At long last, a strong and respected voice has raised the clarion call: we should be concerned about the retarding economic effects of inequality. Yes, inequality is not just a social issue; it is, as many of us have long argued, just as much a threat to long-term economic health and growth.
The Economist confidently shoulders its responsibility to address the threat of economic inequality around the world, but especially here in the U.S. I could not have been more relieved to see the topics of inequality, government subsidies to various industries and the wealthy, as well as reform of social programs, elevated so prominently and with such a sense of immediacy. Its cover story and a special report offer a research-based approach to understanding the nature of the problem and fashioning a new, more responsible progressivism based on it.
From the Leaders section editorial:
A new form of radical centrist politics is needed to tackle inequality without hurting economic growth.
[…] Does inequality really need to be tackled? The twin forces of globalisation and technical innovation have actually narrowed inequality globally, as poorer countries catch up with richer ones. But within many countries income gaps have widened. More than two-thirds of the world’s people live in countries where income disparities have risen since 1980, often to a startling degree. In America the share of national income going to the top 0.01% (some 16,000 families) has risen from just over 1% in 1980 to almost 5% now—an even bigger slice than the top 0.01% got in the Gilded Age.
It is also true that some measure of inequality is good for an economy. It sharpens incentives to work hard and take risks; it rewards the talented innovators who drive economic progress. Free-traders have always accepted that the more global a market, the greater the rewards will be for the winners. But as our special report this week argues, inequality has reached a stage where it can be inefficient and bad for growth.
---“True Progressivism: Inequality and the World Economy,” The Economist, Leaders section (10.13.2012)
That special report includes a summary overview article, “For richer, for poorer,” and eleven supporting articles organized by both topic and regions of the world to reveal what research has led them to conclude and the policy recommendations they feel are necessary. I will not attempt to cover the supporting articles, except for quotes from the concluding two pieces, “Having your cake,” and “Policy Prescriptions.” The others may be accessed directly from margin links in the overview article, “For richer, for poorer.” I often suggest that reading the rest of an article I quote from is worth the time invested. For those who would understand all the pieces of this puzzle, all the steps that lead to their conclusions and recommendations, for those who care to understand this critical and changing area of threat to our economic well-being, this is essential reading.
Now let us return to our summary treatment of the Leaders editorial:
[Inequality] is most obvious in the emerging world. In China credit is siphoned to state-owned enterprises and well-connected insiders; the elite also gain from a string of monopolies. In Russia the oligarchs’ wealth has even less to do with entrepreneurialism. In India, too often, the same is true.
In the rich world the cronyism is better-hidden. One reason why Wall Street accounts for a disproportionate share of the wealthy is the implicit subsidy given to too-big-to-fail banks. From doctors to lawyers, many high-paying professions are full of unnecessary restrictive practices. And then there is the most unfair transfer of all—misdirected welfare spending. Social spending is often less about helping the poor than giving goodies to the relatively wealthy. In America the housing subsidy to the richest fifth (through mortgage-interest relief) is four times the amount spent on public housing for the poorest fifth.
Even the sort of inequality produced by meritocracy can hurt growth. If income gaps get wide enough, they can lead to less equality of opportunity, especially in education. Social mobility in America, contrary to conventional wisdom, is lower than in most European countries. The gap in test scores between rich and poor American children is roughly 30-40% wider than it was 25 years ago. And by some measures class mobility is even stickier in China than in America.
Some of those at the top of the pile will remain sceptical that inequality is a problem in itself. But even they have an interest in mitigating it, for if it continues to rise, momentum for change will build and may lead to a political outcome that serves nobody’s interests. Communism may be past reviving, but there are plenty of other bad ideas out there.
Okay. Having come that far, let’s take a closer look at the economic impact of reducing inequality? I will quote liberally from this penultimate supporting article in the study, the one that deals more directly with the studies and experience that indicate there are inefficient types or aspects of inequality. And while more research is needed for certainty in some areas, others are now quite clear.
A century ago inequality was deemed an essential condition for investment and growth because rich people save more...More recently the focus has been on its incentive effect…Redistribution, in contrast, brings inefficiencies as higher taxes and government handouts deter hard work. The bigger the state, the greater the distortion of private incentives.
