Barack Obama vowed to tackle it in his State of the Union speech in January. Last month, Ed Milliband said it is the new centre ground in politics. Christine Lagarde of the IMF thinks it deserves urgent attention. Alan Greenspan thinks it’s the most dangerous part of what's going on in the US. The OECD and national statistical agencies produce ever-greater amounts of data on it. Income inequality, take a bow, it looks like your time has come. But as I’ll explain, bringing the subject of income inequality into the mainstream is relatively simple, compared to the challenge of getting politicians to do something sensible about it.
Even though some politicians and social commentators simply want to punish the better off for being, well, better off, most abhor growing income inequality on moral grounds, based on fairness, equality of sacrifice in hard economic times and so on. Important though this moral case is for social policy, the plague of rising income inequality merits a much more thorough economic examination. The reason is that income inequality is endogenous to our capitalist system. It is a function of how we incentivise businesses, entrepreneurs and innovation. But taken to extremes it can become pernicious to the pace and durability of economic growth. It does this by undermining progress in health standards, educational attainment levels, economic stability, and the social cohesion needed to keep our system adaptable and responsive to shocks.
Awareness of rising income inequality has been rising, not surprisingly, since the financial crisis. Raghuram Rajan, now Governor of the Reserve Bank of India, published his book Fault Lines in 2010, explaining how growing income inequality had intensified the leverage cycle that eventually erupted in the turbulence of 2008-09. Now with access to credit more restricted, our system’s flaws have become more visible. Others, such as Nobel prize-winner Joseph Stiglitz and Robert Reich, President Clinton’s former Labour Secretary, have emphasised the political economy of income inequality, including how vested interests and the beneficiaries of the pre-crisis boom years used their political and economic influence to achieve legislative and regulatory outcomes that strengthened their… political and economic influence.
But Karl Marx said it all a century and a half ago. This wily philosopher’s predictive powers haven’t been covered in glory, but his analysis of the driving forces and tensions in capitalism were pretty prescient. The inherent conflict between capital and labour would result in companies pursuing profits and productivity and the creation of an “industrial reserve army” of the poor and unemployed, or as he wrote “accumulation of wealth at one pole is, therefore, at the same time accumulation of misery.”
The language sits rather awkwardly today. But the processes he was concerned about have been playing out for some time now, exacerbated by the financial crisis, its aftermath and the exploitation of new technologies. We can see them in the strong uptrend in the share of profits in national income, at the expense of wages and salaries, the skewed distribution of income to the top 1 per cent or 5 per cent of income earners, and the stagnation in real wages and the substitution of low for middle wage-paying jobs and occupations.
We may not now be over-investing as Marx said capitalists would, but we are definitely under-consuming relative to our capacity to produce goods and services. Again, “poverty and the restricted consumption of the masses” may be inappropriate for most people in 2014 but rising income inequality is a modern-day equivalent, not least because better-off people have a lower tendency to consume out of incremental income. Meanwhile people on average incomes or minimum wages, with a diminished share of income, have to cut discretionary spending. In short, rising income inequality is a growth retardant.
To illustrate the point, income inequality is now as or more extreme than at any time since the 1920s and 1930s. According to the High Pay Centre, an independent UK think tank, the share of income going to the top 1 per cent of earners rose from 6 per cent in 1979 to 14 per cent in 2012. Among them, the top 0.1 per cent saw their share rise from 1.3 per cent to 6.5 per cent.
In the US, income inequality is estimated by Professor Emmannuel Saez at the University of California, Berkeley, to be higher than at any time since 1928. In that year, the top 1 per cent of families received 23.9 per cent of pre-tax income and the bottom 90 per cent received 50.7 per cent. By 1944, and until about the early 1980s, the share of the top 1% dropped to 11.3 per cent, and that of the bottom 90 per cent rose to 67.5 per cent. But by 2012, the share of the former had risen to 22.5 per cent, and that of the latter had fallen to 49.6 per cent—the first time it had dropped below 50 per cent. Most other OECD countries have followed this path of growing income inequality since the 1980s.
Cue a recent discussion paper by three IMF economists, “Redistribution, Inequality and Growth” by Jonathan Ostry, Andrew Berg, and Charalambos Tsangarides. Looking at a lot of data for both advanced and developing countries, the authors have brought the subject of income inequality off the soapbox and firmly into the policy arena.
They don’t argue they’ve discovered the holy grail. They don’t say income equality per se is a good thing; they admit that there are important cause and effect issues looking at stronger growth and lower inequality, and they warn that redistribution can lead to perverse outcomes and incentives, and failures if societies have weak administrative capacity and poor governance. But they conclude that income inequality matters. The more unequal the society, the more likely it is that growth will be slow and fragile. And they allege that a modestly redistributive tax system doesn’t tend to have a marked effect on economic growth, except in the most extreme cases of redistribution. Over time, a move towards greater equality in income distribution tends to enhance the capacity for higher growth.
The principal evidence-based conclusions are potentially of great significance. If we think about redistribution constructively, rather than as a punishment, we could pressure a reluctant political class to change incentive structures and behaviour. We could tax activities that have high social costs or what we call in the jargon, “negative externalities”, such as riskier financial services practices. We could revisit the so-called Tobin Tax on global foreign exchange trading, which runs at over $5 trillion a day, far in excess of the annual $22 trillion value of world trade in goods and services. We could change the corporate governance system to induce corporate managers to be rewarded for delivering longer-term investment and returns than for maximising short term compensation and stock price appreciation. We could demand that governments take advantage of the cheapest borrowing rates in a generation to invest in infrastructure, health and education in a transparent way, rather than running it through amorphous Treasury funding arrangements while reallocating fiscal benefits from those that don’t need them to those that do.
We just need people to care enough to demand these things, and politicians to be prepared to articulate sensible redistributive policies, not populist claptrap.
George Magnus is an economist and author
The unevenness problem
March 05, 2014
