What to Do About Inequality
March 1, 2012
With Responses From
Mar 1, 2012
19 Min read time
If we’re serious about reducing inequality, we need to do more than raise taxes on the rich. We need to correct the market failures in labor and education that generate it.
That inequality is a major social problem was once a niche belief on the left. From time to time, a small cadre of anti-inequality intellectuals would rail about the false consciousness of the public.
Why, they would ask, is the American public so accepting, even unaware, of the spectacular takeoff in economic inequality? When would middle-class voters—inside of Kansas and out—finally open their eyes, acknowledge the problem, and stop backing the political party that bears so much responsibility for the creation of a new Gilded Age?
That was then. Now we live in a world in which a broad swath of journalists, intellectuals, and the informed public is openly worrying about economic inequality and debating what to do about it.
Judging by current legislative proposals and Democratic Party rhetoric, there is an emerging consensus that our main response to inequality should be to increase tax rates for the well off. There is much to be said for this tax-based redistributive agenda and good reason to pursue it. But we ought not stop there. If we’re serious about reducing inequality, a higher tax rate for the rich will not suffice. We need other inequality-reducing interventions. It would be a shame if Occupy Wall Street (OWS)—whose concerns extend well beyond tax policy—were reduced to a push for increasing the marginal tax rates for people earning more than a million dollars a year.
What’s wrong with relying exclusively on a “tax the 1 percent” agenda? The most obvious problem is that it is hard to sell in a tax-fearing country. It’s just not convincing to go on with that well-rehearsed mantra: if only voters were narrowly self-interested they would support raising rates on those in tax brackets higher than their own. Whatever our simple models may imply on this point, we know they’re wrong and that American conservatives are remarkably adept at discrediting pro-tax proposals as Eurosocialism.
It’s even more troubling that the tax-based redistributive agenda is founded on a misdiagnosis. The driving assumption seems to be that inequality is increasing mainly because of reduced levies on capital gains, the Bush tax cuts, and related changes in U.S. tax policy. If that assumption were correct, then it would make sense to limit ourselves to reversing those policies.
But the takeoff in inequality cannot be explained by tax policy alone. To the contrary, as economists Emmanuel Saez and Thomas Piketty have shown [see their response to Grusky], there has been a dramatic rise over the last 30 years in pre-tax income inequality. The share of pre-tax income flowing to the top 1 percent of households increased from less than 10 percent in 1975 to more than 20 percent now. This spectacular increase in market inequality is of course exacerbated by changes in after-market taxation. However, because the takeoff in inequality is mainly generated within the market, we should look to market institutions to understand its main causes.
As important as tax-based redistribution is, we therefore need to supplement it with policies that address market inequality. We would do well to look to OWS for inspiration here. Although OWS hardly sings with a single voice, one line in the polyphony implies an institutional critique of inequality and a market-based remedy for it. The institutional critique is not about the tax system but about the ways in which American labor and capital markets generate extreme pre-tax inequality. The core idea is that powerful players have built self-serving and inequality-generating institutions that are often codified in law and come to be represented—through an ingenious sleight of hand—as laissez-faire capitalism.
We all are familiar with the argument that extreme inequality is the inevitable outcome of a highly competitive market. The institutional critique turns this idea on its head and implies that extreme inequality comes from a lack of competition and associated market failure. Put simply, we’d have far less inequality if our labor market and other institutions were more competitive—if our commitment to competition weren’t mere lip service but were honored even when the rich and powerful would lose out.
A Knee-Jerk Solution
Before laying out the institutional argument in more detail, let’s step back and ask why we reflexively assume that tax-based redistribution is the best way to take on inequality. This assumption makes sense only insofar as the institutions that generate wages and other income are treated as sacrosanct. If such institutions are indeed given a free pass, our only opportunity for reducing inequality is to intervene after they operate. Hence we turn by default to taxation.
If we’re truly serious about reducing inequality, taxing the rich will not suffice.
This raises a key question: Why do we think our existing labor market institutions are sacred? In the context of liberal economies, we think as much because these institutions are presumed to be based on a thin set of rules that ensure labor contracts are easily formed and terminated and that a worker’s compensation therefore equals her contribution to the firm’s output. We assume, in other words, that our institutions are fine-tuned to allow the market’s invisible hand to do its good work.
If our labor market institutions were actually “thin” in this way, then we could only tinker with them at our peril. By revising the sacred rules, we would break the link between compensation and contribution, thereby introducing inefficiencies and reducing total output. This heroic assumption underlies the political consensus around deregulation that emerged in the last several decades. In an unspoken compact, liberals (i.e., leftists) have agreed to let conservatives run a competitive and “regulation-free” economy, while conservatives have in turn agreed that the fruits of economic growth will be used to fund programs that redistribute market income.
