Should We Worry about the Rising Inequality in Income and Wealth?--Posner

Economic inequality is growing in the United States and other developed countries, and also in rapidly developing countries, notably China and India. Becker and I blogged about economic inequality on April 23, almost eight months ago, but indications that inequality is surging at the very top of the income distribution merits a further look, as does the recent study of world income inequality that is the focus of Becker's comment. Recent reports in the media document phenomenal returns to hedge-fund operators, private-equity investors, and other finance specialists, astronomical CEO salaries, enormous returns to software entrepreneurs, a stampede of lawyers and doctors to Wall Street, $200,000 law-firm signing bonuses for 27-year-olds who have clerked for the Supreme Court, enormous philanthropic gifts ($100 million gifts to colleges and universities by alumni are no longer unusual), and soaring demand for products bought only by superwealthy people, such as full-sized passsenger airliners converted at great expense to private airplanes, $40 million homes, paintings costing tens of millions of dollars, and automobiles costing several hundred thousand dollars. There are now almost 800 billionaires in the United States and countless millionaires, and one out of every 500 U.S. households have an annual income of at least $1 million. Now this is to look only at the top of the income distribution. It is not to consider the income distribution as a whole, let alone poverty. In the more conventional focus on earnings by quintiles, one sees little change in recent years. But since 1980 the percentage of total personal income going to the top 1 percent of earners has risen from 8 percent to 16 percent. It is the top of the distribution on which I’ll be focusing. What are the causes, and what are the effects, of this trend in the income (and of course wealth) of the highest-earning segment of the distribution? Part of it is reduced marginal tax rates, because high marginal tax rates discourage risk-taking. Consider two individuals: one is a salaried worker with an annual income of $100,000 and good job security, and the other is an entrepreneur with a 10 percent chance of earning $1 million in a given year and a 90 percent chance of earning nothing that year. Their average annual incomes are the same, but a highly progressive tax will make the entrepreneur's expected after-tax income much lower than the salaried worker's. Many of the people at the top of the income distribution are risk takers who turned out to be lucky; the unlucky risk takers fell into a lower part of the distribution. It is rich people as a class who are growing relatively richer, not necessarily individual rich persons. Marginal income tax rates on the wealthy have not declined much in recent years, however; but the income tax rate cuts since 2001 have favored the wealthy. Another and more important factor in the recent wealth surge is a growing return to high IQs; outstanding success in highly complex fields such as finance and software is highly correlated with high levels of intelligence. And increased size of markets as a consequence of increased international trade provides greater returns to successful innovations. I am more interested in the effects of the increasing incomes of the rich--though one might ask: are there any effects, other than those that are perfectly benign? Even though the federal income tax is increasingly a proportional rather than a progressive tax (though it is still somewhat progressive--the average tax rate for the top 1 percent of earners--24 percent--is roughly twice that for all federal taxpayers), the more skewed the distribution of income, the higher the proportion of taxes that is paid by the rich. And in fact the top 1 percent of earners pay more than one-third of all federal income taxes today, which is a boon to the rest of the population. Very wealthy people also provide patronage for the arts, funds for high-risk ventures (actually, art is one of those ventures), and money for philanthropic enterprises. And there is very little envy of the rich on the part of other Americans, in part perhaps because of the much-derided but very real "trickle down" effect. This is due partly to philanthropy but more to the enormous consumer surplus generated by products such as Microsoft Windows, the brainchild of persons who are now billionaires. It is also due in part to the fact that, given diminishing marginal utility of income, income increases at lower levels in the income hierarchy increase personal welfare more than increases at higher levels do. Moreover, real wealth is a function of improvements in the quality and variety of products and services, and these improvements benefit all classes of the population. All this is not to say that the existence of a stratum of exceedingly wealthy people is altogether to the good. There are three potentially bad consequences for our society: 1. The existence of enormous financial returns to IQ deflects high-IQ people from entering careers in which the social returns may greatly exceed the private returns: government service, basic science, and teaching. The quality of both the civil service and the public schools appears to be falling. 2. Massive philanthropy directed abroad can interfere with a coherent foreign policy. Major philanthropies such as the Gates Foundation do not coordinate their spending decisions with U.S. national goals. 3. Huge personal wealth may play a disproportionate role in political competition. Personal wealth confers an enormous advantage on a candidate, but also permits a person who does not want to be a candidate to exert an influence on candidates and policies, as in the case of Richard Mellon Scaife and George Soros. The fact that a person is a highly intelligent speculator, such as Soros, is no guarantor of political insight or wisdom; and the fact that a person has inherited a vast fortune, such as Scaife, is no guarantor of ability of any sort. More important, however, heavy campaign spending by the wealthy force nonwealthy candidates to spend increased time and effort on fund raising, which makes a political career less attractive to nonwealthy persons and makes nonwealthy politicians less well informed about policy and more dependent on interest groups than if campaign spending were lower. Are these consequences serious enough to warrant remedial action? I think not, except that they may provide some grounds for wanting to retain, perhaps even to strengthen, the estate tax. The disincentive effects of taxing estates are much less than those of income taxation.

