In Part I of this post I discussed power laws and how they describe the distribution of wealth and income. In Part II I explained the basic dynamics of power laws and wealth distributions by offering some simple analogies and models. In this post I will discuss the policy ramifications of inequality.
Power laws in economic exchange markets lead to instability because of the inter-temporal breakdown of the necessary recycling/feedback processes. Let me explain that in English. An economy is a cyclical flow process that feeds back on itself over time. What we produce today we consume today, and save and invest for tomorrow. Tomorrow we expect to reap the rewards of producing, saving, and investing today so that we can repeat the process again and again, gradually accumulating a surplus = a pot of wealth. This is how an economy grows and how each productive member gets rich.
Now, what happens if 20% of the people receive 80% of the success in terms of the returns? How much will they consume relative to the 80% ‘have-nots’ who have to divvy up 20% of the returns? Enough to justify investment in increased production to meet future demand? If 80% of the people are not receiving an adequate return on current production, they have no resources to consume at the same levels in the future, so why would the 20% bother to invest in increased production? Thus, there is an excess of investment funds among the ‘haves’ and a dearth of consumption among the ‘have-nots’, to say nothing of saving and investment for the ‘have-nots’. (A good historical example of this logic is when Henry Ford discovered that he wasn’t going to sell many cars if the workers who built them couldn’t afford to buy them. Raising wages was also his way ot retaining workers and reducing retraining costs, thereby lowering his long-run labor costs despite the wage increase.)
What results with a power law distribution is a breakdown in exchange between the 20% ‘haves’ and the 80% ‘have-nots’. The ‘haves’ have to reinvest their profits, but where? If there is no realized demand, they must seek other ways to invest. They do this by bidding up desirable real and financial assets, like real estate, collectibles, stocks and bonds, hoping that these will continue to rise in value. This is speculating according to the “bigger sucker” sales strategy. It continues until those asset prices become unrealistic and unsupportable as incomes stagnate even more in the ‘have-not’ group. The end result is a crash in asset values that brings prices and wages down to a level where exchange can restart.
This is an oversimplification, of course, but it outlines the basic problem. As I have explained elsewhere, equilibrium economics cannot solve distributional breakdowns like this. Economic theory only tells us how to restart the growth process.
The initial policy response to this puzzle might be to tax wealth away from the ‘haves’ and give it to the ‘have-nots’. Unfortunately, this will not solve the problem because it only redresses the relative endowments and not the power law process. This might be acceptable if we reiterate the policy endlessly, so that at the end of every year we redistribute wealth, but the problem is that this destroys the wealth creating process (In the US we’re reminded of this strategy every April 15!). The ‘haves’ cease to accumulate assets that can be taxed away, and why would they? The USSR tried this over the 20th century and we know where that ended.
The obvious logical solution is that more than 20% must participate in the share-out of success, but how to do that without killing the goose that lays the golden eggs? The success of market capitalism is mostly reflected in the increasing returns to capital. Think about it: a successful business increases profits by reducing costs as well as expanding. This process reduces labor costs and increases profits to the business owners. Obviously, to survive in a capitalist society, one desires to be a capitalist, not a worker. (It’s not so stark as this, as what is optimal is the right combination of capital and labor. The value of capital is to increase the profitability of our labors. If you doubt this, think about how a 20-something trader on Wall St. can make a seven-figure income. He or she is highly leveraged with risk capital.)
Current tax policy discourages the accumulation of capital for ‘have-nots’ under the false pretense that there is something nefarious about ‘capitalists.’ We see this in the current misguided political attacks by the Occupy crowd. (They have legitimate grievances, but it’s not with the market, it’s with the political corruption of the market.) Policies to mitigate inequality should include the following:
- A reduction of payroll taxes on labor;
- A reduction of all capital taxes (capital gains, interest, dividends), especially for the ‘have-nots’;
- Some form of consumption tax to replace capital taxes, with a high threshold to reduce overburdening the poor who consume a greater proportion of their income;
- Gradual substitution of private capital accumulation for entitlements – if one has a large nest egg in retirement, who exactly needs Social Security?
- Means-testing for entitlements;
- Lower income taxes across the board, retaining some progressiveness;
- Higher wealth taxes on real property;
- An estate tax with rules that allow for a high tax-free threshold and voluntary distribution of assets below that threshold that would avoid taxes, before or at death. For example, if the tax-free threshold was $5 million, I could distribute my $100 million estate to 20 or more beneficiaries tax-free.
Proponents of both parties and both ideologies will object to many of these ideas, but compare them to the policies we have in place or are being proposed: raise income taxes, especially taxes on capital; no entitlement reforms to speak of; the expansion of a healthcare entitlement; financial regulation that hampers equity investment; government deficit spending with a rising debt-GDP ratio; a zero-interest rate policy that only rewards asset speculators; a Fed’s stated desire to create a “little inflation”; an estate tax that seeks to confiscate capital; additional plans to bail-out homeowners and student loan borrowers (who really thinks it’s a good investment to pay off an overpriced house for the next 25 years?); failed subsidies for alternative energy and higher taxes existing energy supplies, etc., etc. These are all ideas that reinforce the unequal status quo in our society.
The objective should be to create a dynamic opportunity society that rewards hard work, risk-taking, innovation, and merit rather than political influence or economic power. To do this, we need a set of policies that counter the market’s natural power law of skewed distributions that concentrates wealth and income. The alternative is a dysfunctional society with growing income and wealth inequalities that violates our basic sense of morality and justice.