between countries. I believe the main issues related to judging inequality and its changes over time come down to deciding whether the inequality is of the good or bad kind.
Many people, especially academics and other intellectuals, find the phrase "good inequality" jarring because they can hardly think of any aspect of inequality as being "good". Yet a little thought makes clear that some types of economic inequality have great social value. For example, it would be hard to motivate the vast majority of individuals to exert much effort, including creative effort, if everyone had the same earnings, status, prestige, and other types of rewards. For example, many fewer individuals would engage in the hard work involved in finishing high school and going on to college if they did not expect their additional education to bring higher incomes, better health, more prestige, and better opportunities to marry.
On my first trip to China in 1981 I visited several factories in the Beijing area. All the employees in each factory received more or less the same pay, and they could hardly ever be fired for bad work or absenteeism. This was an extreme eqalitarian approach to compensation, and the result was that no one worked hard, even though Chinese workers have traditionally been known for their diligence and energy. The picture was more or less the same in all of the factories I visited, and there was also little difference in pay between factories. Urban China was then highly eqalitarian, but it was also extremely poor because of very low productivity. China's economic miracle has been in good measure based on allowing much greater inequality in pay and incomes to motivate greater productivity in both urban and rural areas.
Bad inequality is the other side of good inequality, for it is inequality that reduces efficiency, productivity, and utility. About 80% of China's vast population in 1981 lived in rural areas, yet it was then virtually impossible for anyone born in rural China to gain legal residence in a city, even though farm incomes averaged less than half of urban incomes. The result was a large inequality between urban and rural areas that lowered overall efficiency and productivity. Urban-rural inequality has if anything grown over time as China boomed during the past 30 years because of the rapid growth in urban incomes, and a slower growth in farm incomes. People born on farms are still at an artificial disadvantage since rural schools tend to be of low quality, and it is still not easy, although much easier than in the past, to gain legal residency in cities.
Earnings inequality in the United States and many other countries has increased greatly since the late 1970s, due in large measure to globalization and technological progress that raised the productivity of more educated and more skilled individuals. While the average American college graduate earned about a 40% premium over the average high school graduate in 1980, this premium increased to over 70% in 2000. The good side of this higher education-based earnings inequality is that it induced more young men, and especially more young women, to go to and finish college. The bad side is that many sufficiently able children could not take advantage of the greater returns from a college education because their parents did not prepare them to perform well in school, or they went to bad schools, or they lacked the financing to attend college. As a result, the incomes of high school dropouts and of many high school graduates stagnated while incomes boomed for many persons who graduated college, and even more so for those with post graduate education.
Although inequality in many developing and developed countries grew a lot during the past 30 years, world income inequality actually greatly declined. This is because the per capita incomes of developing countries with big populations, including Brazil, China, India, and Indonesia, grew much more rapidly than did the per capita incomes of the rich Western countries and Japan. World poverty declined enormously, and so did the income gap between poorer and richer countries. This meant a large decline in the bad kind of world inequality.
A sizable fraction of the increased income and wealth inequality since the mid 1990s in the United States and some other rich countries was due to the explosion of incomes in the financial sector prior to the financial crisis. Most people are willing to accept huge incomes and vast amounts of wealth when they feel these are earned, such as with Steve Jobs, Bill Gates, and Warren Buffet. However, they are justifiably unhappy about large pay to CEOS who badly manage their companies, huge bonuses and stock options to executives who took unreasonable risks and then were bailed out by the Fed and the Treasury, and other big paydays for work that (perhaps unjustly) does not appear to be particularly socially valuable.
Controversy over inequality arises mainly because some types of inequality are not easily classified as good or bad. For example, would an increase in the marginal income tax rate from 35% to 45% on individuals earning over $500,000 have much of an effect on how hard and how long they work, and their efforts to legally (and illegally) reduce the income they report to tax authorities? Those who support this kind of tax increase deny that it would have a big effect; while opponents are just as certain that it would significantly discourage effort. The evidence is far from conclusive, but studies by Edward Prescott, Richard Rogerson (see his "The Impact of Labor Taxes on Labor Supply": an International Perspective"), and others of the relation among different countries between the amount of work and average tax rates on earnings is convincing that tax rates in general have strong negative effects on effort. However, this evidence is silent on how much higher tax rates on individuals with very high incomes affect their effort and other behavior.
Some authors have claimed a sizable negative relation between social and economic inequality and the healthiness of a population (for an early influential work see MG Marmot's, "Understanding Social Inequalities in Health", 2003). I have no doubt that individuals who try but fail to climb the income and prestige ladder may suffer stress and other causes of poor health. On the other side, the stress and health of those who succeed tends to be improved by their success. The data on happiness and on health show conclusively that higher income persons are both happier and in much better health than others. Less clear is whether narrowing the degree of inequality in health and status, while maintaining the incomes and social ranking of the poor, would significantly improve overall health. I am doubtful, but the evidence is not yet conclusive.