Comments

[Matt Rognlie]

Concern over the super-wealthy is almost universally accompanied by worries about the working and middle classes' welfare. In this context, our question isn't really whether wealth -- and the cirumstances that accompany it -- is in the abstract good or bad. After all, with the massive consumer surpluses that you mention, it's awfully hard to make a negative case for wealth in general.

More important is an action-based question: should we do anything, not necessarily to temper the rich but also to help the poor? I'm a bit puzzled that you mentioned the drastically declining marginal utility of money without noting the obvious implication. When we have all this wealth floating about, the accumulation itself doesn't necessarily have negative consequences, but we may be able to achieve a substantial welfare gain by taxing it properly. While I'm all for your argument on the estate tax, I wonder about your position on a strong progressive consumption tax. It doesn't create the same disincentive effect for risk-taking, and in my mind it's a much better to way to achieve the redistributive effects that could drastically increase overall well-being.

[jarda]

Major philanthropies such as the Gates Foundation do not coordinate their spending decisions with U.S. national goals.

Given the miserable implementation of "U.S. national goals" during the last decade or so, this is actually good news, or?

[Jonathan Berman]

I think you forgot the link between inequality and instability. A lot of economists and others look at Gini coefficients (which measures the distribution of wealth). I believe those countries with Gini coefficients over 6 tend to be unstable. Of course, it's not a perfect measure but it has its uses.

Also, I agree with your comments on the estate tax. It's one thing to tax the person whose ingenuity got them their wealth, it's another to tax their children who were just lucky in being born to the right parents.

[Corey]

Is Bill Gates rich because he is a genius or do you all think he is a genius because he is rich?
I guess it doesn't matter, he is a smart guy with a healthy sense of his own good fortune.

We don't give billions to Bill Gates to incentivize the next Bill Gates, we give billions to someone to keep everyone else working. No one would buy lottery tickets if the paper stopped running stories about winners. A few less Bill Gates stories in the US and people might start thinking the French have something there with their 3 hour lunches and their actually enjoying life.

It is fun to chart income distribution over time. The % of wealth owned by the top 1% is my favorite measure. We are at the same disparity level (40%+) as the country was in the robber-barron era or in 1929.

I really don't understand how paying over $100M for a Klimt painting turns into trickle down. Seems like the assets move between accounts in a block. I'm just glad I got to see the thing before it went to hang in some private mansion.

Has anyone else noticed that there really isn't any space anymore between $29.99 junk-heap version of a thing and $1000 luxury status version of a thing? Trickle up. Sony thinks people have $700 to spend on a video-game machine. Its going to be awhile before I can afford a plasma TV, that's all I know.

"Given the miserable implementation of "U.S. national goals" during the last decade or so,"

I blame the Republicans (After all, they did have total 100% capture of all branches of government for 6 years)

[Corey]

"The disincentive effects of taxing estates are much less than those of income taxation."

Taxing estates disincents people from dying. I support increasing our national average lifespan by raising the estate tax to 100%.

Seriously though, lets say I believe that raising the top income tax rate to 70% (like it was in 1967, when income inequality was at its lowest ever) would somehow stop people from wanting to make their next million. Isn't that a good thing? An incentive spreading method.

