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Income inequality? No problem.

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Published on Sunday, 06 January 2013 23:26

Written by Capitalist

The worst form of inequality is to try to make unequal things equal.

Aristotle

You've heard about income inequality and have probably encountered many articles documenting trends over the last 30 years. Usually the conclusion of these articles is a statement that income inequality is a problem. But have you actually read about why it is a problem? Is it just class warfare attempting to stir up the masses and get votes for a political party? Has jealousy of rich risen? Has perceived conflict increased between the rich and poor, with movements such as Occupy Wall Street taking shape? Why are they so concerned that there are people out there who are so much richer than them? You hear more about the top 1% than the bottom 1% in the media. Why is that?

First, let's begin with some background material on how income inequality is reported. It is generally measured in one of two ways: the Gini coefficient or income share trends. Both have generally been used in the media to document how unequal our society has become. A Gini coefficient of zero expresses perfect equality, where everyone has an exactly equal income, and a Gini coefficient of one expresses maximal inequality, where only one person has all the income. You may have read about how the Gini coefficient has been rising over time signaling that inequality has been rising (barely, if you bother to look at the details), but they are omitting critical information from which they draw their conclusion. They nearly always report on household inequality instead of personal income inequality. What's the difference, you ask? The latter looks at only the individuals, while the former looks households that may include dual earners. This is important because there has been much change in household dynamics of the modern era compared to times in the past, with more women entering careers dominated by men than ever before. This a critical piece of information because people marry other people who are similar to them, through assortative mating. Dentists marry other dentists, lawyers marry executives, teachers marry other teachers, etc... In fact, "across the member countries of the O.E.C.D., 40 percent of couples in which both partners work belong to the same or a neighboring earnings bracket, compared with 33 percent two decades ago," the New York Times reports. The assortative mating trend causes household inequality to rise, but does not cause personal income inequality to rise.

However, since the Gini coefficient is not widely understood by the general masses, the majority of articles in the media usually report on income inequality using the share of income gains or a time period of how much income the top 1% earned compared to some time in the past. They generally mention the top quintile and compare it to the bottom quintile and conclude that the situation is so dire because the top quintile outgrew the bottom quintile by a multiple, or some other simple scheme to make you focus on extremes. The ratio of the average CEO salary to the common worker are usually mentioned, and they will ask hackneyed questions like, "Does a CEO really do 100 times the work of the average worker?*"

Some liberal economists with agendas have written numerous books and newspaper opinion pieces on the subject, but there is one common problem with all these works: they are all opinions with little substance or backing of data. And they are usually opinions that confuse problems with our political system with income inequality. They opine on lots of things correlated to wealth and power, but they do not pinpoint why it is a problem that there are wealthier people out there than others. Because some of them have earned a memorial Nobel Prize in economics (although unrelated to economics of inequality), write for the liberal New York Times [1, 2, 3], and label themselves Democrats, chair the International Socialist Commission, argue against free markets, openly vilify entire industries such as banking [1, 2], they are given a platform to opine for their partisan politics. Most of their arguments detail problems with our political system where lobbyists have extreme power to influence representatives and senators, but then masquerade those political problems as problems resulting from income inequality. For instance, a reviewer of a book by Joseph Stiglitz writes, "The collective argument of these dissidents is not only that inequality violates moral values, but that it also interacts with a money-driven political system to grant excessive power to the most affluent." This is a problem with our political system where such activity is allowed and encouraged, not with having people with a lot of money. Even if most people's incomes were relatively equal, they would still band together like they do now and form groups and funnel their money to these groups to create 'wealthy entities' such as Union PACs. And how is inequality immoral, exactly? Inequality is a state of being, not a planned decision, which is what something would have to be to be immoral. It would only be immoral if someone was out there unfairly distributing income (they certainly don't seem to have a morality problem with the unfair tax code. I digress.) The authors have yet to show a real piece of evidence why inequality is in fact a problem, and not a response by a government that deems it to be a problem and creates policies that makes it a problem in a self fulfilling prophecy (below). Mostly the books involve a lot of 1% bashing and cater to the partisan politics crowd. I find it ironic that they sell a lot of books to the OWS crowd, get rich from these writings and become the people that their writings are so critical about and at the same time create even more income inequality with their prosperity. None of these books have the profits going to charity.

