Rethinking Income Inequality

French economist Thomas Piketty is making a huge splash with his soon to be released book about income inequality — “Capital in the Twenty-First Century”.  The New Yorker’s John Cassidy provided a detailed preview, which follows growing calls by the media, public intellectuals and politicians for quick and aggressive government intervention to remedy the “crisis” of income divergence between the richest and poorest segments of the population in western countries in order to prevent chaos, violence and an end to democratic governance.

Piketty argues that a core of the problem is that returns to capital (and to its owners) have overtaken rates of economic growth such that wealth accumulation among the most affluent disproportionately exceeds gains in productivity (and earnings) by the masses.  The New Republic seemed beside itself over a lecture Piketty gave where he advocated a global, progressive wealth or capital tax to solve the problem. It appears that compensation packages received by “supermanagers” at large companies, coupled with political activism and inheritance laws, have produced a perpetual rentier class consolidating wealth at everyone else’s expense.

It should be acknowledged that Piketty and his colleagues have amassed substantial, credible data on household incomes from various sources and, in some ways, have revolutionized quantitative analysis of wealth disparities. Nevertheless, and while improper to criticize a book before it has been published, it now appears a good time to respond to the income inequality chorus before Piketty and his champions monopolize the discussion.

While the inequality argument can be challenged on its statistical assumptions alone (see Thomas Sowell’s piece on household versus individual income trends), I take a more fundamental, comparative approach and make two contentions: (i) income inequality should be compared across political and economic systems in relative terms rather than within one economic and political system over time; and (ii) income inequality borne out of voluntary exchange rather than cronyism (i.e., market rather than political income inequality) is both inevitable and a social good.

Whose income inequality is worse?

Decades before his election as Russia’s first president, Boris Yeltsin was a Communist Party Secretary of the Sverdlovsk Oblast. Yeltsin worked to improve living conditions for families in his region, many of whom lived cramped in communal apartments well into the 1960s. He recounted in his memoirs that while the residents faced daily food shortages, poor living and sanitary conditions, and had to save for eternity to get new furniture or a car, he and his party colleagues lived like kings. Yeltsin had a summer house, a service car and a special section at local food stores set aside for him and other political bosses.

The disparity of access and treatment was not limited to Yeltsin or Sverdlovsk. It was understood by virtually everyone in Soviet society that unless one became a party member, certain jobs and luxuries of life were off limits. Ironically, an economic model ostensibly designed to aid the least fortunate had made them not only poorer in relative terms to even their poorest counterparts in the West, but produced income inequality an order of magnitude worse than anything decried by Piketty et al. The distinction between the Soviet “1%” and everyone else was who had a car, a refrigerator and functioning furniture. The parallel distinction in the United States, fundamentally, is who has a better car, a better refrigerator and nicer furniture.

The Soviet example is extreme, but yields an important lesson — income inequality is inevitable no matter what economic model a society chooses, but its size and substance vary. Whereas the inequality between a machinist and a corporate CEO in the United States may seem immense and abhorrent when measured in absolute terms, it becomes paltry and not so horrifying when seen relative to income differences between the political haves and have nots in non-market or weak market societies. In the latter, however, political connections are everything and one cannot hope to level the playing field or escape his station without them.

Is massive income inequality inherently wrong or unacceptable?

A counter to my previous contention would be, as noted, that the Soviet case is unrepresentative. We should instead consider the Nordic states and other democratic countries which have taken strides to contain returns to capital and compensate economic losers. Indeed, many of these countries consistently rank among those with the highest living standards and rates of “happiness” in the world. Instead of addressing this popular response now, except to say that real growth and social welfarism have been inversely proportional in some of these countries (possibly by as much as a third), I will make my second contention about income inequality (building on my first) — income inequality arising entirely or largely from voluntary exchange in a free market is neither wrong nor economically problematic.

Joseph Salerno, a renowned Austrian economist, has previously distilled this argument. Basically, a return to capital (to use Piketty’s jargon) that comes from voluntary exchange and trade in a free market rather than cronyism and political favoritism should not be lambasted. Theft is theft no matter if the source is central bank inflation, social security transfers or corporate subsidies. The issue is not whether income inequality does or does not exist (or how much there is), but rather what kind of income inequality exists. Just as we don’t hear attacks against “ballet inequality” or “basketball inequality”, we ought not punish people for having higher incomes based on inherent traits or good decisions.

The corporatist versus free market income inequality distinction collapses Piketty’s attack on the size of managers’ compensation packages. Although committees (not individuals) do decide these on dubious grounds, their decisions are linked to what is best for shareholders and their businesses as a whole. If a board of directors pays a manager too outlandish a package and the share price takes a hit, the board risks a shareholder revolt at the next annual meeting. Compensation, like anything else in a business, does not exist in a vacuum unless it comes as a taxpayer donation (see, e.g., GM and Monsanto). Income inequality caused by corporatism (large businesses using government to enrich themselves and keep out competitors) should be decried, while the other kind should be accepted and praised. It is precisely this latter, good kind of inequality that generates greater capital investment, longer-term improvements in worker productivity, cheaper and higher quality goods and economic growth. As to what someone does with his inheritance, I apply the same principle — if he did not steal it, he can retain and enjoy it to the full.