The ritual complaint of liberals since the Reagan Revolution is that conservatives aren’t holding up their side of this grand deregulative compact. Although pragmatic liberals have signed on to the market deregulation program by allowing unions and the minimum wage to wither, conservatives haven’t in turn lived up to their commitment to use some reasonable proportion of the national income for purposes of redistribution. As OWS grew, it provided liberals with an occasion to remind conservatives of the compact and press for changes in tax policy.
But this interpretation of OWS reduces it to a business-as-usual movement that is exploited simply to expand the redistributive side of the bargain. And there is more to OWS than business as usual. The anti-inequality critique entails rejecting the social compact’s core belief that our market institutions are just thin regulations that equate contribution and compensation. That is, much OWS rhetoric recognizes that market institutions are riddled with inequality-generating corruption, bottlenecks, and sweetheart deals, a state of affairs that demands that our institutions be reformed rather than treated as inviolable. When OWS participants point out that market regulations are shaped by lobbyists, powerful corporations, and the well off, they are hardly telling a story about thin rules that merely enable the invisible hand. Instead the story is about a very visible hand distorting market principles.
This variant of OWS rhetoric has diffused widely. Jon Stewart recently lectured Lou Dobbs to the effect that our current economic institutions are a gerrymandered “perversion of capitalism,” while Newt Gingrich experimented with populist stump speeches emphasizing that “deals are being cut on behalf of Wall Street institutions and very rich people.” We are in the midst of an unusual moment in history in which the deregulative compact’s core premise is being called into question by liberal icons and Republican presidential candidates alike. It would be foolish to waste this moment by falling back to a regressive compact that presumes that our institutions are inviolable and that all that can be done is after-the-fact redistribution.
The institutional critique turns our attention to market failures that generate what economists call “rent.” Rent is income that exceeds what would be needed to ensure that a particular asset, such as labor, continues to be deployed in a competitive market. A manager, for instance, is collecting rent when she earns more than she would in a perfectly competitive market (bearing in mind that a perfectly competitive market is an “ideal type” that doesn’t obtain in any existing economy). Because of corruption, bottlenecks in labor supply, or sweetheart deals, the manager is paid in excess of what would be needed to convince her to do the job.
The concept of rent is tailor-made for the OWS argument that power and privilege are built into our markets. Although the market is usually represented as highly competitive, the OWS retort is that such a representation only camouflages the many ways in which the rules are rigged to benefit the already advantaged. This is a simple story about an economy rife with rent.
It’s one matter to argue that opponents of inequality have embraced the rhetoric of rent and quite another to demonstrate that the rhetoric is on the mark. To make that case, I offer two illustrations. The first suggests that the increasing financial benefits of schooling, well appreciated as a main cause of rising inequality, are partly attributable to market failure. The second suggests that excessive executive compensation is rooted in non-competitive practices and that a true market wage would likely reduce inequality. These two examples imply that rent benefits the rank-and-file college-educated worker as well as members of the 1 percent. In laying out both, I will draw heavily on the work of others, especially that of Kim Weeden.
With all the recent worrying about the travails of the college-educated, it is easy to forget that the payoff of a college education has dramatically increased over the long run, with the sharpest increase occurring in the 1980s. The growing earnings gap between the college-educated and the rest of the labor force is an important source of rising inequality.
But why has this college premium endured, indeed, expanded? To understand the puzzle, let’s imagine that we live in a perfectly competitive economy. In that economy, information about the high returns of a college education would gradually diffuse, workers in pursuit of those returns would invest in college, and the resulting influx of college-educated workers would drive down the premium. The high returns generated by a shortage of educated labor would therefore disappear.
Since 1975, the share of pre-tax income flowing to the top 1 percent has more than doubled.
But they haven’t disappeared. The persistence of high returns suggests that institutionalized bottlenecks are preventing workers from responding as they would in a competitive market. Although other explanations are possible, the bottleneck account is appealing because it is consistent with our understanding of how education is rationed to the select few.
Two types of bottlenecks are especially important. The supply of potential college students is artificially lowered because children born into disadvantaged families are poorly prepared for college and, in any event, haven’t the money to afford it. The demand for college students is kept artificially low because most elite universities, both public and private, ration their available slots. It’s not as if Stanford, Harvard, and Berkeley are meeting the rising demand for their degrees by selling some profit-maximizing number of them. If top universities met demand in this way, the outsized benefits of a high-prestige education would disappear.
Is this how a competitive market works? Absolutely not. When, for example, the demand for hybrid cars increased dramatically in the United States, car manufacturers didn’t set up admissions committees charged with evaluating the qualifications of prospective buyers. Instead, they ramped up production to a profit-maximizing level, and the shortage-driven uptick in prices soon corrected itself. We have become so accommodated to high prices for college-educated labor that we don’t appreciate the rationing and market failure that underlie them.
