What Should Be Done About Growing Inequality?

Many factors contribute to increasing inequality. Public policy should focus on eliminating only the bad ones

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America is becoming more unequal economically, and most people find that disturbing. Indeed, the trend toward greater inequality has been one of the consistent themes of the election campaign. Some believe that inequality is necessary to reward hard work, achievement and entrepreneurship but think that the current level is too extreme. Others blame unfair tax policies and see the extent of today’s inequality as a sign that the government has abandoned the goal of equal opportunity.

In fact, whenever inequality increases in a society, there are both good reasons for the trend — that is, reasons we should not discourage — as well as bad ones. To best address the genuine problems caused by inequality today, it’s essential to identify the bad reasons and focus on reducing those.

First, though, let’s be clear: there’s no doubt that the very richest in the U.S. have been getting richer. One of the often quoted indicators, albeit a simplistic one, is the share of pretax income going to the top 1% of the population. These data suggest that the U.S. was most equal right before the oil crisis hit in the early 1970s, and that it has since returned to levels of inequality not seen since the Great Depression.

More sophisticated indicators, like the Gini coefficient, also show the U.S. becoming notably more unequal. As a generality, countries such as Brazil and South Africa rate high on this scale, while most European countries have lower levels of inequality. The U.S. is in between — at almost the same level as China. Prior to 1980, the U.S. was much closer to the European level, and some countries — such as France and Italy — actually had higher levels of inequality at that time.

(MORE: Who Should Pay More in Taxes?)

Let’s also dispose of a red herring in the inequality debate: taxes. Contrary to popular belief, the data clearly show that growing inequality is being driven by changes in income, not by changes in tax rates. In fact, four separate studies have concluded that since 1969, the federal income tax has become slightly but steadily more progressive overall. The explanation: various credits, deductions and exemptions have reduced the effective tax rate on the lower half of the population — and especially the bottom fifth — more than tax-rate cuts have benefited the upper half. In any event, the effect of tax-rate changes can’t possibly compare with the fourfold increase in top executive compensation since 1989.

As a result, we have to look at the causes of greater divergence in pretax income — and distinguish between the good ones and the bad ones. The good ones are those that clearly contribute to the overall well-being of society: rewards for hard work, achievement, artistic talent and entrepreneurship, all of which encourage activities that benefit the common good.

It’s also noteworthy that inequality tends to rise when societies are enjoying above-average growth, which is probably one of the reasons both China and the U.S. have become more unequal over the past 30 years, compared with France, for example. Especially when that growth is the result of new technology, big fortunes — such as those of Apple and Microsoft executives — can be made in a relatively short period of time. So, again, we need to be careful to avoid policies that inhibit economic growth.

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Then there are causes of inequality that are neutral, such as the aging of the population and changes in living arrangements. A clump of baby boomers in their peak earning years may swell the number of upper-middle-income households. And an increase in the number of people living alone may multiply households that appear less affluent. Those demographic changes alter income distributions but they don’t necessarily mean anyone is worse off. Similarly, immigration may increase the number of relatively poor people in the U.S., but that doesn’t mean that the people already in the U.S. have lost anything.

The bad causes of growing inequality are the ones that undermine both fairness and the future of the country. Weakness in basic education is one of the worst. America’s global superiority in graduate and professional schools — including law and business — helps to create an elite of extra-high-earners. But subpar student performance at the high school level not only increases inequality but also is a huge drag on long-term growth.

Failures of regulation are a big problem too. Institutions that earn large profits worsen inequality if they also create costs that fall on everyone else. Examples include companies that extract natural resources while producing large amounts of pollution and banks that speculate in hopes of big profits but then ask for bailouts if they end up with losses.

(MORE: How Wall Street is Still Rigging the Game)

Finally, special-interest groups add to inequality while eroding the common good. As 18th century economist Adam Smith famously remarked, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public.” Such special-interest groups can be found throughout a modern economy, from bankers and defense contractors to public-sector unions.

The bad causes of inequality are also damaging because they decrease social mobility. Fortunes made in the computer industry may propel some middle-class kids into the upper class. But bad basic education is likely to prevent someone in the lower 40% of the population from ever moving up. Social mobility has declined in the U.S. over the past 50 years and is now lower than in Canada and Western Europe. And that lack of mobility, in fact, may be a more serious long-term social problem than inequality itself.

Total equality is neither possible nor desirable, since it would require a completely stagnant society — one without growth opportunities or economic incentives to succeed. But to increase future prosperity and restore historical social mobility, policymakers need to focus on reducing the bad causes of inequality. Using tax policy to try to equalize incomes not only discourages growth but also addresses the problem after much of the real social damage has already been done.

