The Simple Economics of Income Inequality
We are in the midst of a vital policy debate about inequality and the distribution of income. Many distinguished economists are participants in this debate. Nonetheless, a simple discussion of the basic economics of inequality is lacking. On this topic, there are several points worth making.
Income is not “divided”; it is earned. There is no pot of income to be divided among the citizens of a society. Rather, individuals make choices about work and allocation of capital that they control, and these choices lead to earning of incomes.
No zero-sum world. The fallacy of assuming a division of a fixed sum of income is an example of a more general fallacy, the belief in a zero-sum world. In a zero-sum world, there would indeed be a pot of income to divide. But in the actual nonzero-sum world in which we live, the amount of income for each individual is determined by the decisions of that individual operating in a market, and different decisions can lead to different outcomes. Belief in a zero-sum world is one of the major fallacies leading to destructive economic policies.
Earnings differ by productivity. In particular, economics teaches us that individual earnings are approximately equal to each individuals “marginal product,” the additional contribution of a worker to earnings of the employer. This means that as a first approximation, differences in earnings are due to differences in productivity, and those with higher earnings are simply more productive. Moreover, the total product created by an individual (whether a worker or an investor) is greater than the marginal product, so that higher earning individuals also contribute more to society.
Human capital affects earnings. Although economists distinguish between capital and labor, in reality it is impossible to separate them because all workers have embedded in themselves some human capital. Some of this human capital is innate, some is acquired in school, and some on the job, but a wage includes a payment both for the labor provided by the worker and for the human capital involved. Moreover, the human capital component of the wage is much larger for most workers (those earning above the minimum wage) than is the labor component. It is not meaningful to distinguish between earnings of labor and of capital.
People respond to incentives. Workers and owners of capital make choices about allocation of their labor and capital. Any attempt to use the tax system to reduce inequality will lead to different choices. Higher taxes on labor will lead some to work less, or to retire earlier, or to take easier but lower paying jobs. Investors will also skew their investments in response to taxes, perhaps by investing in safer but less productive alternatives. Therefore, any effort to redistribute income will also have the effect of reducing the total amount of income in society, and the amount which might be redistributed. Reduced incomes will lead to reduced economic growth, and so will harm everyone, including the poor, in the long run.
Income levels are what matter. What should concern us is the level of incomes of the poor and middle class, not the pattern of incomes by class. To increase the incomes of lower income people, we should adopt policies which increase their opportunities, and refrain from policies that reduce these opportunities. For example, minimum wages reduce entry level jobs, and for those workers who are hired, there is less on-the-job training. For both of these reasons, it is more difficult for low wage workers to move to the middle class. Obamacare creates incentives for small firms to hire no more than 49 workers, and for workers to work no more than 29 hours; both of these policies reduce middle class earnings and economic mobility. Laws such as Dodd-Frank and other increases in economic regulation create uncertainties for lenders and investors, and so restrict the use of capital in the economy. Reduced investment means lower earnings of labor.
The real danger from focusing on inequality is that it leads to a static view of the economy. The only way to benefit people in the long run is to focus on economic growth, and paying attention to inequality leads us in exactly the wrong direction. This may be the purpose of the current focus on inequality: It is to draw attention away from the actual destructive policies of the current administration.
Paul H. Rubin is Professor of Economics at Emory University. He is a former President of the Southern Economic Association and was a senior economist in the Reagan Administration.
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