You know, the actual inventive process in this country is: a) some researcher invents something because they had a flash of inspiration, b) the company enforces its mandatory assignment clause and perhaps its at-will employment clause against the researcher, c) shareholders make money

[Redmund Sum]

Judge Posner does a good deal better this time than last, when he pompously denigrated F.A. von Hayek. Nonetheless, I take issue with all three negative consequences the great judge asserted for concentrated wealth.

1. Most high IQ people steer clear of government service, including teaching, not just for remunerative reasons, which is certainly true to some degree, but more, I believe, for the institutional culture that frustrates excellence and innovativeness.

2. I don't think philanthropic acts, even massive philanthropic acts, or even massive non-philanthropic acts, for that matter, should be constrained to be in concert with national goals. This is the essence of freedom. The consequence may not be seen as good by all, but it's his/her money. It must be a good for him or her to spend it that way.

3. Disproportionate influence in politics. Very true. But again, I don't see it as negative. As a matter of fact, the very idea of one-person-one-vote is the least costly method of instituting democratic participation, but it is not at all fair. I don't think that preference of Bill Gates and that of a chronic welfare recipient should have equal weight on who should be the next governor, or the next president. Through political contributions, those who are more successful, who are usually greater contributors to the society, should have greater influence on who should make our laws and lead our nation. Of course, Judge Posner is arguing in the case of highly concentrated wealth. But even then, all they can do is influence, not decide.

[Jack]

It seems difficult to learn much using MSFT/Gates as an example as much of its success seems a comedy of errors of those around them. Apparently Gates "borrowed" or bought the early DOS from the military in an era when software had no copyright protection and stuff that made computers work were sent around much like Linux today. Xerox had the first "Windows" with Apple doing the same. Not sure what happened at Apple but my guess is that they were so successful at selling their over-priced systems to our naive school administrators that they couldn't see prices falling in the open system world. Then the luck that IBM foolishly opted not to buy him out. And that prices of computing power fell rapidly enough to run the bloated patchwork of DOS/Windows.

IT's clear that MSFT used its early success and bankroll (and was "slow" to release their "calls" to writers of other software) to clobber a number of spreadsheet, word processor programs, along with Netscape that was of interest to what remained of an Anti-Trust division that's usually gassed and put into suspended animation during Republican era which includes the Clinton era for most of these purposes.

Arguably we'd all be far better off were MSFT not holding such a monopoly in which Win98 in its final days of support costs nearly the same as when it was new and we're back to the "lease only" for XP that's reminiscent of the heyday of IBM and perhaps we're stuck with them. But "forever" is a long time and who could or might create a competitive product? They'd have to be big, savvy and tough.

Google comes to mind as they have search, youtube and a ton of cash and Linux is free. How hard or expensive would it be today to create a low cost product and take a big bite out of Windows/operating system? Gates may want to peek out once in a while! Jack

[Jack]

Posner sez: "Consider two individuals: one is a salaried worker with an annual income of $100,000 and good job security, and the other is an entrepreneur with a 10 percent chance of earning $1 million in a given year and a 90 percent chance of earning nothing that year. Their average annual incomes are the same, but a highly progressive tax will make the entrepreneur's expected after-tax income much lower than the salaried worker's."

Probably not. The employee would have much of his income taxed at the top 33% rate with $85,000 subject to his 7.5% share of SS.

The entrepreneur would likely pay himself the same or perhaps much less? and I'd guess much of his million would be in stocks, options or dividends?

If he was confident of his stock price he'd perhaps sell none or very little of it, instead taking a loan against the stock for say, building a nice home and deduct the quite sizable interest payments against his taxable income with the remainder of the loan costs pretty well covered by inflation. If he DID cash in some stock he'd pay about half the employee rate on capital gains and no more on SS than would the employee.

It is "too bad" that he's missed out on the Hummer/Lincoln Navigator deal of writing off up to $100,000 for "business use" of gashogs over 6000GVW the Gov will now only subsidize his cars up to $25,000 ..... each.

