Economics Lesson: Income Inequality

French economist Thomas Piketty’s bestselling book on wealth inequality, “Capital in the Twenty-First Century,” has become the focus of a debate over increasing income inequality in the US and many other countries. I have not read the book, which apparently presents lots of interesting data, the use and interpretation of which is also being debated. A recent paper on Piketty worth reading is by a young PhD candidate at MIT: http://www.washingtonpost.com/blogs/wonkblog/wp/2015/03/19/meet-the-26-year-old-whos-taking-on-thomas-pikettys-ominous-warnings-about-inequality/

The issue that interests me in this note is the great divide in attitudes toward inequality and thus the policies proposed to address it. Some people think income inequality, or at least too much of it, is bad per se. Thus taxing the rich and redistributing the proceeds to middle and lower income families is the solution. For me, and many others, the issue is whether the wealthy (to simplify) earned their income fair and square (to be explained below) and is thus a just reward for their contributions to the economy providing an important incentive for their efforts. To the extent that they have not (monopoly power, government favors, etc.) the solution is to attack and remove the policies and impediments to competitive markets that made their exorbitant incomes possible.

If it is not desirable (fair) for some people to be wealthy when others are not, the collateral damage from income redistribution may be a price worth paying. This collateral damage is well known. If the wealthy cannot keep the income they get from their efforts and/or from their investments in innovative technology, miracle drugs, or the companies that produce what we want and provide our jobs, they will reduce their efforts and investments, thus reducing the income available to us all and available to redistribute. At the other end—recipient—of the redistribution, if the programs through which middle and lower income families receive such income are not well designed they will reduce incentives to work and or misallocate resources further reducing the income available to redistribute. The policy issues become how to design such programs and what is the optimal balance between the “good” effect of more equal income distribution and the bad effects of lower income.

In my book of moral principles, disapproval of the higher incomes of others per se is due to envy, and envy is not a virtue and should be resisted. There is some evidence that many people care both about their absolute income and their income relative to others. Such envy should be discouraged in my view. My standard of morality in this area is that people deserve what they fairly earn but this requires an understanding and agreement on what income is fair. Economists have a straightforward definition of “fair” income. Profits (revenue in excess of costs) earned without artificial government help (subsidies, regulations that keep out or discourage competitors, or state sanctioned monopolies) are fair because they are the (ultimately) competitive return on providing something people value. With competition, profits will be normal, what economists call a normal rate of return on investment.

Unless the government interferes, excessive profits (those above a normal rate of return) will ultimately be competed away as others enter the field to grab some of the high return. While the inventor and developer of a new technology or product may enjoy a quasi monopoly return initially, as long as there are no artificial impediments to competition, i.e. as long as the monopoly is contestable, returns will ultimately become normal. George Will provides some relevant and interesting cases drawn from a new book by John Tamny. “With the iPod, iPhone and iPad, unique products when introduced, Jobs’ Apple created monopolies. But instead of raising their prices, Apple has cut them because ‘profits attract imitators and innovators.’ Which is one reason why monopolies come and go.” “Since 2000, the price of a 50-inch plasma TV has fallen from $20,000 to $550.” “Henry Ford doubled his employees’ basic wage in 1914, supposedly to enable them to buy Fords. Actually, he did it because in 1913 annual worker turnover was 370 percent. He lowered labor costs by reducing turnover and the expense of constantly training new hires.” http://www.washingtonpost.com/opinions/how-income-inequality-benefits-everybody/2015/03/25/1122ee02-d255-11e4-a62f-ee745911a4ff_story.html

There are many examples of profits that are not normal or contestable, which by definition are unfair. Those on my side of this issue would look for the government favors or interferences that made them possible and seek to remove them. There is no doubt, for example, that US monetary and regulatory policies have made possible lopsided returns from one-sided risk taking by Wall Street (the moral hazard of tax payer bail outs when excessive bank risk taking goes wrong). These policies need to be reformed in order to make the economy fairer and more efficient. See my Letter from the Editorial Board in the next issue of the Cayman Financial Review.

