Just Right Inequality

MARCH 4, 2014
If we cant have (and dont actually want) total equality or total inequality, what is the right amount of
inequality?
Anemic economic growth and the gutting of middle class jobs have given new impetus to a debate over
optimal inequality, a concept dating back at least six decades to a legendary speech given in 1954 at the
annual meeting of the American Economic Association by Simon Kuznets, a Nobel Prize-winning
economist, who asked, Does inequality in the distribution of income increase or decrease in the course of
a countrys economic growth?
Kuznetss research into the relationship between inequality and growth laid the foundation for modern
thinking about what has become a critical question: Has inequality in this country reached a tipping point
at which it no longer provides an incentive to strive and to innovate, but has instead created a
permanently disadvantaged class, as well as a continuingthreat of social instability?
One of the most articulate contemporary proponents of the optimal inequality thesis is Richard
Freeman, a labor economist at Harvard. In a 2011 paper, Freeman wrote: Is there a level of inequality
that optimizes economic growth, stability, and shared prosperity? My answer is yes. The relation between
inequality and economic outcomes follows an inverted-U shape, so that increases in inequality improve
economic performance up to the optimum and then reduce it.
Freeman argues that the costs of excessive inequality are high: Inequality that results from monopoly
power, rent-seeking or activities with negative externalities that enrich their owners while lowering
societal income (think pollution or crime), adversely affect economic performance. High inequality
reinforces corruption by allowing a few crony capitalists to lobby politicians or regulators to protect their
economic advantages. When national income goes mostly to those at the top, there is little left to motivate
people lower down. The 2007 collapse of Wall Street and bailout of banks-too-big-to-fail showed that
inequality in income and power can threaten economic stability and give the few a stranglehold on the
economy.
Conservative economists look at the issue of equality from the opposite vantage point: When do
government efforts to remedy inequality and to redistribute income worsen conditions by serving as a
deterrent to work and productive activity?
Casey Mulligan, an economist at the University of Chicago, is one of the leading critics of government
intervention. In his most recent book, The Redistribution Recession: How Labor Market Distortions
Contracted the Economy, Mulligan argues that safety net programs face a well-known equity-efficiency
tradeoff: providing more resources for the poor can raise their living standards, but it also gives them less
incentive to raise their own living standards.
Carrying this logic a step further, Mulligan contends that the expansion of the safety net both immediately
before and after the financial collapse of 2007-9 was the major cause of rising unemployment. Mulligan
estimatesthat from 2007 to 2010, expanded food stamp, Medicaid and unemployment benefits together
with new federal programs providing loan forgiveness to homeowners with underwater mortgages as
well as other means-tested programs meant that for nonelderly heads of households, federal safety net
benefits increased from about $10,000 per year in 2007 to almost $15,000 per year in 2010, adjusted
for inflation.
The explicit intent of Mulligans book is to show that actual safety net expansions and minimum wage
hikes were, in combination, enough to explain the reduction in labor hours since 2007, and many of the
other changes in the major economic variables.

In other words, government enhancement of payments to people who do not work prompted, in
Mulligans view, a few million people to do what the government paid them to do: not work.

Some recent analyses dispute Mulligans findings, perhaps most important an International Monetary
Fund study, Redistribution, Inequality, and Growth, published in February.
Written by three I.M.F. economists Jonathan D. Ostry, Andrew Berg and Charalambos G. Tsangarides
the study found that lower net inequality is robustly correlated with faster and more durable growth,
for a given level of redistribution.
And, most significantly from a policy perspective, the three I.M.F. economists argue that redistribution
appears generally benign in terms of its impact on growth; only in extreme cases is there some evidence
that it may have direct negative effects on growth. Thus the combined direct and indirect effects of
redistribution including the growth effects of the resulting lower inequality are on average progrowth.
These economists suggest that instead of making blanket statements about the pluses and minuses of
redistributive policies, analysts should focus on the very different effects of specific policies.
High tax rates and large subsidies to the nonworking poor can dampen incentives to work and invest,
they write. But other steps can be highly beneficial: Redistribution need not be inherently detrimental to
growth, to the degree that it involves reducing tax expenditures or loopholes that benefit the rich or as
part of broader tax reforms (such as higher inheritance taxes offset by lower taxes on labor income). More
broadly, redistribution can also occur when progressive taxes finance public investment, when social
insurance spending enhances the welfare of the poor and risk taking, or when higher health and education
spending benefits the poor, helping to offset labor and capital market imperfections. In such cases,
redistributive policies could increase both equality and growth.
Lawrence Katz, also a Harvard economist, basically agrees. In response to my emailed inquiry, he wrote,
too low a level of inequality from low returns to investment, entrepreneurial activity, and investment in
education/skills could certainly harm growth and productivity by reducing incentives for innovation,
productive investments, and labor supply, and by harming the health and well-being of the non-elite.
At the same time, Katz suggested, inequality that is too high could harm growth and inequality through
capital market constraints that prevent many talented individuals from non-elite backgrounds from
investing in human capital, through rent seeking behavior driving out productive activity, from the
elites/incumbent firms investing in entry barrier rather than innovation, and from political instability.
Katz pointed me toward a 2011 paper, Optimal Taxation of Top Labor Incomes, by Thomas Piketty,
Emmanuel Saez and Stefanie Stantcheva, which shows that lowering tax rates on high incomes can have
detrimental consequences, forcing up C.E.O. pay at the expense of subordinate employees.
For C.E.O.'s, in this analysis, the value of a pay raise grows in direct proportion to the lowering of the top
tax rate. For an executive making $10 million annually, getting a raise of $2 million has an after-tax value
of $1.3 million if the top rate is 35 percent. If the top rate is 70 percent, the raise has an after-tax value of
$600,000.
Lowering the top rate creates a powerful incentive for C.E.O.'s to press sympathetic boards of directors for
a larger pay hike than company performance justifies.
Katz, explaining the complex formulas and statistical measurement techniques used by Piketty and his
colleagues, says that their findings suggest that a 10 percent cut in the top tax rate increases the income of
the top 1 percent 2.6 percent.

