Richard Epstein: In Praise of Income Inequality

You cannot make the poor richer by making the rich poorer.

One month into the second term of the Obama administration, the economic prognosis looks mixed at best. On growth, the U.S. Department of Commerce reports the last quarter of 2012 produced a small decline in gross domestic product, without any prospects for a quick reversal. On income inequality, the most recent statistics (which only go through 2011) focus on the top 1 percent.

“Incomes Flat in Recovery, But Not for the 1%” reports Annie Lawrey of the New York Times. Relying on a recent report prepared by the well-known economist Professor Emmanuel Saez, who is the director for the Center of Equitable Growth at Berkeley, Lawrey reports that the income of the top 1 percent has increased by 11.2 percent, while the overall income of the rest of the population has decreased slightly by 0.4 percent.

Growth vs. Equality

What should we make of these numbers? One approach is to stress the increase in wealth inequality, deploring the gains of the top 1 percent while lamenting the decline in the income of the remainder of the population. But this approach is only half right. We should be uneasy about any and all income declines, period. But, by the same token, we should collectively be pleased by increases in income at the top, so long as they were not caused by taking, whether through taxation or regulation, from individuals at the bottom.

This conclusion rests on the notion of a Pareto improvement, which favors any changes in overall utility or wealth that make at least one person better off without making anyone else worse off. By that measure, there would be an unambiguous social improvement if the income of the wealthy went up by 100 percent so long as the income of those at the bottom end did not, as a consequence, go down. That same measure would, of course, applaud gains in the income of the 99 percent so long as the income of the top 1 percent did not fall either.

This line of thought is quite alien to thinkers like Saez, who view the excessive concentration of income as a harm even if it results from a Pareto improvement. Any center for “equitable growth” has to pay as much attention to the first constraint as it does to the second. Under Saez’s view of equity, it is better to narrow the gap between the top and the bottom than to increase the overall wealth.

To see the limits of this reasoning, consider two hypothetical scenarios. In the first, 99 percent of the population has an average income of $10 and the top 1 percent has an income of $100. In the second, we increase the income gap. Now, the 99 percent earn $12 and the top 1 percent earns $130. Which scenario is better?

This hypothetical comparison captures several key points. First, everyone is better off with the second distribution of wealth than with the first—a clear Pareto improvement. Second, the gap between the rich and the poor in the second distribution is greater in both absolute and relative terms.

The stark challenge to ardent egalitarians is explaining why anyone should prefer the first distribution to the second. Many will argue for some intermediate solution. But how much wealth are they prepared to sacrifice for the sake of equality? Beyond that, they will have a hard time finding a political mechanism that could achieve a greater measure of equality and a program of equitable growth. The public choice problems, which arise from self-interested intrigue in the political arena, are hard to crack.

These unresolved tensions are revealed by looking at a passage from Saez’s report Striking it Richer. Saez is largely indifferent to these problems of implementation when he observes ominously that

falls in income concentration due to economic downturns are temporary unless drastic regulation and tax policy changes are implemented and prevent income concentration from bouncing back. Such policy changes took place after the Great Depression during the New Deal and permanently reduced income concentration until the 1970s. In contrast, recent downturns, such as the 2001 recession, lead to only very temporary drops in income concentration. 

The policy changes that are taking place coming out of the Great Recession (financial regulation and top tax rate increase in 2013) are not negligible but they are modest relative to the policy changes that took place coming out of the Great Depression. Therefore, it seems unlikely that US income concentration will fall much in the coming years.

Let’s unpack this. It is surely true that the top 1 percent (or at least the top 1 percent of that 1 percent) is heavily invested in financial instruments, and thus will suffer a decline in income with the regulation of the financial markets. But by the same token, it would be absurd to praise any declines in overall capital wealth because of its supposed contribution to greater equality for all individuals. Nor would it make any sense to describe, as Saez does, the current situation as one of “booming stock-prices” when the Dow Jones Industrial Average still teeters below its 2007 high. Take into account inflation and one finds that the real capital stock of the United States has actually declined over the last six years, which reduces the wealth available to create private sector jobs.