Jack

[robert]

Why all the handwringing about income inequality? This issue is as bogus now as it was in the past when the same story from a hundred or more years ago--think of the income disparity associated with the poor relative to the so-called "robber barons"--no doubt roiled the press rooms of that era's newspapers.
As long as the rich are rich because they legitimately earned it, then who cares if Bill Gates is richer than the "average" worker by a factor of ten thousand or ten billion? Would the Bill & Melinda Gates Foundation, and all the good that it confers on the world (separate and apart from the value and wealth created by Microsfoft's products) exist absent the ability of talented people to amass enormous wealth?
I think that this issue is a thinly disguised attempt at class warfare. As correctly noted by Judge Posner ("...there is very little envy of the rich..."), class warfare will never succeed in America.

[robert]

(Microsoft's)

[N.E.Hatfield]

Perhaps we're witnessing the rise of a new economic paradigm. The conversion of the "Trickle Down Theory" to the new "Tickle Up Theory" and the rise of the New Gilded Age. Or perhaps it's just the return of the Old Gilded Age that eventually collapsed of it's own internal rot. Whatever the case, there may be more economic truths hidden away in "Kapital" than we care to admit.

[Mike G]

Corey's first comment is revealing. He thinks the omnipresence of plasma TVs he can't afford shows inequality. What it actually shows is how expectations rise. He could go buy a 30" tube TV, with a very nice picture, for $300; the same TV ten years ago would have cost $800 (and $800 then is that much more now). But he isn't even looking at those TVs-- because he expects he should be able to have a plasma.

Which brings us to another point. The very rich may drive up the cost of finite things like Klimts, but they subsidize the cost of mass-produced things by paying for their R&D early on. Plasmas are $3000 because richer people paid $10,000 for them in 2001. Cheap cars are safer because bankers and movie stars and doctors paid Mercedes and BMW and Volvo to innovate things that are now standard on Chevys and Hyundais. Soon Wal-Mart will be full of organic food because I overpaid so much for it at Whole Foods and helped sustain the category. (No, I'm not very rich, but well-off enough to pay for WF's produce.) That's trickle-down in action.

[Richard Mason]

It seems to me that the second derivative of the Lorenz curve is important if people take cues from their socioeconomic peers.

A person who is located on a part of the Lorenz curve with high second derivative can see that those people who are just above him in the economic pecking order have significantly greater income than he does, while those who are just below him have significantly less. He may therefore be highly incentivized to seek promotion, move to Wall Street, or do whatever it takes to improve or maintain his position, since the prospect of greatly increased or reduced income is very real to him.

On the other hand, a person who is located on a part of the Lorenz curve with low second derivative sees that his immediate economic superior does not actually make much more money than he does. It may be that everyone he comes into any social contact with has about the same income, and substantial changes in income seem unrealistic, like winning the lottery or a peasant becoming king. Although there may be significant inequality elsewhere in the society, his own socioeconomic neighborhood is in effect an incentive-sucking egalitarian mini-society.

Based on this simple theoretical argument, one might propose that the second derivative of the Lorenz curve should ideally be constant across social strata, in which case the ideal Gini coefficient is 0.33.

For economists who prize inequality as the means and result of properly incentivizing productive behavior: one problem with too much inequality is that you cannot make the Lorenz curve too steeply rising in one place without flattening it elsewhere. If the second derivative is exceptionally high at the upper end of the income spectrum, that may be creating too much relative equality elsewhere.

[Patrick R. Sullivan]

'Huge personal wealth may play a disproportionate role in political competition.'

Reminding me that Barry Goldwater was once asked if it bothered him that the country was moving toward a position where only a millionaire (JFK, LBJ) could get elected President.

Goldwater replied, 'Not nearly as much as if only the President could become a millionaire.'

[Bill]

I’d argue that the wealth gap will bring down democracy.

1. At some basic level, democracy threatens excellence* (the one who excels can always be outvoted by those who don’t). This plays out over time in more and more wealth re-distribution. The current status is a series of financially-shaky social safety nets where a non-productive person can lead a more or less normal life in comfort. Pictures of the victims of the depression show thin people. A lot different than what we saw in New Orleans.

