Inequality has become a hot political topic these days and may be most contentious issue of the 2016 presidential election (unless a geopolitical crisis occurs before then). The study of economic inequality and what to do about it has a long history though, and not much has changed.
In this post I would like to suggest some different ways of looking at the problem and what to do about it from a policy perspective. Many people look at the distributional outcomes of success in a winner-take-all society and declaim the results as unfair. It probably is unfair, just like it is when all the tallest kids get chosen to play on the basketball team. But, more seriously, fairness is not an objective measure by which we can set policy.
Most people think they can define what’s fair and what’s not. I would tend to agree, but mine probably departs from the common sense definition. When looking at results in life, one person’s fairness (the winners’ bracket) is another’s unfairness (the losers’ bracket). So, should fairness be determined by who has the most political power and influence in society, even if that is a tyranny of the majority? I fail to see how that would be fair.
Fairness can actually be defined by the legal idea that consequence should follow action. In other words, the guilty, not the innocent, should pay for their sins. In finance, this idea of fairness is couched in the concept of risk and reward: he who takes the risk, reaps the reward (or the loss).
The question is how do we apply this objective idea of fairness (I would prefer the word “justice”) to policies to mitigate unequal outcomes? Or even should we?
I will argue that we should, but that we’re devising all the wrong policies because we are trapped in a conceptual maze. Economic inequality is truly a maze of confusion. There are many different factors that lead to unequal results and it’s quite easy and common to focus on the wrong ones. The factors that have become politically salient today are related to the diverging returns between capital and labor. This is at the root of all the hullabaloo over French economist Thomas Piketty’s work, a work that has been politicized to confirm the worse fears of labor advocates.
In short, globalization and technology has led to wage repression for the 99%, while increasing the returns to capital (the 1%). The keen-jerk solution is to tax capital after the fact and redistribute the funds to labor. The POTUS stated this proposal explicitly in his recent SOTU address: “Let’s close the loopholes that lead to inequality by allowing the top 1 percent to avoid paying taxes on their accumulated wealth.” In effect, he was advocating for tax reform, but he failed to specify details. But we have a good idea on what kind of economic policies Mr. Obama favors: free community college tuition, minimum wage laws, family childcare and education credits, paid sick leave. One can argue the pros and cons of these policies, but none of them really addresses the growing problem of inequality. My guess is that is because the administration really doesn’t have any new ideas about what to do about inequality except to wave it as a red flag during election season.
There is a serious problem with trying to tax capital to redistribute to labor that I would like to present here in the simplest of terms. Capital has dominant strategies to win any conflict with labor in a free society. If we tax capital, it can instantly move elsewhere to avoid the tax. Financial capital is fungible, it can change it’s use. Or it can lie dormant in the bank vault or a mattress. Labor enjoys none of these advantages: we can’t easily get up and move, we are specialized by skills and education, and we can’t be idle for long because we have to eat. In a class war between capital and labor, labor must capitulate, at least in a free society.
The political measures that seek to prevent this – such as repatriation laws, tax penalties, capital controls, crackdowns on tax havens and accounting rules – are largely ineffective because capital enjoys these freedoms that are partly incumbent to its nature. Eliminating capital mobility would require the complete coordination of the international community, which implies state control over the deployment of capital. This would be contradictory to a free society, as much as the complete state control of labor mobility would. In other words, state coercion is incompatible with a free society and thus any tax costs will fall mostly on labor. This is not the result we want.
So, are we stuck in an impossible situation where those who own and control capital dominate those who don’t? I don’t believe so, but the solutions lie outside the present constellation of policies.
The first lesson is that if capital dominates the distribution of returns, then success in capitalism requires access, ownership, and control of capital. Simply put, in a capitalist society, why aren’t we all clamoring to become capitalists? (You don’t have to run a business to be a capitalist, you just need to buy into public corporate share ownership and control.)
The next objection is that capital ownership and control cannot be pried from the hands of the rich and powerful without coercion by a democratically-elected government. In other words, we’re back to tax coercion. It is certainly true that we can tax physical capital and wealth through property and estate taxes. A mansion cannot be moved or disappear because it is taxed and the tax cannot be avoided by selling the property since the sales price will instantly reflect the tax liability. Wealth taxes are probably necessary due to the massive transfer of wealth under the misguided policies of the past two decades, but we’re missing the larger point if we focus solely on this redistribution of wealth after the fact. (My proposal for estate taxes is that they could be avoided entirely if the estate distributed the capital in limited amounts voluntarily according to the wishes of the principal. This happens to a certain extent with charitable gifts, but I would broaden the idea to cover any beneficiaries.)
However, beyond wealth taxes, there IS a way to incentivize someone to surrender at least some of their capital voluntarily. In fact, we all do it all the time when we buy insurance. By paying insurance premiums we surrender capital wealth in order to reduce risk and preserve the remainder. The rich have long practiced capital preservation strategies to protect their wealth. So risk is exchanged with capital.
This is also how Wall Street bankers get rich – they assume risk, manage it successfully, and then reap the rewards. So, if those without capital assume the equity risks going forward, and their property rights are vigorously defended, they can reap the rewards of economic success through their labor and their capital accumulation. The rich willingly give up some of their control in return for reducing their risks. As a society we can redistribute wealth by redistributing and managing risk.
This happens now when we save and invest in new business ventures, or accumulate a portfolio of financial assets such as stocks and bonds. But to really make a dent in inequality we must broaden and deepen capital ownership with a range of policy reforms that consistently reward working, saving, investing, accumulating capital, and diversifying risk. In a free society the government was never meant to do all of this for us, especially when we can do it better ourselves. I also would not expect most politicians in Washington to someday wake up and discover these reforms by themselves.