Look deeper to find the real cost of attempting to reduce income inequality

 

Since time immemorial, man has been led to confirm, perhaps arguably, and reconfirm the overwhelming importance of incentives and rewards in the mere survival, if not growth, of civilization.

Even some idealists acknowledge the key role of incentive/rewards in economic development. Now President Obama informs us that the incentive/reward structure plays little, if any, role in the development process (should you build a useful product, some mysterious other person actually built it).

 

INEQUALITY OF INCOME is again under severe attack, spearheaded by Obama and his dutiful followers, the media, academia and entertainment sectors. Study after study is cited purporting to show increasing inequality. While this sudden renewed interest in inequality is motivated to some degree, if not wholly, to divert the public’s attention from the HealthCare.gov debacle, the media treatment of the subject is so misleading that it merits greater discussion.

There are myriad ways to measure income inequality. A simple measure identifies income, say $1 million, which separates those with incomes below $1 million from those above $1 million. Suppose the percentage of income earners above $1 million is 1 percent. Do the same calculation for next year and find, say that the income that separates the top 1 percent from others now has jumped to $1.1 million. Then income inequality is said to have increased.

The most recent U.S. data (expressed in nominal not real terms), comparing 2011 incomes to 2012 incomes, show an increase in inequality. Other inequality measures, including the most sophisticated, give similar findings.

These measures, however, suffer from severe weaknesses. One is that most of them use an income definition that includes taxes paid and excludes transfer payments (e.g., Obamacare subsidies, food stamps.) Since taxes have increased so much lately, this produces an upward bias to the study results. Most studies used incomes that were unadjusted for inflation.

The most fatal flaw is that people who are in a given income class or bracket in one year are not necessarily the ones inhabiting that class next year. This churning of income recipients from one class to another is masked by these measures; thus, they easily can provide misleading results: increases, or decreases, in inequality when no changes actually take place.

 

TO HELP REMEDY this flaw, the U.S. Treasury has conducted a study (because it has access to confidential data) in which a sample of incomes is observed over an extended period of time – 20 years. Naturally, much movement of income recipients among classes is bound to be observed. Remember that when a sample of observations is arrayed by order of magnitude, any one-fifth of the sample is, by definition, a quintile.

If so, then the U.S. Treasury reports that in the decades 1987-1996 and 1996-2005 considerable income mobility of incomes took place. Moreover, roughly half of those in the bottom quintile in 1996 had moved to a higher quintile by 2005. Just as important is that “the median (that value such that half of the observations are above it, and half are below) of those in the lowest income groups increased more in percentage terms than did median incomes of those in higher income groups.”

 

WE CAN CONCLUDE that during periods of robust growth in the economy, such as the 1980s and 1990s, most citizens enjoy significant growth in incomes. In contrast, during slow times opportunities for income growth, not unsurprisingly, are diminished. Further, as noted by Robert E. Grady (The Wall Street Journal, Dec. 23), the interval from 1982 to 2007, a period of robust growth, median family real income (inflation adjusted income) responded by improving 21.6 percent, on average, over all incomes. After 2007, however, as we all know incomes suffered declines across all quintiles. But overall, however, we know that real income does increase over all income classes.

The notion that the rich get richer because they somehow take what rightfully belongs to the poor is the most pervasive of all false notions about inequality. We all tend, on average, to be paid in accordance with our productivity. The view that what someone receives is at the cost of someone losing assumes that economic activity is a “zero-sum” game, which is patently false.

The remarkable U.S. achievement over the past half-century is that these results occurred despite a steeply progressive tax system, an overly aggressive regulatory system and an undisciplined educational system that has lost its will to teach children how to think with care and rigor. We have forgotten that it is the incentive/reward process (IRP) that drives the economy.

Indeed, the key to our long-run enviable success, our growth and even our short-run successes lies within a framework of personal freedom – freedom to choose, freedom to own private property, freedom to contract – where we allow the IRP to flourish. This encourages incentives to work, to save, and to satisfy community demands. It allows for freely contracted production of goods and services; through innovations, the application of organizational skills and leadership; and the assumption of investment risks.

 

BUT THESE TALENTS are brought forth by a social organization that allows sufficient rewards to risk-takers. This whole alignment we have labeled the IRP.

Critics of the process point mainly, if not exclusively, to the need to have wealth and income-transfer programs to soften the inequalities of rewards that emerge from applying IRP. But eliminating those rewards is a fatal blow to the incentives that generate growth in GDP, in our overall standard of living, and in employment.

We just aren’t clever enough.

While difficult to understand, and virtually impossible for many to accept, our social organization represents a tremendous achievement that few economists appreciate. It also is difficult for people to understand that mankind currently lacks the analytical tools – the cleverness, if you will – for achieving the goals of critics wanting reductions in inequalities without sacrificing growth in income and innovations, personal freedom and the dynamism that personal freedom, like fresh air, brings.

 

BUT NEVERTHELESS, many show no lack of hubris in attempting to achieve these objectives: They remain hard at work striving to show that these goals are attainable. In the misty distant future they may have some success.

But this dim prospect does not justify current massive and costly redistributive efforts. In sum, we lack the ability to attain these objectives without incurring the great risk of throwing further disabling monkey wrenches into the social process, including the IRP.

Like early alchemists in search of the formula for gold, liberals seek to feed the world from a flower pot through the magic of taxes and regulations. We are simply not that clever.

 

(The writer is a professor emeritus of financial economics at the University of Georgia. He lives in Aiken, S.C.)

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Wed, 12/07/2016 - 23:19

Rick McKee Editorial Cartoon