That logic remains as powerful as ever. Economic freedom and better incentives boosted growth in China, India and elsewhere. Sweden’s experience shows that deregulation, lower taxes and fewer benefits increase economic dynamism even as they reduce equality. Yet the analysis in this special report suggests that logic is incomplete. Some of today’s inequality may be inefficient rather than growth-promoting, for several reasons.
First, in countries with the biggest income gaps, increasing inequality is partly a function of rigidities and rent-seeking [political or economic manipulation for uncompensated gain] —be it labour laws in India, the hukou system and state monopolies in China or too-big-to-fail finance in America. Such distortions reduce economies’ efficiency. Second, rising inequality has not, by and large, been accompanied by a smaller (and hence less distortive) state. In many rich countries government spending has risen since the 1970s. The composition has changed, with more money spent on the health care of older, richer folk, and relatively less invested in poorer kids. Modern transfers are both less progressive and less growth-promoting.
Third, recent experience from China to America suggests that high and growing levels of income inequality can translate into growing inequality of opportunity for the next generation and hence declining social mobility. That link seems strongest in countries with low levels of public services and decentralised funding of education. Bigger gaps in opportunity, in turn, mean fewer people with skills and hence slower growth in the future.
[…] More recent studies support the idea that inequality can be inefficient. In an influential analysis in 2011 two IMF economists, Andrew Berg and Jonathan Ostry, looked at the length of “growth spells” rather than simply comparing growth rates. They found that growth was more persistent in more equal countries, and that income distribution mattered more for the length of growth spells than either the degree of trade liberalisation or the quality of a country’s political institutions.
Other researchers have tried to isolate the “unhealthy” types of inequality using the two indices of inequality of opportunity first developed by the World Bank and described earlier in this special report. Two Spanish economists… built an index of economic opportunity for individual American states. They found that states’ GDP growth was inversely correlated with their inequality of opportunity, but not with overall inequality. In a forthcoming World Bank working paper, [it was found] that countries with lower educational equality, as measured by the Human Opportunity Index, grow more slowly.
This line of research is in its early stages, but a second strand of evidence, which examines the link between inequality and social mobility, is more developed. There are now plenty of studies which use the inter-generational elasticity of income to measure social mobility in different countries. Miles Corak, a Canadian economist, first plotted the results of these studies on a single graph. It is known as the “Great Gatsby Curve” (see chart 4), and suggests that countries with higher Gini coefficients [0=perfect equality, 1=one person has all income; Sweden increased to .24, US increased to.39, China=.42-.48] tend to have lower inter-generational social mobility.
[…] Perpetuating advantage
In some ways the link between wider income gaps and lower social mobility is unsurprising. From violin lessons to tutors for tests, richer parents can invest more in their children, improving their chances of getting into the best universities. The meritocratic assumption is that public provision of basic services, particularly education, does enough to counter this advantage to give everyone a reasonable start. That was never true in poor countries with rudimentary social services. Increasingly, it does not seem to be true in rich ones either, particularly America. But the link between inequality and declining mobility is not inevitable. Countries such as Sweden that invest heavily and progressively in public services are more likely to prevent widening income inequality from reducing opportunity. And Latin America shows that investing more in education at the bottom can improve social mobility even in the most stratified places.
[…] Quite legitimately, different people have different notions of what is fair, and what is the right balance between fairness and efficiency. But whatever their views, there is a reform agenda which both sides should embrace, one that both boosts efficiency and mitigates inequality.
---“Trade offs: Having your cake,” The Economist (10.13.2012)Now that we’ve surveyed some of the analysis, let’s look to the last supporting study, the prescriptions The Economist believes are called for by this research, what they call a true progressive agenda, and one which borrows some of the best thinking from both the right and the left.
Bold moves are needed to tackle inequality and boost growth at the same time.
One is to curb cronyism and enhance competition, particularly in emerging markets. Just as Roosevelt broke up America’s trusts (monopolies) and cracked down on political corruption, China, India and many other emerging economies need to do some trust busting and graft-attacking of their own…
In advanced countries, removing subsidies for too-big-to-fail financial institutions should also be high on the new progressive agenda. That, too, would result in more balanced economies and remove the rents that lie behind a lot of the surge in wealth at the top. Rich countries also need more competition in traditionally mollycoddled sectors such as education. Governments have a responsibility to invest in the young, but also to ensure that teachers have incentives to do their best.