So what are the main conclusions usually drawn to say why income inequality is bad? Some authors point to studies that found inequality led to slower growth in some countries. For those claimants who are really lazy, they just take a few countries in Africa and conclude that a high level of income inequality is the reason for their poverty. Inside actual peer reviewed studies that attempt to draw deeper conclusions on the link between slower growth in countries with high income inequality, authors find that it is the political policy designed to redistribute wealth that is the cause of the slower growth, not income inequality itself. So it is in fact, the liberal policies attempting to address class envy that slows growth [1, 2]. And when controlling for intra-country differences with panel data, Barro finds that there is "little overall relation between income inequality and rates of growth and investment." Others have claimed that inequality leads to financial crisis. Subsequent studies debunked these claims. Others, including Stiglitz, claim that income mobility is restrained in unequal societies such as the US. But income mobility is high in the US [1, 2].

"The rich getting richer and the poor getting poorer" is a classic cliche where the unspoken assumption implies that the growing income of the rich somehow causes the poor to be poorer, even though they too are becoming richer, and the quality of life for those defined by the income threshold of poverty has also risen. The rising tide does lift all boats.

What also causes income inequality that is not being talked about? The fact that income inequality is a reflection of the market. People have different talents, motivations, and abilities. As the the economy changes, an educated workforce with specialized skills is required and is leaving the uneducated behind. And then there are population dynamics that will increase the number of lower earning peoples, skewing the statistics. There are an influx of low earning immigrants, more college students than ever before, currently high unemployment for the past few years, a lot of part-time employees unable to find full employment whom are not included in the unemployment rate, and a large and growing number of retirees.

Income is a moving target through each individual's different stages of life, so taking snapshots of income distribution really doesn't tell the story that the liberals are trying to narrate. One individual can be labeled poor, rich, and then poor again over time if using income as the gauge. But is a college kid working a part time job earning $10,000 a year really what we think of when we consider poverty? How about a retiree who owns his home and has a multimillion dollar investment portfolio but only sells off $25,000 a year to live off of? It is perfectly normal for adults at the peak of their careers to out earn college students and retirees, and it makes no sense to just pick a number and say anyone who earns less than that lives in poverty. Furthermore, for those usually at the focus of the income inequality debate, those at the million dollar income level, there is a lot of churn in the ranks and those making the list this year are not usually the same ones making the list next year. The rich are more exposed to financial markets, so when the economy does well, they do very well, but when the economy does poorly, they do much poorer than the other income classes.

So how do those who see income inequality as a problem propose to solve the "problem?" Taxation: they want to take their income away from them. High income earners are a minority, so it is easy to discriminate against them and increase their taxes. The American public has been led to falsely believe through comments by Obama and Warren Buffet that the rich pay lower taxes than middle class Americans. Warren buffet says it would be a morale booster. Somehow your life is going to improve because more weight is added to someone else's back? The "tax the rich" supporters fail to mention that the US already has the most progressive tax system of all the OECD countries [1, 2].

They try to mask their class envy and try to justify their reasoning for raising taxes on high income earners in a multiple of ways. The most cited reasons are:
A) The rich need to pay their fair share.- But they are currently paying the lions share.
- Taxes are progressive meaning that the more income one earns, the higher the rate one pays. What definition of 'fair' is being applied here?

B) They can afford to pay more
- By paying more taxes they end up being able to afford less.

- Who are you to say what they can afford just because you have a lower living standard?
- Why should they have to pick up the slack and divert money away from their own success to support the rest of America?

- I don't think they sought out to earn high incomes so that they could pay other people's taxes.
- They may be able to afford a herd of buffalo but should they be required to buy one?

c) They have more to lose
- Which is why they pay more money to insurance companies on their extra property.
- They currently pay the most in taxes, so they are already paying extra.
- This very statement implies that all tax money goes towards national defense (only about 14% of it does).
- Our lives and liberties are what will be defended in the event of a country invasion or war, not property.

