How Can Inequality Be Good?

Wednesday, July 13, 2011

How are we to understand inequality? I believe that the main way to evaluate inequality in income or wealth—and how those numbers change over time, both within and among countries—is to ask whether the inequality is the good or bad kind.

Many people, especially academics and other intellectuals, would find the phrase “good inequality” jarring. They can hardly think of any aspect of inequality as being good. Yet a little thought makes clear that some types of economic inequality have great social value. For example, it would be hard to motivate most people to exert much effort, including creative effort, if everyone had the same earnings, status, prestige, and other rewards. Many fewer individuals would engage in the hard work involved in finishing high school and going on to college if they did not expect their additional education to bring higher incomes, better health, more prestige, and better opportunities to marry.

On my first trip to China in 1981, I visited several factories in the Beijing area. All the employees in each factory received more or less the same pay, and they could hardly ever be fired for bad work or absenteeism. This was an extreme egalitarian approach to compensation, with the result that no one worked hard, even though Chinese workers have traditionally been known for their diligence and energy. The picture was more or less the same in all the factories I visited. Urban China, highly egalitarian at the time, was also extremely poor because of very low productivity. China’s economic miracle has been based, in good measure, on allowing much greater inequality in pay to motivate greater productivity in both urban and rural areas.

It would be hard to motivate most people to exert much effort if everyone had the same earnings, status, prestige, and other rewards.

Bad inequality is the kind that reduces efficiency, productivity, and utility. About 80 percent of China’s vast population in 1981 lived in rural areas, yet it was then virtually impossible for anyone born in rural China to gain legal residence in a city, even though farm incomes averaged less than half of urban incomes. The result was a large inequality between urban and rural areas that lowered overall efficiency and productivity. Urban-rural inequality has not gone away in China; if anything, it has grown worse during the past thirty years because urban incomes have grown much faster than farm incomes. People born on farms are still at an artificial disadvantage: their schools tend to be of low quality and it is still not easy, although much easier than in the past, to gain legal residency in a city.

Earnings inequality in the United States and many other countries has increased greatly since the late 1970s, in large part because of globalization and technological progress that raised the productivity of people with greater education and skills. The average American college graduate earned about a 40 percent premium over the average high school graduate in 1980; twenty years later this premium had risen to 70 percent. The good side of this earnings inequality based on higher education is that it induced more young people—especially young women—to attend and finish college. The bad side is that many sufficiently able children could not take advantage of the greater returns from a college education because their parents failed to prepare them to perform well in school, or they went to bad schools, or they could not afford to attend. As a result, the incomes of high school dropouts and of many high school graduates stagnated while incomes boomed for many college graduates, especially those with postgraduate education.

Although inequality in many developing and developed countries grew during the past thirty years, world income inequality actually declined. Credit this to a much more vigorous growth in per capita income in populous developing countries—Brazil, China, India, and Indonesia, for example—than in the rich Western countries and Japan. World poverty declined enormously, and so did the income gap between poorer and richer countries. Thus, a large decline in the bad kind of world inequality.

A large part of the increased income and wealth inequality since the mid-1990s in the United States and some other rich countries was due to the explosion of financial-sector incomes before the financial crisis. Most people will not object to huge incomes and vast wealth when they feel the money was earned, as with icons such as Steve Jobs, Bill Gates, and Warren Buffett. However, they are justifiably unhappy about large paychecks for CEOs who mismanage their companies, huge bonuses and stock options for executives who took unreasonable risks and then were bailed out by the Fed and the Treasury, and other big paydays for work that (perhaps unjustly) does not appear to be particularly socially valuable.

People are justifiably unhappy about large paychecks for CEOs who mismanage their companies, and huge bonuses and stock options for executives who took unreasonable risks and then grabbed taxpayer bailouts.

Some types of inequality are not easily classified. For example, would an increase in the marginal income tax rate from 35 percent to 45 percent on individuals earning over $500,000 have much of an effect on how hard and how long they work, and their efforts to legally (and illegally) reduce the income reported to tax authorities? Those who support this kind of tax increase deny that it would have a big effect, while opponents are just as certain that it would significantly discourage effort. The evidence is far from conclusive, but studies by Edward Prescott, Richard Rogerson (see The Impact of Labor Taxes on Labor Supply: An International Perspective), and others into the relationship between the amount of work and average tax rates on earnings is persuasive: tax rates in general seem to have strong negative effects on effort. However, the evidence is silent on the ways in which much-higher tax rates on individuals with very high incomes affect their effort and other behavior.

Some authors have claimed a sizable negative relation between social and economic inequality and the healthiness of a population (for an influential work see M. G. Marmot’s “Understanding Social Inequalities in Health,” published in Perspectives in Biology and Medicine in 2003). I have no doubt that people who try but fail to climb the income and prestige ladder may suffer stress and poor health. On the other side, the stress levels and health of those who succeed tend to be improved by their success. The data on happiness and health show conclusively that higher-income persons are both happier and much healthier than others. Less clear is whether narrowing the degree of inequality in health and status, while maintaining the incomes and social ranking of the poor, would significantly improve overall health. I am doubtful.