39 comments
deliverysuccess
deliverysuccess

“We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting Government spending. I tell you in all candor that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step. Higher inflation followed by higher unemployment. We have just escaped from the highest rate of inflation this country has known; we have not yet escaped from the consequences: high unemployment.”

geoffrobinson
geoffrobinson

What about monetary policy? People who have access to easy credit get the benefits of it first. The people who get their hands on the money later, get devalued dollars.

lolly52
lolly52

"Social mobility has declined in the U.S. over the past 50 years and is now lower than in Canada and WesternEurope."

First, thank you for this article.  I rarely read an article that seems honest and well-balanced.  Your article impressed me.  

I wonder if the reason that the US is suffering more in regards to social mobility is  because the US is more focused on free trade.  The other countries you name with greater social mobility seem to protect their industries.  Phil Gramm once said that protectionism is the crack cocaine of economics.  He was one of the master minds behind repealing Glass Steagall.

But free trade only works if the rest of the world is playing by the same rules.  Could this explain the US's lack of social mobility?

GaryKennedy
GaryKennedy

" ... bad basic education is likely to prevent someone in the lower 40% of the population from ever moving up."

This is the crux of the matter.  When Bill Gates tells US parents "I cannot hire your kids", we have a problem.  And when the state of Texas (where I live) severely cuts funding for education (while preserving a "rainy day fund" for  ...?), we all lose.

berty88
berty88

The USA is starting to look like a developing world nation (demographic stats).  The numbers of rich grow in numbers and % the number of poor and really poor grow in numbers and %.  Do you remember the days when one working adult per family could keep the family unit (and famlies were larger) middle class?  Imagine one working adult today keeping the family going....Those that have capital resources make sure the equations of society are going to keep them at advantage.  It was industry that created a middle class.  With industry less (% of whole--more service sector) there is less of middle class creation.  You have capital holders...and you have those that sell their labor.  it is just today....  there is not as large of value on labor...  heck, you don't like earning $10-$15 an hour...  the capital holder will pick up the factory (means of production) and move it to a place that will appreciate $2 and hr.  The formulas of capital and labor produced a "have- have not" society.

saulcausano
saulcausano

Tax income at the current rates for dividends and capital gains, tax capital gains & dividends at the current rate for income. Make the estate tax 100% for any inherited money over $5 million. Amend the constitution to clearly state that money does not equal speech and only people have the right to free speech. Define corporations as lifeless sociopathic organizations existing solely for the purpose of profit, not as people.

PuddinTame
PuddinTame

The national motto has gone from 'E Pluribus Unum' (1782) to 'In God We Trust' (1956).  I submit it's time for another update, and I propose it be changed to: 'I Got Mine, Jack!  Too Bad For Y'all'.

LogicalPosition
LogicalPosition

When a certain element of American Society is birthing children out of wedlock at 72% rates, dropping out of HS at 50-80% rates, and would rather smoke, drink and socialize on Obamaphones than work...it becomes impossible to make them "equal". BTW no one forced them to make these poor decisions, their CHARACTER is such that they CHOOSE this lifestyle. The effective COST to control "those people" is an enormous drain on America's resources, and the return on investment to make "those people" more equal is paltry.

walstir
walstir

Suppose it was possible to double the income of everyone in the US overnight. You earned $50k before and now you will earn $100k. What about your neighbor across the street who was earning $100k before and will now earn $200k? The inequality gap between the two of you has now ballooned from $50k to $100k; but you are nevertheless much better off than you were before. Growing inequality only involves reduced incomes for some when you assume that there is a fixed pool of total income so that raising one person’s income necessarily involves reducing the income of someone else.

MoisesIssi
MoisesIssi

The more innequality the more wealth. The more wealth the more people make.  The more people make in a job the more they can spend. More spending means more jobs and happiness (United States).

The more equality the less wealth.  The less wealth the lower people's income.  The lower people's income the less money to spend. The less money to spend, less happiness (Europe).  

joshgibson
joshgibson

The cause of income inequality is an over efficient resource allocation system. This a natural off shoot of free market capitalism's progression through the long term economic cycle. The cure is also offered by free market capitalism. Our elites in their so called wisdom simply refuse to accept it. The cures are depressions and stagflation. We are simple living through the end of a long term business cycle. Sometime after the next recession (I guess between 2016-2018) we will see the eight to twelve percent quarter upon quarter growth rates required to right our economic ship. 

American capitalism is a middle class economic system which skews towards too much efficiency over time putting too much wealth in too few hands (global corporations not wealthy individuals in our era). It proceeds to contract to the point that enough efficiency is rung out the economy. 2008 was a brutal but necessary moment in the history of American capitalism. The sad thing is elites chose the wrong course. Wall Street should have been allowed to fell. The resulting contraction would have set the stage for an unprecedented economic boom.

The proper course for government would have been to allow the collapse. Then use the resulting price and wage decline be the impetus for a jobs program built around the reconstruction of our nation's infrastructure. Ah, the road not taked would have all the difference in our children's future.