Sunday, September 21, 2014

The Oligarchy Fallacy

CAMBRIDGE – Income inequality has received a lot of attention lately, particularly in two arenas where it previously received little: American public debate and the International Monetary Fund. A major reason is concern in the United States that income inequality has returned to Gilded Age extremes; but inequality has increased in many other parts of the world as well, and remains high in Latin America.

What have we learned so far? Perhaps what is most interesting about the current discussion is that much of the focus has been on the consequences of inequality beyond its adverse effect on the welfare of the poor.

One such avenue of debate starts from the hypothesis that inequality is bad for overall economic growth. Another begins with the view that inequality leads to volatility and instability. Did inequality cause, for example, the subprime mortgage crisis of 2007 and hence the global financial crisis of 2008?

A third proposition is that inequality translates into envy and unhappiness: someone who would have been happy at a given income is unhappy if he discovers that others are getting more. A persuasive version of this claim holds that top executives demand and receive outlandish compensation not because they value the money so much, but because they compete with each other for status.

A fourth concern appears to trump even the first three. It is the fear that, because there is so much money in politics, the rich succeed in persuading governments to adopt policies that favor them as a class. Whereas the first three sources of concern are amenable to self-correction, at least in a democracy, the concentration of economic and political power in an oligarchy is self-reinforcing. In the US, recent Supreme Court decisions regarding campaign contributions suggest that the influence of money in politics will only grow.

But pursuing the anti-oligarchy argument is not the best way to reduce inequality. Rather, we should work from the premise that poverty in particular, and inequality in general, is simply undesirable. Even in the US, most voters care about inequality, and even among the top 1%, approximately two-thirds believe that income differences are too large and support progressive taxation. Most Americans believe in helping the less fortunate, provided that it can be accomplished without undermining economic efficiency through excessive government intervention or distortion of incentives.

The problem is that, despite their economic self-interest, voters often elect, and reelect, politicians who enact laws that are inconsistent with such goals. Ten years ago, for example, America’s elected leaders somehow hoodwinked the median US voter – who is most likely to leave little to his or her heirs – into believing that it was necessary to eliminate taxes on $5 million estates in order to protect small family-owned farms.

In other words, the problem is not that the median voter is unwilling to trade off growth in exchange for more equality. The problem is that the political process produces outcomes that deliver both less growth and less equality.

For the US, the most sensible measures include expansion of the Earned Income Tax Credit (EITC), elimination of payroll taxes for low-income workers, a cut in deductions for high-income taxpayers, and restoration of higher inheritance taxes. These are policies that reduce inequality efficiently, at relatively low cost to aggregate income. Other policies – including universal pre-school education and universal health care – may even promote overall economic growth while reducing inequality, especially if they are financed by efficiency-enhancing measures such as the elimination of fossil-fuel subsidies (and, preferably, their replacement with a tax).

Meanwhile, many government programs that are billed as ways to improve income distribution benefit the poor relatively little and impair economic efficiency. The original rationale for agricultural subsidies was largely to help small farmers, but the main beneficiary has long been agribusiness. Mortgage subsidies contributed to the subprime loan crisis, without even primarily helping lower-income families. And yet many Americans are persuaded to support such policies, not because it is in their interest, but because they do not understand the economics.

Other countries have similar programs that are sold as pro-equality but are inefficient or even undermine their stated goal. In developing countries, distortionary measures that tax, subsidize, or regulate food and energy prices tend to be poor tools for improving income distribution, and frequently have the opposite effect. Of the more than $400 billion that countries spend on fossil fuel subsidies each year, for example, far less than 20% of the benefits go to the poorest 20% of the population. A disproportionately small share of social spending goes to the poorest 40%. Conditional cash transfers, on the other hand, have proven highly effective; they reach the poor while promoting education and health.

The anti-oligarchy argument claim is that the rich have too much money, which they use to elect politicians who will enact laws that favor their interests. But it seems better to argue about 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.

The alternative to such engagement is a very roundabout strategy that would achieve more enlightened policies by weakening the ability of the rich to buy votes. However important that goal may be, attaining it requires reducing the share of income that goes to the rich by addressing inequality, which requires pursuing pro-equality policies, like the EITC and pre-school education. Is complaining about oligarchy really a more effective strategy for achieving these policies than arguing the case for them directly?

Read more from "Piketty's Charge"

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  1. CommentedBruce Steinback

    Not bad, but not enough. The fact of the matter is that the split between labor and capital, which used to be fairly stable at about 60% labor, has now dipped into the low 50s (in the US at least). Unless something is done to stop this erosion, we will become a nation of haves and have-nots. It strikes me that at least one place to start is an increase in the minimum wage. Why should we increase EITFC to subsidize Walmart? Let them pay their workers a living wage.

