How to Address Inequality

By Jeffrey Frankel, April 19, 2014

Jeffrey Frankel - Professor of Economics, Harvard, Kennedy School

Jeffrey Frankel – Professor of Economics, Harvard, Kennedy School

Professor of Economics at Harvard, Kennedy School, Jeffrey Frankel, argues that commentators should focus on identifying the policies that are best suited to improving income distributions efficiently, and the politicians that support them.

Inequality has received a lot of attention lately, particularly in two arenas where it had not previously received as much: American public debate and the International Monetary Fund. A major driver is the observation in the US that income inequality has now returned to the extreme levels of the Gilded Age (Piketty 2014).

• The share of income held by the top 1% rose from 8% in 1980 to 19% in 2012 – a level last seen in 1928, and probably the highest among advanced countries (Alvaredo et al. 2014).

• The share held by the top 0.1% rose from 2% to almost 9% currently – a level least seen in 1916.

And mobility remains as low as ever (Chetty et al. 2014). Inequality has increased in many other parts of the world as well (Cassidy 2014). The major exceptions are Latin America, where it has always been very high and remains so, and parts of continental Europe where it remains relatively low.

Wrinkles in the argument
The current discussion goes beyond the starting point that we should be concerned about the distribution of the pie, not just about the total size. It tends to focus on one of several extra ‘wrinkles’ – adverse effects of inequality beyond the obvious one of the welfare of those with lower income.

• One such wrinkle is the hypothesis that inequality is bad for overall economic growth – for example, in times of inadequate demand, because the rich save more than others (Ostry et al. 2014).
• Another is that inequality leads to volatility and instability – for example, that it may have been responsible for the sub-prime mortgage crisis of 2007 and hence the global financial crisis of 2008 (Rajan 2010).
• A third is the proposition that inequality translates into envy and unhappiness (Brooks 2014).

Someone who would have been happy at a given income is unhappy if he discovers that others are getting more. One persuasive version of this latter claim holds that top executives demand and receive outlandish compensation not because they value so much the money itself, but because they compete with each other for status (Frank 1993, 2010). A fourth concern appears to trump even the first three (Jencks 2009).

• Because there is so much money in politics, the rich succeed in getting governments to adopt policies that favour them as a class (Stiglitz 2012).

The system often goes under the name of oligarchy (Krugman 2011). It generates extra handwringing because of the notion that it is self-perpetuating.

The first three concerns have the consolation that they might at some stage be self-correcting, at least in a democracy. After all, the upper 1% doesn’t have many votes. Under oligarchy, however, the concentration of economic and political power is self-reinforcing. Recent decisions by the US Supreme Court regarding campaign contributions suggest that the role of money in the electoral process will only get worse. Hence the outpouring of opinion columns and editorials sounding the alarm on the political economy ramifications of inequality.

Each of these four concerns carries a big element of truth. To do any one of them justice would require diving into the details. Two examples. On the relationship between inequality and growth:

• The one-time land redistribution that took place in northeast Asian countries after World War II was probably good for growth.
• A system where the hard-working, thrifty and entrepreneurial fear that they will not be allowed to keep much of the fruits of their efforts is bad for growth.

On volatility: Programmes to ‘help’ the poor by facilitating housing loans that they cannot afford are bad for them and for financial stability, not good.

Poverty and inequality undesirable for their own sake
But what is wrong with working from the premise that poverty in particular and inequality in general are undesirable for its own sake, other things equal? I question the rationale for writing opinion columns that focus overwhelmingly on the political-economy dangers of the wealth of the upper 1%. Yes, those dangers are important. But how useful is it to pursue the argument?

Even in the US, most voters believe that inequality matters in addition to total national income. This is true even recognising that the poor are less heavily represented among those who vote.

• Even among the upper 1%, approximately two-thirds believe that US differences in income are too large and support progressive taxation (Page et al. 2013).

• Most Americans believe in helping the less fortunate, provided it can be done without government intervening so intrusively or distorting incentives so much as to seriously damage economic efficiency.

The problem is that they often vote for politicians who enact laws inconsistent with those goals. For example, ten years ago someone hoodwinked the median voter – most of whom themselves leave negligible estates – into believing that to protect small family-owned farms it was necessary to eliminate taxes on $5 million estates (Huang and Frentz 2013).

Politics leads to less growth and less equality
In other words, the problem isn’t that the median voter is unwilling to trade off any growth in return for more equality (Okun 1975). The problem is that the political process produces outcomes that deliver both less growth and less equality than we could get under the optimal tradeoff.

For the US, the most sensible measures include:

• expansion of the Earned Income Tax Credit;
• elimination of payroll taxes for low-income workers;
• cutting deductions for high-income taxpayers; and
• restoring higher inheritance taxes.