These bottlenecks create inequality by changing the relative size of the college-educated and poorly educated classes. Because bottlenecks generate an artificially small college-educated class, its wages are inflated and its unemployment rate suppressed. Because they generate an artificially bloated class of poorly educated workers, its wages are suppressed and its unemployment rate inflated. This crowding at the bottom has helped build a massive reserve army of unskilled labor evocative of mid-nineteenth century England.
By addressing such market failure with redistribution, we could indeed prop up wages at the bottom, but with all the angst, opposition, and political drama that redistributive programs evoke in a market-loving society. The better response to market failure is to undertake market repair. If all children, even those born into poor families, had access to adequate primary and secondary school training and then to college education, the high unemployment and poor pay at the bottom would be reduced, as would the low unemployment and excessive pay at the top. We’d have less poverty and inequality if we increased the number of slots in higher education and committed to fair and open competition for them.
Who would win and who would lose from such market repair? The losers would be those who are now artificially protected from competition and are therefore reaping excessive returns. The winners, by contrast, are those currently locked out of higher education who would gain access once markets are repaired.
But these are not the only winners. The other main winners are the businesses that currently pay inflated prices for high-skill employees but will no longer have to do so once higher education is opened up fully to competition. It’s hardly in the interest of business to pay the excessive cost of rationed higher education, nor is it in the wider interest of any country to settle for the lower national income that such restrictions on competition imply. If the emerging economic niche for the United States is product innovation, creative oversight of global product streams, and related forms of high-skill production, then we need a well-educated labor force. We risk choking off that high-road strategy by allowing bottlenecks and high labor costs to persist.
The happy conclusion is that market repair, if taken seriously, can yield a higher national income as well as less inequality. Although it’s conventionally argued that a taste for equality can only be indulged at the cost of reducing total output, this standard tradeoff thesis no longer holds once we realize that existing economies, and perhaps especially the U.S. economy, are burdened with inequality-increasing rent.
This rent will not be shorn off with the usual half-hearted, flavor-of-the-day reform efforts. What’s required is a radical overhaul of our education system. The seemingly uncontroversial objectives of such reform would be to provide the same opportunities to rich and poor children alike and to provide enough higher-education slots to meet the additional demand that equalization would generate. In the education reform industry, most initiatives are marketed on the basis of their effects on school quality, and any possible residual effects on equalizing opportunity are treated as a convenient side benefit. That’s a travesty. We should instead begin and end all discussion of reform by asking whether it secures our commitment to equalizing opportunity. This should be our main goal in just the same way that equalizing civil rights was in the 1960s and 1970s. If we were to commit to this objective, as many other countries have, it would be child’s play to settle on the reforms needed to implement it.
Conventional wisdom notwithstanding, extreme inequality comes from a lack of competition.
This is not the place to debate how equal opportunity is best achieved: there are all sorts of ways to skin the cat, and what matters for my argument is only that the cat be skinned. It’s not that we don’t know how to secure equal opportunity. We’ve just given up on it. It’s inexcusable that, despite our putatively deep commitment to equal opportunity, we’ve become inured to the profound bottlenecks in educational access and have failed to appreciate them for the market failure that they are.
Rent Among The 1 Percent
As important as authentic educational reform is, it probably wouldn’t slow down the growth in inequality at the very top of the income distribution, as that growth is undergirded by a rather different type of rent. Because the takeoff at the top has been so spectacular, it’s instructive to consider how market failure and rent are implicated there as well.
The case for addressing the high-end takeoff by raising additional taxes from the highest earners might seem sensible at first blush. But again we should insist on reaching a correct diagnosis before settling on the best prescription. If top earnings are generated from corrupt, rigged, or particularistic compensation practices, then we would do better to address those practices than to treat them as sacred and assume that our only recourse is after-the-fact taxation.
Consider the case of CEO pay. The extraordinary rise in CEO pay, like the more general explosion of inequality, dates to the late 1970s. The acceleration, however, has been especially sharp since the mid-1990s. For a host of reasons, the gap between CEOs and average workers varies from year to year, but there is no mistaking the dramatic increase in recent decades.
Why are CEOs paid so well? Under current pay-setting practices, an opportunity for rent arises because board members, often sitting at the behest of the CEO, effectively set the CEO’s pay. (Although shareholders of publicly owned companies can, in theory, vote against management-sponsored compensation proposals, they rarely do.) If board members are rational, they will favor ample compensation packages because their own interests, such as remaining on the board, are served by keeping the CEO happy. It’s rather like asking a professor’s students to decide on her pay in advance of receiving their grades.