2. These social safety nets are attracting people from less successful societies by the millions. This demographic tends to vote for additional wealth re-distribution for social services, further threatening excellence.

3. Taxes re-distribute people far more efficiently than they re-distribute income. One percent of the US population pays 34% of the tax burden. If taxes target them to fund social spending, many of these people can re-locate to lower tax Countries who welcome them with open arms. French businesspeople are already leaving (tax rates there can be as high as 90% for a small business owner). Trump is building in Panama. Many well-known people have land in Belize. Costa Rica is very popular. Switching Citizenship is quick and easy.

4. Democratic societies addicted to the social safety net will be reluctant to vote to eliminate or reduce it when massive, and growing, blocks of the voting public do not pay any significant taxes. I'll predict that the $90k cap on Social Security contributions will end soon, then there will be means testing. That will buy the program a few years.

5. The course the West is on is unsustainable. Borrow me a trillion dollars and I’ll show you a good time too. But the checks will, sooner or later, stop showing up in the mail. And that, in my opinion, is how the great experiment will end.

* The word excellence is used hypothetically. The correlation between excellence and wealth is shaky at best, refer to the US Senate.

[TJIC]

Corey writes:

We don't give billions to Bill Gates to incentivize the next Bill Gates, we give billions to someone to keep everyone else working.

In fact, we give billions to Bill Gates, because - $200 at a time - we want access to the software that he provides.

To say that "we" (in anything more than the emergent sense) give Bill Gates money "to accomplish" some society goal assumes, by default, that we as individuals and Bill Gates, as an individual, have no rights to our own assetts, and trade them back and forth only with the permission of and/or at the command of "society" (which is to say, government).

We can discuss the beneficial or harmful effects of free people trading with each other, but let's not lose sight of the fact that trade itself is an emergent process which serves to enrich everyone, and any analysis of it comes after the fact.

[TJIC]

Jack wrote:

Apparently Gates "borrowed" or bought the early DOS from the military in an era when software had no copyright protection

Huh?

Microsoft licensed QDOS from Seattle Computer Products in 1980.

[lucy]

hi every one ! i was wondering could you tell me all about Malthusian theory please becuase i don't understand it compleatly so would anyone be able to tell me about it ? if so plz write a comment back for me thanks very much !!!

[Michael Sullivan]

hmmmm, Kinda flies in the face of the widening wage gap? Even after transfer payments? I would FAR rather the min wage be a living wage than to have taxpayers try to fill the gaps left by Walmart and similar. Want to trade? I'll take a living min wage in the range of $15 and hand over the EITC and a whole alphabet soup of transfer programs that fill that wage gap for the working poor. Deal?

Ugh.

Transfer programs (done even halfway competently) are *far* more economically efficient than raising the minimum wage that much. While small changes in the min wage don't seem to have a big effect on unemployment or inflation, a rise to $15/hr is likely to be disastrous for the economy. The reason having a minimum wage a bit over the equilibrium unskilled wage level doesn't cause significant unemployment is because of transaction costs. It's easier to suck up a 10% wage hike, than go through the capital investment and training that lets you get the same productivity out of 10% fewer employees. But the money has to come from somewhere. Profits get cut for a bit, and then at some point, the money starts coming from customers (which may cause inflation), and at some further point it goes toward capital investments that let companies lay off unskilled workers.

A small min wage increase is basicallly a tax on certain relatively well off shareholders and private business owners which gets paid to unskilled and low skilled workers. But with a big increase things start to go haywire and your egalitarian dreams are all undone. The more you try to raise the min wage over that equilibrium level, the more likely and more pronounced the bad side effects.

The only way to pay everybody $15 without merely deflating the currency or driving up unemployment is to have the social capital available for any willing warm body/brain to produce $15/hour+ worth of wealth. We don't have that, and legislation won't make it so.

