NOTE: The Growth Economics Blog has moved sites. Click here to find this post at the new site.
“Inequality” is a term that has been tossed about quite a bit. The Occupy movement, to Piketty’s book, to debates over the minimum wage, to Greg Mankiw‘s defense of the 1%. Just today Mark Thoma published an op-ed on inequality. A few days ago John Cochrane had a post about why we care about inequality.
One of Cochrane’s main points is that the term “inequality” has been used in so many contexts, and to refer to so many different things, that it is ceasing to lose meaning. I’ll agree with him on this completely. If you want to talk about “inequality”, you have to be very clear about what precisely you mean.
There are three things that people generally mean by “inequality”:
- The 1% versus the 99%. That is, the difference in average annual income of the top 1% of all households versus the average annual income of the bottom 99%.
- The stagnation of median real wages and those below the median.
- The college premium, or the gap in earnings between those who finished college and those who did not (or did not attend).
When I say I care about inequality, I mean mainly the second – the stagnation of median wages – but this is going to take me into territory covered by the first – the growth in top 1% income. There are things to say about the college premium, but I’m not going to say them here.
Why do I care about the stagnation of median wages?
- Because I’m going to be better off if everyone shares in prosperity. I want services like education, health care, and home repairs to be readily available and cheap. The way to achieve that is to invest in developing a large pool of skilled workers – teachers, nurses, electricians, carpenters. Those at the bottom of the distribution don’t have sufficient income to make those investments privately, so that requires public provision of those investments (i.e. schools) or transfers to support private investments. You want to have an argument about whether public provision or transfers are more efficient? Okay. But the fact that there is an argument on implementation doesn’t change the fact that stagnant wages are a barrier to these investments right now.
- Because people at the bottom of the income distribution aren’t going to disappear. We can invest in these people, or we can blow our money trying to shield ourselves from them with prisons, police officers, and just enough income support to keep them from literally starving. I vote for investment.
One response to this is that I don’t care about inequality per se, I care about certain structural issues in labor markets, education, and law enforcement. So why don’t we address those fundamental structural issues, rather than waving our hands around about inequality, which is meaningless? Because these strutural issues are a problem of under-investment. The current allocation of income/wealth across the population is not organically producing enough of this investment, so that allocation is a problem. In short, if you care about these structural issues, you cannot escape talking about the distribution of income/wealth. In particular, you have to talk about another kind of inequality, the 1%/99% kind.
Let me be very clear about this too, because I don’t want anyone to think I’m trying to be clever and hide something. I would take some of the income and/or wealth from people with lots of it, and then (a) give some of that to currently poor people so they can afford to make private investments and (b) use the rest to invest in public good provision like education, infrastructure, and health care.
Would I use a pitchfork and torches to do this? No. Would I institute “confiscatory taxation” on rich people? No, that’s a meaningless term that Cochrane and others use to suggest that somehow rich people are going to be persecuted for being rich. I am talking about raising marginal income tax rates and estate tax rates back to the archaic levels seen in the 1990s.
Why do I not feel bad about taxing rich people further?
- Because rich people spend their money on useless stuff. Not far from where I live, there is a new house going up. It will be over 10,000 square feet when it is complete. 2,500 of those square feet will be a closet that has two separate floors, one for regular clothes and one for formal wear. If that is what you are spending your money on, then yes, I believe raising your taxes to fund education, infrastructure, and health spending is a net gain for society.
Don’t poor people spend money on stupid stuff? Of course they do. Isn’t the government an inefficient provider of some of these goods, like education? Maybe. But even if both those things are true, public investment and/or transfers to poor people will result in some net investment that I’m not currently getting from the mega-closet family. I’m happy to talk about alternative institutional settings that would ensure a greater proportion of the funds get spent on actual investments.
- Because I’m not afraid that some embattled, industrious core of “makers” will decide to “go Galt” and drop out of society, leaving the rest of us poor schleps to fend for ourselves. Oh, however will we figure out how to feed ourselves without hedge fund managers around to guide us?
