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Tuesday, March 4, 2014

The Crony Gap

Political inequality is the real problem

When it comes to public discourse, inequality is immensely fashionable. Along with its featured position at this year’s Davos conference, it received top billing in President Obama’s recent State of the Union address. But most of this talk lacks merit.

Some inequality is in fact necessary; it provides the incentives for creativity and innovation. In other words, if inequality is a consequence of overall growth, then it’s a positive symptom. Apple revolutionized cell phone and tablet technology—fields littered with less-profitable models—and very few would argue its profits were unearned, any more than they would argue that ordinary people have been made worse off by owning iPhones. If we can agree that some inequality is needed to incentivize wealth creation, the question becomes: What are the illegitimate sources of the inequality we see in the world?

Sources of Inequality

Inequality has emerged in the modern world for a number of reasons. For one, more money is currently accruing to capital than labor, as capital becomes scarcer in a regulated market. These returns to capital outpace that which goes to labor, and the divergence becomes significant over time.

The marketplace for labor has also changed, favoring those with unique skills in technology and finance. Those who are most productive in these areas are compensated handsomely. People who can put their skills to use in the new knowledge economy also often find increasing returns to their investment as compared with more traditional industries, which face diminishing patterns of growth.

President Obama’s answer is to spend more on education. His argument is that higher levels of education lead to increased productivity and better wages. But even if every dollar of additional spending was translated into human capital, this would be insufficient to prevent inequality. After all, many people eschew careers with high salaries because they want something different for their lives—think of art history majors. While these preferences may generate greater well-being, they will not necessarily alleviate income inequality; after all, engineers and computer scientists would see their productivity rise alongside their peers’.

So what about politics? Oxfam made waves at this year’s Davos World Economic Forum with a widely touted study of rising global inequality, “Working for the Few: Political Capture and Economic Inequality.” What sets this piece apart from the virtual avalanche of recent anti-inequality manifestos is that it calls attention to an underreported, though fundamental, cause of economic inequality: political capture. Coming from Oxfam, which doesn't exactly have the best record when it comes to economic assessment, it's a welcome development.

The difference between political and economic causes of inequality is that political inequality is an artifact of government control, while economic inequality flows as a natural consequence of voluntary human action. Political inequality arises when the State controls access to markets or intervenes with largesse extracted from the market. It creates juicy prizes that only the politically connected can access and increases the value of otherwise expensive routes around the State.

The irony here is even when we properly diagnose the problem, we are just as likely to reinforce it as address it. So it is with the Oxfam report. While chastising the business community for putting its hands in public coffers, Oxfam cannot help but recommend policies that encourage only more political panhandling. Progressive taxation, greater public presence in education, health care and social protection, demand for a living wage, and stronger regulation of markets—each, in its own way, contributes to the very problem Oxfam ostensibly hopes to solve.

Take progressive taxation. On the face of it, this is a simple transfer from the rich to the poor. But if that’s the case, why does Warren Buffet pay so little in taxes in an already-progressive system? Or Mitt Romney? Steepening the tax curve only benefits wealthy accountants as the rich discover legal loopholes and tax shelters. Cayman Island accounts provide little in the way of “public benefit,” instead enabling such assets to go to greater capital investment. And greater capital investment only serves to widen the inequality gap, as we explained above.

Regulation of markets is another disturbing entry on the list. Regulation has long been a means for special interest groups to toy with the market process to further their own interests while burdening their competitors. Studies show there is a strong correlation between market regulation, political corruption, and an erosion of trust in public institutions. In other words, talented rent-seekers learn to rig the rules in their favor.

Furthermore, regulatory uncertainty can lead to capital scarcity as lenders will only invest in new ventures with a high enough rate of return to compensate for the increased risk. Firms also operate within a given capital structure that depends on the productivity of their employees. If well-intentioned regulation prices these employees out of the market, there might not be a viable substitute, in which case the productivity and return to that capital falls. Put another way, highly skilled workers are not always a substitute for unskilled workers if you have to radically alter the capital structure to accommodate them. So, say, if meatpackers are priced out of the market, their tools might not maintain their value; instead, the firm may hire an engineer to monitor and maintain a chicken de-boning robot. Ultimately, if regulation causes the existing capital structure to shift radically, existing capital might lose value—leading to far greater returns to what capital remains, increasing the divergence in income between those who hold the capital and those who don’t (e.g., computer coders vs. art history majors).

Finally, wage controls are probably one of the surest ways of undermining the efforts of the poor. It’s no wonder that unions are among the fiercest advocates for wage controls; they jump at any chance to push workers willing to accept lower wages out of the running for jobs. Even worse, those who are willing to work for less are usually the very poor who need the income most. It might not pay all the bills, but it’s certainly better than no job at all. This was indeed the finding of a recent CBO report indicating that current proposals to raise wage floors to $10.10 would result in the elimination of 500,000 jobs.

To competently address any justifiable concerns regarding income inequality, we have to maintain focus on the problematic features of society that lead to it. Simply decrying inequality itself clouds the issue. Political inequality is the sort that makes people worse off, and kudos go to those who are willing to admit this. But it takes more than acknowledgement. It takes an understanding of how wealth is created and how it is distributed to truly root out the illegitimate causes of wealth inequality. Considering just how political inequality operates to undermine the economic forces of wealth creation is therefore a useful lens in determining what makes our society less equal.

  • Adam C. Smith is an assistant professor of economics and director of the Center for Free Market Studies at Johnson & Wales University. He is also a visiting scholar with the Regulatory Studies Center at George Washington University and coauthor of the forthcoming Bootleggers and Baptists: How Economic Forces and Moral Persuasion Interact to Shape Regulatory Politics.
  • Stewart Dompe received his PhD in Economics from George Mason University. He has published articles in Econ Journal Watch and is a contributor to Homer Economicus: Using The Simpsons to Teach Economics. Follow him on Twitter @stewartdompe