The sooner the better
A second priority is to attack inequality with more targeted and progressive social spending. In emerging economies, especially in Asia, that means replacing expensive universal subsidies for energy with tailored social safety nets. It means wider use of conditional cash transfers. Latin America’s models are gradually being copied elsewhere, but there is much farther to go: rich countries would do well to adopt the idea of tying social assistance to individuals’ investment in skills and education.
Both rich and emerging economies must bring about a shift in government spending—from transfers [payments under social programs] to education, and from older and richer people to younger and poorer ones. Even if inequality were irrelevant, developed countries would need to reform their pension and health-care systems because today’s promises are simply unaffordable. Concerns about distribution and its effect on future growth add impetus: the longer that governments prevaricate about reforming entitlements, the more will be squeezed from investment in the young and poor.
These days, public investment in education needs to go beyond primary and secondary school. Giving the less advantaged a leg up means beginning with pre-school and includes retraining for the less skilled. In both areas America, in particular, is found wanting. Its government spends barely more than 0.1% of GDP on “active labour-market policies” to get the less skilled back to work, one-fifth of the OECD average. Only half of American children attend pre-school. China plans to have 70% of its children in three years of pre-school by 2020.
The third priority is to reform taxes, to make them a lot more efficient and somewhat fairer. Critics of inequality often tout higher marginal taxes on the rich. Yet in most countries other than America, government spending is a much more important tool for combating inequality than the tax system. Tax revenue is better seen as a way to fund the state, not a tool to punish the rich. Economists argue about the disincentive effects of higher tax rates. (Messrs Piketty and Saez, the economists who have transformed analysis of income concentration at the top, reckon, controversially, that the optimal top income-tax rate could be as high as 80%.) But no one doubts that there are trade-offs.
In countries where the state is already large, rebalancing government spending should take precedence over raising more revenue. But given the mess that public finances in most countries are in, more tax revenue is likely to be necessary, particularly in less highly taxed countries such as America. Even there, though, higher marginal income-tax rates should not be the first choice. Instead, the focus should be on eliminating distortions that reduce both progressivity and the tax system’s efficiency.
The “carried-interest” loophole, which allows private-equity managers to pay (low) capital-gains rather than (higher) income tax on their earnings, is one such sore. So are many tax deductions, from those for charitable contributions to mortgage interest, most of which disproportionately benefit the wealthy. An overhaul of the tax code to reduce corporate tax rates and narrow the gap between individuals’ tax rates on capital and labour income would improve its efficiency and make richer people pay higher average tax rates. Higher property taxes would be an efficient and progressive source of revenue. Inheritance tax could be reformed so that it falls on individual beneficiaries rather than on the estate as a whole, as it does in Germany. That would encourage the wealthy to distribute their wealth widely, thereby making a hereditary elite less likely.
[…] The most shocking shortcomings are in America, the rich country where income gaps are biggest and have increased fastest. The Republicans are right to say that Medicare, America’s health-care system for the old, must be overhauled. But by slashing government spending on basic services such as education and advocating yet more tax cuts at the top, they undermine equality of opportunity.
The Democrats are little better. Barack Obama gave his own speech at Osawatomie last year, wrapping himself in Roosevelt’s mantle. Inequality, he said, was the “defining issue of our time”. But his response, from raising the top income-tax rate to increasing college-tuition subsidies, was just a laundry list of small initiatives. Roosevelt would have been appalled at the timidity. A subject of such importance requires something much bolder.
---“Policy prescriptions: A True Progressivism,” The Economist (10.13.2012)
I have little to add to this bold, well-researched analysis and the responsible set of recommendations that logically follow. The fact that I have long agreed with most of it makes it easier to be a cheerleader, of course.
Many thanks to The Economist for bringing this most thoughtful synthesis of research, economic and social wisdom to us at this time when our country, our electorate and our politicians, desperately need to hear it.
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