Thursday, January 30, 2014

Can Economsts Explain Growing Income Inequality?

A recent article by Justin Fox (which I posted previously) argued that economists are not likely to make a good case against the growth in executive pay.  He pointed to an article by a prominent Harvard economist (Mankiw), who argued that increases in executive pay were determined by market forces.  Standard economic theory suggests that everyone is rewarded for their marginal contribution to output.  Some may believe that this is unfair or immoral but economists don't believe that they should make moral judgements (even though the prevailing theory makes growth in executive compensation appear to be based upon performance).   Simon Wren-Lewis argues that economists can contribute to the debate on executive pay in this article.

Wren-Lewis argues that executive pay has been growing rapidly because of two forces.  Executives have always had bargaining power because it is costly to remove a CEO, but they have a greater incentive to take advantage of their bargaining power more recently because the top marginal tax rates have been lowered.  He believes that economists are in the best position to explain this to the public because they are largely unaware of the growth in income inequality, and because politicians from both major political parties realize that the public will elect the politician who they believe is most competent to run the economy.  Consequently, politicians in both parties must convince the public that they will do nothing to damage business confidence.  That, of course, was Romney's argument in the 2012 US election.  He portrayed himself as a successful executive who was more able to run the economy.  Obama won the election, but he did as much as he could to convince the public that business leaders had confidence in his ability to run the country.

Wren-Lewis is obviously correct in his argument about public opinion and the efforts by both major parties to present themselves as business friendly.  However, his argument that economists are best suited to make the case for a higher marginal tax rates because they have done research on executive bargaining power, and they understand the power of tax incentives, does not pass the smell test.  Economists, with few exceptions, have not made this case to the public.

One of the comments to the Wren-Lewis article makes a further point that is closely related to my following post about an economist who has made a forceful argument for higher tax rates on the wealthy.  The rule of 72 provides a simple way to calculate the length of time in which it takes a quantity to double.  We simply divide the rate of change into 72.  For example, if the economy grows by 2%, it will take a little over 35 years for national income to double.  If income for the top 1% grows by 7%, their share of national income will double in around 10 years.  The share of income going to bottom 99% must continue to fall relative to that of the top 1% as long as the economy grows less rapidly than the growth rate of income for the top 1%.

The following post which makes the strongest case for a high tax on wealth was published yesterday in the NYT.  It has not received the attention that it deserves.  It goes much more deeply into the problem of growing inequality than most economists are willing to go.

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