This shift in the share of national income going to the top 1 percent produces no increase in G.D.P.
growth, according to Piketty et al. It does, however, reduce the share of national income going to the
bottom 99 percent by just under 1 percent.
Separately, Saez and Piketty argue that there is no correlation between cuts in top tax rates and average
annual real G.D.P.-per-capita growth since the 1970s. The two contend that top rates could be raised at
high as 70 or 80 percent without inflicting damage on the economy.
Katz is far less sanguine. In a series of email exchanges, he warned that there are reasons to worry that
tax avoidance and international migration and capital flows of the rich could be more important today
than in the historical variation they examine. I would certainly be nervous going up to marginal tax rates
as high as they suggest and I think even they believe one would need international coordination to do so.
More conservative economists have examined the issue of inequality and growth and come to very
different conclusions from their counterparts on the left.

Lara
35 minutes ago
"The rich earn higher incomes because they contribute more to society...." I don't think
so. As an attorney for nearly 30 years, I've...

Yars
2 hours ago
"Lowering the top rate creates a powerful incentive for C.E.O.'s to press sympathetic
boards of directors for a larger pay hike than company...

C. ANDERSON
3 hours ago
I think one thing is for sure. "Experts" who declare that social safety nets motivate
millions of "the lower incomes" to not look for jobs...
Robert Barro, a professor of economics at Harvard and a senior fellow at the Hoover Institution, has also
studied the relationship between growth and inequality, reaching the conclusion in a 2008 analysis that a
cross-country-growth framework reveals a negative effect from income inequality on economic growth,
holding fixed a familiar set of other explanatory variables. This effect of inequality on growth diminishes
as per capita G.D.P. rises and may be positive for the richest countries.
Gregory Mankiw, yet another member of the Harvard economics department, threw down a gauntlet to
the left in his now famous or infamous, depending on your point of view 2013 essay, Defending the
One Percent. He writes: Since the 1970s, average incomes have grown, but the growth has not been
uniform across the income distribution. The incomes at the top, especially in the top 1 percent, have
grown much faster than average. These high earners have made significant economic contributions, but
they have also reaped large gains.
What, then, should government do?
Mankiws answer: nothing: In the end, I am led to conclude that concern about income inequality, and
especially growth in incomes of the top 1 percent, cannot be founded primarily on concern about
inefficiency and inequality of opportunity.
Mankiw mocks liberal thinking on redistribution: The rich earn higher incomes because they contribute
more to society than others do. However, because of diminishing marginal utility, they dont get much
value from their last few dollars of consumption. So we should take some of their income away and give it

to less-productive members of society. While this policy would cause the most productive members to
work less, shrinking the size of the economic pie, that is a cost we should bear, to some degree, to increase
utility for societys less-productive citizens.
Economists are deeply polarized on the issue of optimal inequality, as well as on optimal top tax rates.
Insofar as there is any resolution, it will be determined by a political power struggle.
The concentration of income and wealth at the top has greatly increased the leverage of the affluent over
politicians in both parties. This is evident in thedominant sources of cash in 2012 for the Democratic
Party (securities and investment, $29,000,459; TV/movies/music, $19,035,557; real estate, $16,064,201;
business services, $15,241,379; computers/internet, $13,786,977) and for the Republican Party (securities
and investment, $69,769,785; real estate, $36,205,385; finance, $23,695,605; oil and gas, $18,525,999).
On the other hand, the steady increase in the number of minority voters black, Hispanic and Asian
will strengthen the hand of liberal critics of inequality.
Not surprisingly, minority voters and Democrats generally, including single women and single mothers
are far more supportive of taxing the rich than Republicans or independents. Gallup, in April, 2013,
found that three-quarters of Democrats think the government should redistribute wealth by heavy taxes
on the rich, while 72 percent of Republicans opposed such action.
However, this leftward ideological and demographic shift is taking place largely within the Democratic
electorate and much less so among the public at large.
With recent history as a guide, the smart handicapper will take the safe bet on the power of money over
demographics. For the moment, the political reality is that the Democratic Party does not have the
stomach to seriously engage the issue of inequality, and remains far too conflicted to take on the
concentration of power and income at the top. Those benefiting most from the system as it is will continue
to determine the operative definition of optimal inequality.
The role of money in politics, amplified by Citizens United v F.E.C. and lower court rulings, will continue
to obstruct legislative initiatives to reduce inequality. Economic winners are not going to cede ground
without a fierce fight.