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Deserving and Undeserving Inequality

From the Becker-Posner Blog:

During the past 25 years, inequality in the world has greatly declined mainly because of the rapid growth in incomes in large poorer nations, especially China, India, and Brazil. This led to enormous declines in worldwide poverty as hundreds of millions of families were pulled above poverty thresholds, such as having to live on $1 or $2 dollars a day. At the same time, however, inequality between families grew rapidly within many countries, especially the United States and other Anglo-Saxon countries, China, and India. Although attitudes to inequality differ across cultures and countries (see, for example Alesina, Di Tella, and MacCulloch, “Inequality and Happiness: are Europeans and Americans different?”), in every society these attitudes depend on whether the inequality is considered to improve efficiency and to be deserving – the difference between “good” and “bad” inequality.

The great majority of people in different cultures do not object to someone who has made lots of money when they have superior abilities and talents, and they work hard at producing what are considered useful goods or services. Actors like Tom Hanks or Jennifer Aniston earn millions of dollars per film, yet they are admired as stars rather than condemned for being millionaires because films are a popular form of entertainment. Bill Gates, Steve Jobs, and others who became billionaires by creating innovative companies that provide highly valuable goods and services to millions of individuals are widely admired as the business equivalents of rock stars rather than attacked for their great wealth. Leading transplant and other doctors who become successful and very wealthy through extensive education and superior skills are recognized for their valuable contributions to extending the lives of very sick individuals, and few object to their high earnings.

On the other hand, when hedge fund managers become rich by using arbitrage activities to narrow the spreads in interest rates and other prices between different regions (most hedge funds do not only engage in arbitrage) they produce useful services, but the value of what they do is not so apparent as the businessmen who make successful products. It is still harder for many to understand the usefulness of “speculators” who do well financially by successfully shorting shares of companies or commodities, such as oil, because they believe correctly that their prices will fall in the future. Their activities add value by smoothing out the prices of these shares and commodities over time, but few people like individuals who bring bad news, or who profit from anticipating bad news.

Other forms of behavior are objectionable because they both add to inequality and lower economic efficiency. These are the most dangerous sources of inequality, and they create negative attitudes toward the wealthy, and even at times social unrest. One illustration is the arbitrary use of government power to give or take away wealth. Some individuals become very wealthy because of the political favors they receive, while others lose much of their wealth because of unjust governmental treatment. Examples include Carlos Slim and the Russian oligarchs who gained big economic advantages by receiving monopoly positions in industries like telecommunications when they were privatized, and the officials of Fannie Mae and Freddie Mac who became wealthy by using their political connections to acquire a dominant position in the US residential mortgage market. A highly publicized recent example is the Indian businessmen who obtained special privileges in telecommunications and other industries because of corrupt government officials.

Arbitrary taking of property through eminent domain and other government power without proper compensation is a major source of discontent. Chinese farmers objected, and some even rioted, when governments took their land to build infrastructure or factories. Governments in the United States sometimes use eminent domain powers to take the land and housing of families in order to build public and private redevelopment projects. In these and related examples, people object partly to the forced transfers of property to governments, and partly to inadequate compensation to small property owners, at least inadequate in the eyes of those losing their properties and their neighbors.

Since earnings is the biggest contributor to income for the great majority of families, the considerable inequality in earnings has been extensively dissected. During the past several decades, technological advances that favored highly skilled workers raised the earnings of college graduates by a lot relative to those with lesser education in the United States, Great Britain, China, India, and many other countries. This sharply higher relative earnings of the more educated has been accepted for the most part since it contributes to greater productivity. Criticized are the various obstacles that prevent able boys and girls from acquiring a college education, such as broken and poor families, and inadequate schools. These obstacles lead to bad and inefficient inequality that sometimes causes frustration and discontent among those affected.

Attractive public policies encourage the good earnings inequality and attack the bad inequality through laws, taxes and subsidies, and in other ways. For example, charter schools, vouchers, merit pay for good teachers, Head Start programs, and student loans help more able students from disadvantaged backgrounds enter and finish college.

Public policies can also help overcome inefficient sources of inequality in other types of income, although these policies often run into powerful political opposition. Privatization and other sales of government properties should be auctioned off, not given away to favored businessmen. Governments should be allowed to use eminent domain and similar laws to take property from individuals only in sharply constrained circumstances with very high benefit/cost ratios. Regulations should be based on rules rather than discretion, so that the regulators cannot easily get “captured” by the industries they are regulating, including capture through corruption of government officials.

I agree with the argument by Warren Buffet in a recent New York Times op-ed piece that it is neither fair nor efficient for highly wealthy individuals like himself to be paying a smaller fraction of their incomes in taxes than middle income and many lower income persons. However, the way that inequity is corrected can make an enormous difference to economic efficiency as well as to the degree of inequality. The best way to reduce these inequities is to substitute for the present tax mess an inclusive equal percentage tax on all incomes, where the income base would be greatly widened by eliminating deductions on mortgage interest payments, restraining the tax-deductibility of charitable contributions, and eliminating special subsidies, such as the generous ones to ethanol producers. With a flat broad equal percent tax on all incomes, capital gains and other sources of income that currently have special tax treatment should then be taxed at the same flat rate as earnings and other incomes.

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