Andres Manuel Lopez Obrado Vincent Isore/IP3/Getty Images

How Not to Fight Income Inequality

Trying to combat income inequality through mandated wage compression is not just an odd preference. It is a mistake, as Mexico's president-elect, Andrés Manuel López Obrador, will find out in a few years, after much damage has been done.

CAMBRIDGE – Suppose two people hold different opinions about a policy issue. Is it possible to say that one is right and the other wrong, or do they just have different preferences? After all, what is the difference between an odd preference and a mistake?

A preference influences a choice that is expected to deliver the goal the chooser wants to achieve. A mistake is a choice based on a wrong belief about how the world works, so that the outcome is not what the chooser expected. Unfortunately, this may be a costly way to learn. It also may be inconclusive, because it is always possible to attribute the mistake’s bad consequences to other factors.

A case in point is the decision by Mexican President-elect Andrés Manuel López Obrador (AMLO), to lower the salaries of the higher echelons of the civil service, including himself, capping them at $5,707 per month. Many greeted the decision, announced in July, with glee. It showed that AMLO was committed to fiscal austerity and income equality.

But what appears to be a well-articulated preference will prove to be a serious mistake. Unfortunately, AMLO will find out only in a few years, by which point the damage inflicted on Mexico will be huge.

Interfering with market prices to achieve fairness – an idea that harks back to St. Thomas Aquinas and even Aristotle – is probably one of the worst economic policies ever. Governments in many countries regularly set prices – especially for energy, foreign exchange, or credit – artificially low, leading predictably to under-investment and shortages. Venezuela is an extreme case that dramatizes the consequences. But are public sector wages another example of this practice?

The answer is more nuanced. In general, governments pay their employees significantly more on average than the private corporate sector, because government services such as education, health care, justice, and administration are on average more skill-intensive. As a result, government employees have significantly higher levels of schooling – four more years, on average, in Mexico. But even controlling for this, a study by the CAF Development Bank showed that average wages are higher in the public sector in Latin America. In Mexico, government employees’ wages were about 13.5% higher than private-sector wages in 2012.

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The same study also showed that wages in the public sector are significantly less unequal than in the private sector. This means that while the public sector pays more than the private sector at the median, the situation is reversed at the top end of the pay scale. This was not the case in Mexico, where the public-sector premium fell to zero but did not become negative. AMLO now wants to join the rest of the continent.

The compressed wage structure that AMLO will introduce typically means that, at the low end, public sector jobs are highly coveted: they offer higher pay, shorter hours, better benefits (such as pensions and health insurance), and greater stability. Turnover tends to be very low and political parties try to make sure that jobs go to their supporters.

By contrast, at the high end, governments often struggle – and often fail – to attract and retain talent. As a consequence, government agencies never develop the deep knowledge, institutional memory, and competence they need to perform their functions effectively. Central banks, with their separate pay scale, often are the exception that proves the rule.

To cope with this competence deficit in their client countries, multilateral development institutions, such as the World Bank, often create project-management units run by higher-paid consultants, and dismantle them when the project is completed. These workarounds are not ideal, because they don’t develop long-term institutional capabilities. To a large extent, Mexico had been an exception, because it paid salaries that enabled the government to attract and retain highly educated career bureaucrats.

Politicians such as AMLO should ask themselves why profit-maximizing firms believe that they cannot boost their bottom lines by saving on senior management salaries. As firms compete for skills, they bid up wages, leaving the public sector with less qualified employees. Clearly, many young people want to work for the government out of an idealistic commitment to public service and as a learning opportunity. But when public-sector wages are depressed, they usually do so for just a few years, before they start a family, and certainly not for a lifetime, which is what many complex public-sector agencies often require.

Is this a problem? Good governments rightly want major firms and the rich to pay their fair share of taxes. They want corporations not to abuse their market power, pollute the environment, or sell unsafe products. They want to protect people from criminal gangs. They want the currency to be stable and financial institutions to be safe, so that people’s savings are secure and taxpayers do not have to bail out the banks. They want public projects that are well conceived and structured, and procurement processes that protect the budget from opportunistic or corrupt suppliers. They want oil and mining concessions to be allocated efficiently and to maximize government revenue.

Trying to accomplish these valuable tasks while paying below-market salaries is penny wise but pound foolish. Tax collectors, regulators, and prosecutors need adequate resources to win their difficult battles.

AMLO’s decision to lower the wages of public employees has already led many high-ranking officials to seek employment elsewhere. Those who are entitled to early retirement are taking it, rather than waiting for AMLO’s cut. Many in AMLO’s own party will celebrate, because they can fill the vacancies with loyalists. But these benefits will come at the cost of a less capable state that is less able to deliver on AMLO’s most cherished goals.

Trying to achieve greater equality through mandated wage compression is not just an odd preference; it is a mistake. It will deliver a state less able to contribute to a more just society.

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