A very large political/policy battlefield in America today is between those who wish to redistribute income to make it more equal and those who want to make income distribution more equal by reducing or removing the economic rents generated by excessive and inappropriate government regulations and subsidies. They are each motivated by dramatically different philosophies and conceptions of what is fair and what is good. We might call these positions “egalitarianism” and “capitalism.” The motivation of an egalitarian to redistribute income from the rich to the poor is dramatically different than the desire of virtually all American’s to provide what Ronald Reagan called an adequate social safety net for the truly disadvantaged and those who have fallen off the ladder. I am on the side of capitalism.

About wcoats

Dr. Warren L. Coats specializes in advising central banks on monetary policy, and in the development of their capacity to formulate and implement monetary policy. He is retired from the International Monetary Fund, where, as Assistant Director of the Monetary and Financial Systems Department, he led missions to over twenty countries. Before then, he served as Visiting Economist to the Board of Governors of the Federal Reserve System, and to the World Bank, and was Assistant Prof of Economics at the Univ. of Virginia from 1970-75. Most recently he was Senior Monetary Policy Advisor to the Central Bank of Iraq; an IMF consultant to the central banks of Afghanistan, Kenya and Zimbabwe; and a Deloitte/USAID advisor to the Government of South Sudan. He is currently a member of the Editorial Board of the Cayman Financial Review and until the end of 2013 was a member of the IMF program team for Afghanistan. His most recent book is entitled "One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina."
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4 Responses to Economics Lesson: Income Inequality

  1. James Roumasset says:

    Lot’s of critiques of Piketty out there. Feldstein notes that Piketty’s measure of pre-tax, pre-transfer income inequality has been artificially inflated by changes in tax law, e.g. that caused investors to switch from low-tax investments to equity. Rognlie (MIT) is simply following neoclassical intuition, which suggests that capital accumulation will lower the marginal product of capital. Ironically, the creator of said intuition (Solow) is supporting Piketty against Rognlie.

    The inevitability of accumulation is also discredited by evidence that sustained family fortunes are the exception, not the rule.

    In any case, some Pareto-improving redistribution is possible, e.g. via vouchers that satisfy Harbergeresque basic needs (consumption externalities). Even if people deserve what they earn, this doesn’t imply that they should hold on to it. They may be better off by transferring some of their wealth. This Wicksellian view reconciles efficiency and equity w/o the contrivance of a Samuelsonian tradeoff.

  2. empiresentry says:

    “Inequality” is nothing but political fodder to cover for extensive and intrusive government controls and allowances that ensure a 98% of new wealth going to favored wealthy. Under Clinton and Bush with more free market choices, it was 54%.
    My position is personal: inequality is expected in any normal balanced bell curve. There will always be a percentage of the population that is starting at the bottom of their careers, unable to work and unable to produce, unable to participate. I would have a significant portion of equity in exchange for my time, labor and knowledge if I was allowed the Opportunity to participate.

    As such, the very same government controls that ensure the flow of printed cash to the favored few are the same controls that have restricted or eliminated job growth with legislated favoritism for best friends. Plumping the stock market and favored banks does not equate to actual production, hiring, and money for investment outside of the DC/NY backyard. Ensuring one set of favored companies or best friends controls a market or set resources means they will not be hiring the best and brightest to compete with others. They won’t have to since they have all they need.

    Higher wages means nothing to someone like me who does not have a job. Government ‘investment’ in education means nothing to me with several degrees, languages and certificates.
    All it means is fewer jobs and more money taken away from what the wealthy and/or corporations might have invested in new employees.
    ‘Unfair’ profits means someone did it right and is rewarded for it unless they are contrived through government controls and special deals based on political position (Dodd-frank).

  3. Sergio Pombo says:

    Warren, thanks for presenting your ideas some of which are fairly straight forward (economic concepts learnt at school) but some of which don’t seem to hold true given the complexities of globalization, the power that big companies have over government, and the potential collateral damages of not having an income redistribution policy. The concept of economic price fairness and social envy you briefly explain are powerful. But they are also imperfect and human. My current believe (paraphrasing Jamy Dimon) is that without some form of redistribution, we as society will have more social problems. I will leave the science and policies of how to do it to the experts. I agree in the dangers that ill policies may have in disincentivising society.

    • wcoats says:

      Sergio, I contrast and support Reagan’s view that a compassionate society must provide a decent safety net for those unable to succeed or who fail in the competitive world, with antipathy for income inequality per se.

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