  2. CommentedAlessandro Daliana

    Taxing means attacking the problem from the end, the consequences. This means the harm has already been done and in some way that income is legitimized in the process.

    A much more efficient way of reducing income inequality is to increase the cost of doing business thereby valuing the labor component before inequality sets in.

    Historically, businesses evolve from the possession and/or control of an asset that provides a competitive advantage in the markets in which the company operates. This fact is attested to by the preponderance of laws governing property rights. Easily over 80% of the laws on the books of any country. In acknowledging this very simple reality it makes sense to use the legislative process to extend property rights to private information thus with one swoop of the pen obliging information companies to compensate users for the use of their information and reducing inequality.

  3. CommentedLance Brofman

    . In free-market capitalism, capital generates income for the owners of the capital which in turn is used to create additional capital. This is very good. Sometimes, it can be actually too good. As capital continues to accumulate, its owners find it more and more difficult to deploy it efficiently. The business sector generally must interact with the household sector by selling goods and services or lending to them. When capital accumulates too rapidly, the productive capacity of the business sector can outpace the ability of the household sector to absorb the increasing production.

    The capitalists, or if you prefer, job creators use their increasing wealth and income to reinvest, thus increasing the productive capacity of the business they own. They also lend their accumulated wealth to other business as well as other entities after they have exhausted opportunities within business they own. As they seek to deploy ever more capital, excess factories, housing and shopping centers are built and more and more dubious loans are made. This is overinvestment. As one banker described the events leading up to 2008 – First the banks lent all they could to those who could pay them back and then they started to lend to those could not pay them back. As cash poured into banks in ever increasing amounts, caution was thrown to the wind. For a while consumers can use credit to buy more goods and services than their incomes can sustain. Ultimately, the overinvestment results in a financial crisis that causes unemployment, reductions in factory utilization and bankruptcies all of which reduce the value of investments.

    If the economy was suffering from accumulated chronic underinvestment, shifting income from the non-rich to the rich would make sense. Underinvestment would mean there was a shortage of shopping centers, hotels, housing and factories were operating at 100% of capacity but still not able to produce as many cars and other goods as people needed. It might not seem fair, but the quickest way to build up capital is to take income away from the middle class who have a high propensity to consume and give to the rich who have a propensity to save (and invest). Except for periods in the 1950s and 1960s and possibly the 1990’s when tax rates on the rich just happened to be high enough to prevent overinvestment, the economy has generally suffered from periodic overinvestment cycles.

    It is not just a coincidence that tax cuts for the rich have preceded both the 1929 and 2007 depressions. The Revenue acts of 1926 and 1928 worked exactly as the Republican Congresses that pushed them through promised. The dramatic reductions in taxes on the upper income brackets and estates of the wealthy did indeed result in increases in savings and investment. However, overinvestment (by 1929 there were over 600 automobile manufacturing companies in the USA) caused the depression that made the rich, and most everyone else, ultimately much poorer.

    Since 1969 there has been a tremendous shift in the tax burdens away from the rich on onto the middle class. Corporate income tax receipts, whose incidence falls entirely on the owners of corporations, were 4% of GDP then and are now less than 1%. During that same period, payroll tax rates as percent of GDP have increased dramatically. The overinvestment problem caused by the reduction in taxes on the wealthy is exacerbated by the increased tax burden on the middle class. While overinvestment creates more factories, housing and shopping centers; higher payroll taxes reduces the purchasing power of middle-class consumers. ..."

  4. CommentedLee Hubbard

    There is a theme which seems to run through all suggestions to reduce inequality: higher taxes in one form or the other. Should we be convinced that the money thus collected would be spent productively, that would seem to be a correct approach. Alas, our experience is otherwise: Politicians pass legislation designed to get themselves reelected including creation of inefficient, permanent bureaucracies guaranteed to support them or their party in perpetuity. Seems to me, we should a) emphasize tax credits for companies that implement training and apprentice programs, b) reform public education, I.e., remove it from union control, c) require gov't to balance its budget annually at all levels, and d) raise rates on high incomes until the returns are offset by the loss in revenue. Not a perfect solution, but at least some ideas I haven't seen or heard in the current discussion.

  5. CommentedZsolt Hermann

    I think there are two important principles that might guide us building a new, more equal system.
    1. Profit in itself is not evil.
    2. Changes have to be made using positive motivation, otherwise they will not be sustainable.