Given the simple incentives at work, one would be hard pressed to represent CEO pay in pure market terms. But firms try to do so anyway by hiring outside consultants to recommend compensation terms based on what peer firms offer. The recommendation is then represented as the pay level set by a competitive market. This representation is of course wrong. The prevailing wage is just that—the prevailing one—and it reflects not the true contribution of CEOs but the common practice of allowing CEOs to appoint board members who are then beholden to them.
Even so, a large and powerful contingent of scholars, mainly economists, views executive pay arrangements as the product of arm’s length contracting between boards and executives. This framework implies that the CEO’s compensation equals her contribution to the corporation. The statistical models bearing on this debate are inevitably inconclusive because it is difficult to determine a CEO’s true contribution. The best we can do, given such ambiguity, is ask whether our pay-setting institutions allow the opportunity for rent to be collected. If the opportunity exists, it’s reasonable to assume that it will be exploited.
This line of reasoning merely suggests that rent is being collected. It is entirely possible that the “optimal contracting” economists are right that compensation is efficient. But even if this is true, the legitimacy of compensation practices is still everywhere called into question, and much corporate energy must accordingly be devoted to concealing, justifying, or explaining packages that the public and stockholders treat with understandable suspicion. Because these packages are so public, the appearance of impropriety can lead to widespread cynicism about how fair our system is, with resulting costs in the form of increased disaffection. It follows that reform efforts should focus on ending incentives and practices that appear to allow for rent. Although we can never know whether rent has been fully eliminated, we can at least identify and root out the corporate practices that seem to generate it.
Bottlenecks generate an artificially small college-educated class with inflated wages.
If rent is being collected, it’s worth asking how to get rid of it. Could we use tax policy to end rent-seeking in the market? As Saez points out, when marginal tax rates are raised at the top, the after-tax payoff to securing rent is reduced, and hence the incentive to pursue rent is reduced as well. The idea is that a CEO has less incentive to stock a board with cronies when the extra compensation they approve is taxed at a higher rate.
Although the argument is clever, tax policy seems a blunt instrument for the task. In practice, changes in tax rates tend to be small, meaning that the tax-policy effects on rent-seeking would likely be small as well. We would do far better to implement institutional reforms that eliminate the opportunity for rent-seeking than to leave those opportunities intact and settle for some slight reduction in the benefit of pursuing them. Worse yet, Saez’s tax weapon would reduce the incentive for all types of income generation, licit and illicit alike. It is accordingly less efficient than direct institutional reform that eliminates the opportunity for rent-seeking without negative effects on other types of economic activity. Institutional reform, if carried out smartly, is hard to beat.
Really Competitive markets
It has been disheartening to watch commentators, even sympathetic ones, try to shoehorn OWS into a tax-based redistributive agenda. Although tax reform is important, it fails to address the core OWS critique of inequality, misdiagnoses the sources of increasing inequality, and accordingly takes our eye off the prize of fundamental institutional reform.
The institutions that determine compensation are deeply distorted by the visible hand of entrenched and powerful interests. We ought to address this distortion directly through institutional repair. The process will be long and hard, but it should receive political support because it entails aligning our institutions with the rules of fair and open competition that so many Americans embrace. The needed reforms merely require that the rich accept the same harsh market medicine that has for so long been doled out to the poor. If such reform is undertaken, we will end up with much less inequality. To be sure, we will still have some inequality, but at least it will be inequality in which we can believe.
What is the alternative? We could give up hope of institutional repair and settle for rough-and-ready redistribution via taxes and transfers. If we take this road, we should at least do so recognizing that it is nothing more than a pragmatic acknowledgement that the rich and powerful can’t be prevented from shaping the rules to their own advantage. The 1 percent will likely appreciate such pragmatism. If given a choice between paying higher taxes and reforming the rent-ridden institutions that enrich them in the first place, certainly they would opt for the former. This is because tax reform can be readily cast as socialist equality mongering and is accordingly vulnerable to reversal when the political winds change. There’s no similar way to discredit institutional reform focused on equalizing the rules of the game and producing a truly competitive economy for the rich as well as the poor.
The commitment within the general population to equalizing the rules of the game likely trumps all others. There’s much empirical evidence suggesting that Americans are prepared to accept even substantial inequality as long as it’s generated under competitive market rules. It’s therefore wrong to interpret public outrage about CEO pay as a protest against high compensation in and of itself. This outrage is not driven by the class envy about which the GOP presidential candidates so frequently complain. It is, rather, a protest against rationing, corruption, sweetheart deals, and foxes guarding the henhouse. It is a protest, in other words, against the corruption of markets by power. The rush to a tax agenda leaves the corruption untouched and instead fixates on a redistributive band-aid that Americans have never much liked. The market principle is, by contrast, one of our core commitments and a more promising base upon which to take on extreme inequality.
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