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.

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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.

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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.