These are policies that reduce inequality efficiently, at relatively low cost to aggregate income.
Some further policies are ‘win-win’ in that they may even promote overall economic growth while reducing inequality – such as universal pre-school education and universal healthcare – especially if these programmes are financed out of efficiency-enhancing measures such as eliminating fossil-fuel subsidies (and, preferably, taxing fossil fuels instead – see Mankiw 2009). I’d also eliminate the carried interest loophole in the corporate tax code and deductions for stock options (while lowering the statutory tax rate). Most independent economists support most of these proposals, but it is hard to get the message across.

Pro-equality policies that backfire
Meanwhile, there exist many government programmes that are sold on the basis of improving the income distribution but in fact impair economic efficiency severely with relatively little benefit for the poor or – in some cases – none at all. The original rationale for wasteful agricultural supports was largely to help small farmers who were less well off, but it has been a long time since they were positive for the income distribution. Mortgage subsidies contributed to the sub-prime mortgage crisis, but the benefits go overwhelmingly to higher-income families. Many Americans are persuaded to support such policies, not because it is in their interest, but because they don’t understand the economics.

Other countries also have similar programmes that are sold as pro-equality but are inefficient or even harmful for that goal (IMF 2014a). In developing countries, measures that tax, subsidise, or price-regulate food and energy tend to be highly inefficient tools for improving the income distribution, and frequently even have the opposite effect. A disproportionately small share of social spending goes to the poorest 40% of the population (IMF 2014b). Of the $400-plus billion that countries spend on fossil fuel subsidies each year, far less than 20% of the benefits go to the poorest 20% of the population (International Energy Agency 2011). Conditional Cash Transfers, on the other hand, have proven highly effective – they reach the poor and promote education and health.

One way forward: Complain about inequality
How to nudge the political process toward delivering better policies? Some believe that the appropriate strategy is to sound the alarm about inequality and oligarchy.

The argument against oligarchy is not a perfect fit with the reality in the US.
• Most of the income of the upper 0.1% still comes from earned income, not yet from inherited wealth as in other countries.
• Lots of single-issue groups are able to distort the political process severely, not just the rich.
• The opposition among the rich to measures helping the less unfortunate is far from unanimous.

Think of all the Bill Gates and George Soroses. On the other side, think of all the unskilled workers who vote against their self-interest (Frank 2004).

The anti-oligarchy logic for writing a column on inequality is that the rich have too much money, which they use to get the politicians elected and the bills passed that will favour them, the rich. But how is that money weapon used? Not often by outright bribery, at least not in the US. Politicians need money so badly for only one reason – to get elected. They buy advertising to persuade people to vote for them. Hypothetically, if we could persuade people to stop watching the advertisements, that would solve the problem.

More constructively, if we could persuade the poor to vote, that might solve the problem. But op-eds are probably not an effective means of achieving this, because those who are not civically engaged enough to vote are probably not civically engaged enough to read op-eds. The same goes for unskilled workers. (If we thought they were reading, we wouldn’t be using such an insulting term as ‘unskilled’ to describe them.).

Another way forward: Identify pro-equality policies and politicians
It seems to me that op-eds are better used to argue out which are the best policies to improve income distribution efficiently, and to point out which politicians support them. ‘Yes’ to the EITC and pre-school education; ‘no’ to subsidies for oil, agriculture, and mortgage debt.

Too difficult, you say. One must always apologise for the ‘policy-wonkery’ of engaging in substantive discussion. But think, what is the alternative?

Apparently the alternative is the very roundabout strategy of achieving more enlightened policies by trying to reduce the ability of the rich to buy votes, which is to be accomplished by reducing the share of income that goes to the rich, by reducing inequality, by … what? Pursuing pro-equality policies, like the EITC and pre-school education! How can complaining about inequality be a more effective strategy for achieving these policies than arguing the case directly for the policies themselves?

Editor’s note: This is the extended version of an op-ed appearing at Project Syndicate.

Alvaredo, Facundo, Anthony B Atkinson, Thomas Piketty, and Emmanuel Saez (2014), The World Top Incomes Database.
Brooks, Arthur C (2014), “The Downside of Inciting Envy”, New York Times Sunday Review, 1 March.
Cassidy, John (2014), “Piketty’s Inequality Story in Six Charts”, Rational Irrationality, 26 March.
Chetty, Raj, Nathaniel Hendren, Patrick Kline, Emmanuel Saez, and Nicholas Turner (2014), “Is the United States Still a Land of Opportunity? Recent Trends in Intergenerational Mobility”, executive summary of NBER Working Paper 19844.
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Rajan, Raghuram G (2010), Fault Lines: How Hidden Fractures Still Threaten the World Economy, Princeton University Press.
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Jeffrey Frankel is Harpel Professor at Harvard University’s Kennedy School of Government. He directs the program in International Finance and Macroeconomics at the National Bureau of Economic Research, where he is also on the Business Cycle Dating Committee, which officially declares U.S. recessions. Professor Frankel served at the Council of Economic Advisers in 1983-84 and 1996-99; he was appointed by Bill Clinton as CEA Member with responsibility for macroeconomics, international economics, and the environment. Before moving east, he had been professor of economics at the University of California, Berkeley, having joined the faculty in 1979.

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