Wednesday, March 5, 2014

Is There An Optimum Level Of Income Inequality, Or Do We Want A Society Like Downtown Abbey?

This opinion piece in the New York Times looks for an answer to the question of an optimum level of income inequality from economists. It cites the work of three conservative economists and several  liberal economists with opposing views on the topic of inequality.  As one might expect he found that conservative economists do not have a problem with our current level of inequality.  One economist even argues that the government safety net is responsible for our unemployment problem.  He argues that income redistribution destroys the incentive for the unemployed to take the available jobs.  This is consistent with the ideology of many economists who believe that we would not have unemployment if market forces were allowed to work their magic.  Greg Mankiw from Harvard assumes that market forces are doing what they are supposed to do. The top 1% is being being rewarded for its greater contribution to society.  Presumably, Mankiw believes that the contribution to society of the top 1% has been growing rapidly over the last few decades.  They must be much more productive than our top earners in previous generations because they are earning a lot more.  Mankiw agrees, however, that a dollar of marginal income is more important to those with low incomes than it is to those with high incomes.  Therefore, he uses utility theory to justify a more progressive tax policy.  The top 1% would work less hard if we paid them less, and that would effect economic growth.  It may not be a bad price to pay however for the increase in the marginal utility of the poor.  

The liberal economists review some studies which show that moderate levels of income redistribution does not slow down economic growth, and that high levels of income inequality may impede economic growth.  One study also raises questions abut Mankiw's assertion that the top 1% would not work as hard if their taxes were raised.  The top marginal tax rate has moved around considerably over time.  There is not an apparent relationship between the top marginal tax rate and economic growth.

One economist even argues that there is an optimum distribution of income.  He believes that it is described by an inverted U shaped curve.  That is probably true, but few economists would agree about where to set the optimum level on the curve.

The article concludes that economists are polarized on the issue and that income inequality is essentially a political issue.  He does not believe that our political system is capable of addressing the issue of income inequality.  Both political parties are dependent upon campaign contributions from those who believe that they benefit from income inequality.  One almost wonders why the article was written.

Public opinion on income inequality varies widely.  Perhaps it is a mistake to frame the issue around income inequality.  Many Americans might agree with Greg Mankiw that we have a meritocracy, and the we need a very unequal distribution of income that rewards merit.  There is little support, however, for economic system that rewards individuals who do not have to work for their high incomes.  Few American's would like us to have a Downtown Abbey economy in which generation after generation is able to live lavishly on inherited wealth.  Thomas Piketty argues, in Capital In the 21st Century, that this is just where we are headed in Europe, and a bit less so in the US.  The rich are able to save a large portion of their earnings, and they invest their savings in a variety of financial assets.  The value of those assets grows much faster than income.  Those assets will be inherited by future generations that will not need to work in order to live extremely well.  Those who are unable to save much of their income will not be able to accumulate wealth that they can leave to their heirs.  The implications of that dynamic can have a distorting effect on a meritocracy.  Many with large inheritances do not have a strong incentive to work hard. Those who depend upon their labor for income may not see the opportunity to acquire great wealth through their labor.  It may be easier to marry into wealthy families.  Piketty provides some data on this trend.  For example, in 1900 France inherited wealth was 24% of national income.  That percentage fell to 4% by 1950.  In 2010 the percentage had increased to almost 15% and it is trending upward.  A similar trend is apparent in Britain and Germany.

Piketty makes an important point about our movement toward a rentier society similar to what we observe in Downtown Abbey.  This movement has little to do with market imperfections and monopoly.  The rent from inherited income is a consequence of a pure and perfect market for capital.  Capital yields income or "rent" and it grows much faster than labor income.  The concept of rent is built into any market economy in which capital is privately owned.  In the days of Downtown Abbey most people understood their role in the society.  Thankfully, few blamed the poor for not becoming entrepreneurs and as rich as the aristocracy who live lavishly on inherited rents.  Of course, if we assume that we live in a meritocracy, it is easier to blame the poor for not becoming wealthy, and we cannot blame the rich for being rich. We don't live in a pure meritocracy, however, we live in system that does reward merit, but it is also influenced by forces which have nothing to do with merit.  It is important to understand those forces and to make a decision about what kind of society in which we want to live. 

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