    1. Working, selling for profit is normal, as long as the product is naturally necessary for the consumers and the price is agreed by mutual consensus.
    Neither of those conditions exist today. The refined, "brainwashing" marketing is inventing artificial needs, artificial desires and products and than a "necessity" is implanted into the mind of people who start chasing those artificial, and many times even harmful products.
    The price is highly inflated, securing the highest possible profit margin, much higher than it could be agreeable if a true consensus was used. As a result the consumers are forced to work, pay more for goods, products, pleasures they do not even need and they are forced to pay way above their means, pushing them into intolerable debt, thus they become trapped in the system on both ends.
    Moreover as others were saying the system is constantly "refined", "adjusted" towards the tip of the pyramid, making the rich richer, and more powerful. Not many western countries even try to pretend that they are not oligarchies, and that democracy and freedom in its classical meaning does not exist. And we can also mention the "money making out of nothing" effect of the stock exchange, investment banking, hedge funds, and the growing number of "virtual wealth making" schemes which have no place in a natural human system.

    2. Change is obviously necessary, as the human resources are already exhausted, and even if on paper today there is hardly any need for manual human labor to produce enough necessities for everybody, there is still the pressing question what to do with the potentially unemployed billions of people.
    If we also take into consideration that humanity has become a globally interconnected and interdependent system, where everybody is responsible for everybody else while being fully dependent on everybody else, it will become clear the "1%" cannot simply ignore the "99%", since we are all sitting on the same sinking boat.
    If a completely new, global, integral "education program" would be implemented for each and every human being, explaining the principles and necessary conditions of a global, integral system, people on both ends of the spectrum could start understanding and implementing the necessary changes leading to a more equal, mutually complementing and most of all sustainable system.
    There will still be richer and poorer, everybody receiving according to their contribution to the whole and the effort they had to exert.
    Only the artificial extra would be removed in order to make the system work and stay working.
    If we don't choose the positive path the negative path, deepening crisis, uprisings, riots, even wars will force us to change as it happened so far during our history. But we have a chance to take "our fate" into our own hands foregoing the negative blows.

  6. CommentedLynn Carey

    Oh, the irony. How is the author so completely oblivious to the fact that the examples he cites of "poorly conceived governmental programs" are themselves prime illustrations of the problem of inequality, concentration of wealth and concentration of political influence, which is then used to "game the system" and direct earned rents to the economic elite? Is he completely unaware of the recent work of Martin Gilens, Thomas Piketty and Larry Bartels - particularly the new Gilens research showing that politicians are largely influenced by the demands of elites, only slightly concerned about the middle class and not at all interested in the poor? The existence of that bias tells us most of what we need to know about how such rent-seeking policies regarding big ag subsidies, relaxed regulation leading to the sub-prime crisis and the repeal of the estate tax got enacted - it wasn't because votes were "fooled" or "don't understand economics", it was because the folks elected by the voters either were or became captive to economic interests and their lobbyists (who are more than happy to influence politicians of either party). As things stand in terms of economic / political influence, ordinary voters stand little chance of enacting the rational policies that Mr. Frankel advocates - and even if they did enact such policies, the policies are likely to be subverted by the elites (e.g., big ag using its power to convert the farm subsidy program to its own interests). The defective logic of Mr. Frankel's argument is breathtaking.

      Portrait of Jeffrey Frankel

      CommentedJeffrey Frankel

      Wow. Now I know why I don’t usually write on inequality. Within the first few hours of publication of my column I have been accused of being “a very idealistic version of Joe Stiglitz,” a “communist,” and breathtakingly oblivious to the fact that the concentrated wealth buys political influence. I don’t real think I am any of those things. To Lynn Carey: I do know the research of Thomas Piketty and Larry Bartels and there are links to it from places in my op-ed. I fully agree that people with a lot of money wield disproportionate power.

  7. CommentedWalter Gingery

    Frankel's faith in the political process is touching ( '. . .point out which politicians support them. '), but it takes money to do the "pointing out" and as long as the rich and the business interests have the money, the experience of the last 40 years leads me to believe that nothing will change.

    An instance of what we're up against: In the pivotal congressional elections of 2010, business interests pumped in $972 million in soft money contributions, mostly to the Republican Party vs. $10 million for labor -- a staggering 97-to-1 business advantage.

    Another instance: lobbying. Smart lobbyists know that it is not just the final vote on a bill that counts, but every step along the way. Business enjoys huge political advantages by having its lobbyists meet day in and day out with key legislators and their staffs. In the "banner years" of 2009 and 2010, when Washington was busy doling out taxpayer bailout money to troubled banks and Congress was writing laws on health care and regulating Wall Street, $7 billion was spent on lobbying. Of that, $6 billion, or more than 87%, was pent by business interests. No other lobbying interest was even a close second. Business outspent labor on lobbying by 65 to 1.

    Not surprising, since business lobbyists as early as 2006 had outnumbered labor lobbyists by more than 30 to 1 (12,785 business lobbyists to 403 for labor).