This is actually a potential feature of higher marginal tax rates, by the way, not a bug. You’re telling me that a top tax rate at 45% will convince a number of wealthy self-righteous blowhards (*cough* Tom Perkins *cough*) to flee the country? Great. Tell me where they live, I’ll help them pack. And even if these self-proclaimed “makers” do stop working, the economy is going to be just fine. How do I know? Imagine that the entire top 1% of the earnings distribution left the country, took all of their money with them, and isolated themselves on some Pacific island. Who’s going to starve first, them or the remaining 300-odd million of us left here? The income and wealth of the top 1% have value only because there is an economy of another 300-odd million people out there willing to provide services and make goods in exchange for some of that income and wealth.
So, yes, I care about 1%/99% inequality itself, because I cannot count on the 1% to privately make good investment decisions regarding the human capital of the bottom 99%. And the lack of investment in the human capital of the bottom part of the income distribution is a colossal waste of resources.
The Growth Economics Blog 
I could not have put it better. The Cochrane post had been troubling me too. Excellent work, Dietz!
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I would have thought a mention of progressive consumption taxes as a replacement for the very distortionary business income tax would have made the point clearer.
I’m all for rethinking how we tax in general, but getting into that felt like ranging too far afield for one post.
Nice, for once, to see an economist take a moral stance in the inequality debate. We need more comments like this, as opposed to the silly value-neutral slogans even people like Krugman endorse. Economics began as a branch of moral philosophy and it has to be such.
Well said. Except one typo “that it is ceasing to lose meaning”.
I never liked the saccharine, academic usage, “inequality”; I prefer the, if clumsy, “Great Wage Depression” — at least that makes it spells out the problem clearly from my underpaid end.
[cut and paste]
If the top 1% income continues to receive all the economic growth, then, by the time the output per person expands 50% (25-30 years?) the top 1% income will “earn” half of a half-larger economy (25% + 50% = 75% of 150%). By the time output per person doubles (typically 40-50 years) the equation will read 25% + 100% out of 200% = 62.5% of a twice-as-large economy.
Throw in Piketty’s projections — inherited rentier incomes swallowing up even more income share (like the England of old) — and the bottom drops out for pretty much everyone.
There is a decades old, around the world tested answer. Ask Jimmy Hoffa as I always say — who spent 30 years, fighting (by fair means and admittedly sometimes foul) to spread the negotiation of one, single collectively bargained contract for all employees doing similar work with all employers — spreading outward from the jungle of Detroit’s Depression era labor market, finally to the whole country with the Teamsters 1964 National Master Freight Agreement (covering 400,000 truckers then, 50,000 now). Without so-called centralized bargaining every union these days is subjected to the race-to-the-bottom if employers can point to someone down the road paying less — more is needed than just organizing, as with card check. Ask poverty level wage supermarket employees since Walmart, etc., destroyed their middle class one-union-with-one-employer contracts.
Oddly enough to an American (me), legally mandated, centralized bargaining was instituted by the industrialists in post WWII Europe — something about fending off a labor union race to the top; thereby conserving more money for rebuilding. Today centralized bargaining can be found over the world from nearby French Canada to Argentina to Indonesia.
Which is to say that the most successful labor union (relatively speaking *) in this country and the most successful economies in the world have instituted the only labor setup I have ever heard of that results in a fair and balanced market. The way back for America must begin by everyone talking about that way back — to everyone.
Campaign financing and lobbying equal to the 1%’s plus 99% of the vote would neatly fall into place.
* A Pattern of Retreat: The Decline of Pattern Bargaining
http://labornotes.org/2010/02/pattern-retreat-decline-pattern-bargaining
Out of all the problems in the world, how does the stagnation of median wages in developed countries rank?
“Because these structural issues are a problem of under-investment.”
Under-investment relative to what?
“So, yes, I care about 1%/99% inequality itself, because I cannot count on the 1% to privately make good investment decisions regarding the human capital of the bottom 99%.”
It doesn’t sound like you case about inequality itself; it sounds like you care about poverty (via investment in HC). If everyone was perfectly equal, but there was massive under-investment in human capital, would you be happy?
“And the lack of investment in the human capital of the bottom part of the income distribution is a colossal waste of resources.”
Just in America, or globally?
The fact that people have it worse in Africa and Asia doesn’t mean that I cannot think about how to improve living standards in the U.S. for those at or below median wages. They are not mutually exclusive issues. Further, I would argue that improving median wages in the U.S. would make support for alleviating poverty in Africa and Asia easier to sell politically.