So what are my thoughts on income inequality? Inequality is good. Our earth has a finite supply of resources and production. There has to be a system that distributes these goods according to one's means. Should you be able to live in Manhattan just because you want to, or because you bring something to the table and can afford to live there? You know what the opposite of inequality is? Communism. But with communism, since there are not enough resources to go around, everyone ends up with a substandard of living. Innovation is driven by the aspiration of reward. Wealth is a consequence of progress. Not everyone will or can be an innovator, and therefore not everyone will become wealthy. But should we stop this cycle of innovation just to spite those who do become wealthy? Do we have to blow out the brightest candles just so that they don't outshine the dimmest ones?

Here's a thought experiment. You could tax away all earnings above $100,000 a year and increase equality. But would doing this be a good idea? Do you think a business owner making $500,000 a year would bother to work the rest of the year after earning the $100,000 limit? In fact, he is likely to fire the percentage of employees that make up the other $400,000 in profits, so his job becomes easier since he wouldn't be allowed to be paid for the other profits that would accrue to the government. Of course, the newest highest rate just passed in the fiscal cliff deal will be about 43%, but the message and the result is the same. Why take away assets from those who earned them and are making the best use of them? Once commandeered, the resources are no longer being used to their full potential and instead are being wasted on some pet project by a government bureaucrat. Should Micheal Phelps be disallowed a swimmers cap just so that he doesn't blow away his competition as much? Should weights be added to his ankles to reduce the inequality of his performance? Progressiveness is anything but 'fair.'

When the media talks about how the 1% got more of the share of growth over the last several decades, they are missing the key point that they created this share. The economic pie grew because of their action. Without their efforts, it wouldn't even exist for anyone else to take. The populists see it through a lens that these high producers gobbled up all the income growth and took it away from someone else, but they are missing the point that they were the growth! It's not as if, if these producers didn't take action, that extra money would have appeared for everyone else. The pie grew because they built factories, buildings, inventions, companies, and the like. An economy doesn't just grow magically. And wealth isn't created out of thin air. It has to be created by someone with means and who makes an investment. The living standard we enjoy today is the highest it has ever been in the history of our planet and is a direct result of other people making even more money. You can thank them for your iPhones.

*I wonder if those who ask such questions understand that a CEO role is highly specialized and requires a certain educational and experience level. Or have they considered the magnitude of the decisions these executives have to make that can have a large impact on the company's future?

Many populists just cannot stand that they make 'so much' money. Usually they start citing statistics that CEO pay has increased X times while the mean worker's pay has only increased Y times, with X >> Y. Some variant of the phrase "Today's CEOS make 350x the entry level worker's compensation" is added and usually the "rich getting richer" cliche is thrown in for free.
Aside from the obvious fact that CEO pay is a small percentage of total company profits, I could go into company sizes, growth rates, profit margins, stock prices, etc. to explain away the difference in pay, or I could go into a discussion about how a CEO's decisions have 1000 times the impact of the entry level worker's decisions, but it is all unnecessary to the discussion.
The way the populists look at it is if the CEO is getting more, then he or she is taking it from everyone else. They apparently think that if the CEO were getting paid 10% less, that they could be getting 10% more. This may come as a surprise to some of those  reading this, but the CEO pay does not determine your pay! If they slice off a million dollars off the CEO's check, does that mean that they are suddenly going to hire 10 guys making 100k a year? Does that mean that they are going to give everybody a raise to balance out that million dollar influx to the company coffers? Would anyone just give money away for the sake of it? How would that action benefit the business?
Established companies don't spend 100% of their revenues on compensation. Usually it is less than a third. Most take the slack known as "retained earnings" and invest it back into the business. However, sometimes they just earn so much that they don't know what to do with it (such as Apple's $100 billion stock pile). Should Apple just give every employee in the company a $1.3 million check just because they can? Yes, they could do this. But how would that benefit the business? How would that benefit the shareholders? That money is owned by the shareholders and they are the only ones who have grounds to complain over CEO pay because they are the ones with a vested claim on the business decision outcomes and whether that money is being spent wisely.

My concluding point to this digression is that CEO pay is irrelevant to discussions involving mean worker pay or the minimum wage.