Nor, moreover, is there anything permanent about the 2012 gain in income at the top. As Saez himself notes, some portion of the recent income surge has resulted from a “re-timing of income,” by which high-income taxpayers accelerate income to 2012 to avoid the higher 2013 tax rates. Accordingly, we can expect that real incomes at the top will be lower in 2013 than otherwise would have been the case. Indeed, it is possible that these “modestly” higher taxes could produce the worst of both worlds, by depressing government revenues and reducing the income of the rich.

Saez’s own qualification is best read as a backhanded recognition of the perverse incentives that rapid changes in the tax structure create. It is a pity that he does not go one step further to accept the sound position that low, flat, and steady tax rates offer the only way—the only equitable way—to sustainable overall growth.

A Return to the New Deal?

Unfortunately, Saez would rather move our system precisely in the opposite direction. He praises the dramatic shifts that took place during the Great Depression, when marginal tax rates at the federal level reached 62 percent under Hoover’s Revenue Act of 1932, and stayed high during Roosevelt’s New Deal period. The anemic economic performance of the Roosevelt New Deal arose in large part from a combination of high taxation and destructive national policies that strangled free trade, increased union power, and reduced overall agricultural production. Today, Saez concentrates on the income growth of the top 1 percent. He does not address the feeble levels of economic growth over the last five years.

Saez may think that the latest round of tax increases and financial regulations are “modest” in the grand scheme of things. But their effects have been predictable. The declines in productivity have translated into lower levels of income and well-being for all affected groups.

The blunt truth remains that any government-mandated leveling in society will be a leveling down. There is no sustainable way to make the poor richer by making the rich poorer. But increased regulation and taxation will make both groups poorer. Negative growth hardly becomes equitable if a larger fraction of the decline is concentrated at the top earners.

The Middle Class and the Minimum Wage

The effort to promote equitable growth at the expense of the top 1 percent has serious consequences for current policy. It is no accident that in his recent State of the Union Address, President Obama once again called for increases in taxes on “the wealthiest and the most powerful.” If adopted, these changes would make the tax system more progressive and the economy more sluggish. 

Indeed the President goes further. He pushes for the adoption of other wrong-headed policies that would also hurt the very people whom they are intended to help. Consider that the Lowrey story featured a picture of President Obama appearing before a crowd at the Linamar Corporation in Arden, N.C., seeking to make good on his promise to raise the minimum wage to $9.00—to advance, of course, the interests of the middle class to whom the President pays undying allegiance.

The President thinks he can redistribute income without stifling economic growth. The simple rules of supply and demand dictate that any increase in the minimum wage that expands the gap between the market wage and the statutory wage will increase the level of unemployment. The jobs that potential employees desperately need will disappear from the marketplace. In a weak economy, a jump in the minimum wage is likely, as the Wall Street Journal has noted, to reduce total jobs, with unskilled minority workers bearing the brunt of the losses.

Unfortunately, the President displays his resolute economic ignorance by proclaiming, “Employers may get a more stable workforce due to reduced turnover and increased productivity.” But they can get that stability benefit unilaterally, without new legislation that throttles other employers for whom the proposition is false. Only higher productivity secures long-term higher wages.

Indeed, the best thing the President could do is to just get out of the way. After over four years of his failed policies, Mortimer Zuckerman reports that unemployment rates still hover at 8 percent, and 6.4 million fewer people have jobs today than in 2007. That’s an overall jobs decline of 4.9 percent in the face of a population growth of 12.5 million people from July 2007 to July of 2012. The same period has registered sharp increases in the number of people on disability insurance (to 11 million people) and food stamps (to some 48 million).

There is a deep irony in all of these dismal consequences. The President’s State of the Union Address targeted the plight of the middle class. That appeal always makes political sense—but it also makes for horrific economic policy. All too often, the calls for equitable growth yield anything but the desired outcome.

Rather than focus on “equitable growth,” the President should focus on flattening the income tax and deregulating labor markets. Today’s constant emphasis on progressive taxation and government intervention in labor markets will continue to lead the country, especially the middle class, on a downward path.

Richard A. Epstein, the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, is the Laurence A. Tisch Professor of Law, New York University Law School, and a senior lecturer at the University of Chicago.