You’re right – I care about stagnant wages, low investments in human capital and infrastructure, and other things. I don’t care about inequality as a first-order thing (e.g. I don’t care if the Gini coefficient is necessarily 0.5 or 0.4). But, as I said in the post, once you care about stagnant wages and low investments in HC you end up caring about the distribution of income, because the distribution is part of what is limiting those investments.
If everyone was perfectly equal, but we were under-investing in HC, then no I would not be happy. But I would have to draw different conclusions about what was limiting the investment in HC. It might be because everyone was too poor to invest in those goods privately (as in many developing countries) or because there were institutional failures that limited the investment.
Those investments, by the way, are under- the rate that would maximize output/wages/living standards.
And yes, there is massive under-investment in HC globally. See the first point of the response.
Thanks for the response!
It seems to me that they are mutually exclusive issues: I can donate a dollar to a GiveWell-recommended charity focused on developing countries, or I can donate it to a U.S. charity. Even if increasing median U.S. wages increases support for charity abroad, that’s unlikely to be the most effective way to reduce poverty (i.e., it won’t be a top GiveWell charity).
Also, how is education a public good? Where’s the externality?
The externality is that educated workers are complements with each other. So the private return to getting an education is lower than the aggregate return. Education will be under-provided privately. Micro estimates of the return to education for individuals are around 10% per year of schooling. But at the aggregate level, you get things like 20-40% return per average year of education.
There’s a reason that the U.S. and other countries started public education systems in the first place. It wasn’t an accident.
Is this a virtuous/vicious cycle story, where you end up with low- and high-education equilibria? If so, wouldn’t the scope for government intervention just be in moving from one to the other? Also, couldn’t these externalities be internalized at the firm level?
Pritchett’s take (in his new book) is that governments run public education systems to socialize their citizenry, not because of public goods characteristics.
Lant Pritchett on envy and inequality:
“I am all for reducing poverty. I’ve spent most of my career working on that issue. I’m all for economic growth that’s inclusive and that raises the productivity and incomes of the poorest. I’m for social justice and attacking inequities. I’m against the privilege and corruption that denies opportunities to others. I am all for fairness, not least in economic affairs, and for state intervention when necessary to serve that purpose. What I’m against is talking about “inequality” as if that term denoted any of those concerns. Poverty matters; injustice matters. Mere inequality is beside the point.
… let’s stop talking about inequality and talk directly about the things we ought to care about: absolute deprivation, abusive power, rigged markets and unearned privilege.”
“This is actually a potential feature of higher marginal tax rates, by the way, not a bug. You’re telling me that a top tax rate at 45% will convince a number of wealthy self-righteous blowhards (*cough* Tom Perkins *cough*) to flee the country? Great. Tell me where they live, I’ll help them pack. And even if these self-proclaimed “makers” do stop working, the economy is going to be just fine. How do I know? Imagine that the entire top 1% of the earnings distribution left the country, took all of their money with them, and isolated themselves on some Pacific island. Who’s going to starve first, them or the remaining 300-odd million of us left here?”
I question several of your assumptions, or at least your hyperbole. In general, in a reasonably well working economy those making the highest incomes tend to be adding the most value to fellow humans. Consumers are voting with their dollars. Gates and the Waltons really did probably add more value to humanity than the janitor at my school. The exceptions — which clearly do exist– point back to improperly functioning markets.
As marginal tax rates increase, these higher producers are increasingly incentivized to either reduce their contributions or go somewhere else where they are treated more fairly in their estimation. A desert island is probably not on their short list, as the cons outweigh the benefits. Is this amount above or below 45%? Beats me. But the point is that it exists.
I do not want to discourage the most productive experts within their respective field of specialization to either stop producing or to seek better terms elsewhere. Doing so is counterproductive.
I am a business person, not an economist. But I think I am representing an impartial economist’s view better than you are on this topic.
Roger – I cribbed a line from your reply for my latest post. But a shorter version is this: higher tax rates don’t necessarily reduce the incentives for innovation. Innovation depends not only on individual creativity but on economic scale, and if I can foster greater scale through public investments (human capital, health, infrastructure) then the incentives to innovate will be greater, even if the marginal tax rate is large.
Second, you can’t tell me that if we made tax rates equal to their mid-1990’s rates, this would stifle innovation. The fastest productivity growth of the last 30 years was in the mid-1990s. The elasticity of people’s effort with respect to taxes isn’t that high given our current tax rates (yes, if you made taxes 100% people would stop working, but we’re not close to that at all).