What can make it so is a lot of innovation. If you look at what was considered a living wage in 1950, and compare a life then on that to a life now at the dem proposed min wage of $7.25/hour (a rate that most economists think would provide very little distortion in most areas of the US), they're pretty comparable. Some things would be worse for our modern minwage earner (housing), some things would be similar (food) and some things would be much better (tech and entertainment). Overall, I'd tend to side on the modern side if anything, but it's a pretty close decision. So we've gotten to the point where almost everybody can have a lifestyle equivalent to what we would have considered a living wage in 1950.

But now, that doesn't look like a living wage. Why? because the bulk of people live better than that now. But you see that this problem never goes away. If we double wealth across the board, those currently commanding $7.50.hr will be making $15 an hour, but the people around the median would be living like the top 10% do today, and all the $15/hour people will start thinking of $30/hr as a "living wage".

There's no limit to it. Unless we're willing to demand a completely egalitarian society, there will always be people who live less well than the median who feel like they are poor. And we know what happens when we try to demand a completely egalitarian society. I'm egalitarian enough to believe it criminal for a wealthy society not to make some provision for the unable or unskilled to at least have basic health and safety (shelter, food etc.), but trying to eliminate relative wealth disparity completely or even mostly looks like a wild goose chase with no end.

I've lived on the equivalent of a modern $9-10/hour (more than min wage but much less than your proposed "living wage". It's not fun, and I didn't have much insurance against catastrophe, and I certainly prefer what I make now, but I didn't seriously worry about whether I'd have a place to sleep, food to eat or water to drink. I couldn't afford anything that americans would consider luxuries, although much of what I could afford *would* be considered luxuries by half the people on the planet.

I had a stereo, a guitar, a car, and a shelf full of interesting books, and once or twice a year I could afford to take a bus to NYC and go to a show or a nice restaurant or maybe take a trip to see relatives or friends across the country. I was able to eat meat and fresh vegetables and take a shower every day. How many people in East Africa live like that? 5%? 1%?

What standard of living are we as a society obligated to provide to those who cannot earn enough? It would take a lot of chutzpah for me to demand more than the proposed new minimum wage of $7.25/hr if I couldn't demonstrate enough skill to command a higher wage without a law. Nobody says I have to live in the generally high-income, high-cost northeast (where btw, there are almost no jobs below $8/hr now anyway), or not have a roomate, etc.

[Aidan]

Judge Posner's model of a stable vs. variant cash flow (the 100k/1000k model) is incomplete. It either assumes a one period world or a low discount rate on future earnings, or more precisely it doesn't seem to consider when that is not the case. When the agent decides between a stable income flow or a variant income flow s/he considers the present value based on a given discount rate and expected career lifespan. This is not considered in Judge Posner's model and I believe that that can lead to an erroneous conclusion.

For example, one can quickly show a case using Excel where the present value is greater for the variant cash flow choice even with a higher marginal tax rate. Assume a 10 year career, 30% marginal tax rate for income up to $100k, 50% for income above that. If a single $1000k payoff happens in year 1 and there is a discount rate >8% then the present value is higher for the variant cash flow choice, despite the higher marginal tax rate.

While this is just one example, the discount rate and expected career length are critical to the conclusion but not included in Judge Posner's model. Higher marginal rates alone are not sufficient to induce risk taking.

[Aidan]

oops, I meant "risk aversion" at the end there...

[Aidan]

you can see the sample spreadsheet here: http://spreadsheets.google.com/pub?key=pQjZNumX4v1xl089aKRyqMA

[N.E.Hatfield]

Lucy, In a nutshell, the Maltusian Theory states that populations increase faster than the available food supply. Hence there will a decrease in the quantity of food per person. Possibly leading to famines.

Never happened. The problem was that T.Malthus's analysis was static in nature i.e. the use of the economists caveat, "caveat emptor- things remain the same". What wasn't taken into account was agricultrual innovation. Such things as mechanization, improved seed stocks, better land management practices, better transport networks, etc. Hope this helps.

[N.E.Hatfield]

Lucy, Whoops! Sometimes my Latin gets the better of me. That caveat, "caveat emptor" ought to be, Ceterus Paribus. The caveat emptor is another econ. market principle known as "buyer beware".

[alphie]

Better tax-based remedial action than French Revolution-style remedial action to level America's income distribution.

Will America's fat cats realize this too late?