Opinion: The right amount of inequality (1)

POSTED: 03/7/14 12:22 AM

If we can’t have (and don’t actually want) total equality or total inequality, what is the right amount of inequality? Contributing op-ed writer Thomas Edsall dealt with this question in the New York Times. Today we share part 1 with our readers.

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 country’s economic growth?”

Kuznets’s 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 continuing threat 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 estimates that 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 Mulligan’s 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 Mulligan’s view, “a few million people to do what the government paid them to do: not work.”

Some recent analyses dispute Mulligan’s 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 pro-growth.”

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.”

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