Editor’s Note: This is an edited excerpt from a longer essay by Mr. Lazear, published by the Hoover Institution as part of a new initiative, "Socialism and Free-Market Capitalism: The Human Prosperity Project."
Income is certainly among the most important metrics of societal success, but average income may mask much of what is important. A country that has a small proportion of very wealthy people coupled with a large group of very poor people is not what most would judge as a desirable society. Free-market capitalism with private ownership and market-determined allocation of goods and services is often credited with generating economic growth and high average income. But critics argue that a market-based economy does not help the poor enough. Socialism, which couples government ownership of much of the means of production with substantial centrally determined allocation, is championed as being more benevolent than free-market capitalism.
Much of the literature analyzes relative well-being. Benevolence is often measured by inequality or how the rich do relative to the poor, but inequality is not a good measure of how well the poor fare in general.
China is perhaps the best case in point. Completely different inferences with respect to the welfare of the poor are likely to be drawn depending on the choice of measure. Figure 1 shows what happened to income inequality in China since 1980 as the economy moved from strict command to a more market-oriented one with significant private ownership and business flexibility. The increase in inequality is enormous. The ratio of the average income of those in the top decile to average income of those in the bottom decile went from eight in the 1980s to about forty, only beginning to reverse in recent years. Presented alone, this fact suggests that although the move to the market has benefited the wealthy in China, it has not helped the poor.
Figure 2, which tracks the absolute monthly income of the lowest decile in China over time, suggests a different conclusion. Although it took a decade, in the mid-1990s income of the poorest in China began to grow and the growth rate picked up in the last decade. Today, the poorest Chinese earn five times as much as they did just two decades earlier. Throughout the 1980s and before, a large fraction of the Chinese population lived in abject poverty. Today’s poor in China remain poor by developed-country standards, but there is no denying that they are far better off than they were even two decades ago. Indeed, the rapid lifting of so many out of the worst state of poverty is likely the greatest change in human welfare in world history.
China’s experience is perhaps the most pronounced and most important because so many are affected. But it is not unique. India, with a population almost the same as that of China, experienced a similar phenomenon, albeit to a lesser extent. The ratio of income of those in the top decile to those in the bottom decile went from sixteen to twenty over the past three decades. At the same time, the absolute income of the poorest decile approximately doubled. Inequality rose, but the poor became substantially richer. India, too, adopted market reforms in the late 1980s and ’90s.
Although surprising, the distinction between inequality and absolute income is an important one that is generally ignored in most of the literature. Almost all analyses of economic systems and outcomes for income focus on mean income and income inequality, not how well the poor have fared under the various systems. It is possible to argue that both are relevant, but it is inappropriate to ignore the importance of poor people’s income level as society moves from one system to another. It is doubtful that many earners in the lowest quartile of China would prefer to return to the situation that prevailed before the reforms of the 1980s, despite the dramatic rise in inequality.
A Brief Review of the Literature
The literature on economic systems is replete with theoretical justifications for one system over another. Marx (1867) supplied the most historically important argument for the advantages of socialism over capitalism and the natural replacement of capitalism by socialism. Capitalism brings about its own demise as technology creates more material goods for society and the abundance causes the rate of profit to decline, which results in depression, falling living standards, and the subsequent rise of the proletariat to overthrow the capitalist class. More recently, Thomas Piketty (2014) presents a modern view of the doctrine that traces back to Marx.
Piketty’s work is both theoretical and empirical. The conceptual analysis builds on modern growth theory that begins with R. F. Harrod (1939), Evsey Domar (1946, 1947), and especially Robert Solow (1956). Piketty documents the rise in capital’s share over time and argues that this will continue to happen unless action is taken to stop it. Concomitant increases in wage inequality are the inevitable result. There are a number of serious critiques of Piketty’s analysis.
On the other side, the notion that incentives matter is found throughout the economic literature and goes back to Adam Smith (1776). Perhaps most important in the context of incentives is labor supply. Workers generally must be paid in order to provide labor hours and effort. The literature on how paying higher wages affects labor and effort goes back at least to the late nineteenth century (Alfred Marshall 1890). More specifically, Harvey Rosen (1976) provides early estimates of the adverse effects of taxes on hours worked. Higher taxes imply lower take-home wages and Rosen finds that labor hours are diminished as a result. More recent work includes Steven Davis and Magnus Henrekson (2004), which finds a reduction in work hours in response to higher taxes, using data from OECD countries. Edward Prescott (2004) analyzes lower work hours among Europeans than among Americans and attributes the majority of the difference to tax rates on labor income. Barry Eichengreen (2008) examines this and asks whether and why European leaders were naive about the effect of taxes on labor supply. Additional analysis is provided by Richard Rogerson (2006, 2007) who argues that it is important to understand how the tax revenue is spent because this affects the labor supply/tax elasticity.
Ludwig von Mises (1920) and Friedrich Hayek (1945) argued that market prices are necessary and provide the best coordination in a world where no single consumer, worker, or firm can possess all the necessary information.
A few authors have compared the performance of public and private firms within economies rather than attempting to compare entire economies under different systems. Early work by Anthony Boardman and Aidan Vining (1989) finds that state-owned or -operated firms are less profitable and less efficient than their private counterparts. Stephen Martin and David Parker (1997) examine eleven UK firms that transition from public to private ownership and obtain mixed results, concluding that “neither private nor public sector production is inherently or necessarily more efficient.” Clifford Winston (2010) examines the US transportation system and estimates that government involvement costs $100 billion per year in lost performance. Arthur Comstock, Richard Kish, and Geraldo Vasconcellos (2003) analyze the long-term performance of privatized state-owned enterprises and find poorer stock returns that are about 50 percent below market performance for former state-owned enterprises.
Transitions from one form of government to another have been studied by a number of researchers in different contexts. János Kornai has a large body of work on transitions and Kornai (2008) examines the transition from socialism to capitalism in a series of essays. Nina Bandelj and Matthew Mahutga (2010) find that income inequality in socialist Central and Eastern European countries was lower than in other countries at a similar stage of development. Furthermore, inequality increased substantially after the fall of communism. In an earlier study, Abram Bergson (1984) estimates that income inequality was low in the 1970s Soviet Union. This does not speak to whether the poorest Soviets earned more than the poor in other countries. Bergson finds that in the mid-1970s, inequality in the USSR, as measured by share of income earned by the highest and lowest quintiles, was comparable to that of Norway and the United Kingdom, but less than in the United States and France.
Neither socialism nor capitalism guarantees or precludes democracy. As an empirical matter (using the data below), there is a negative correlation between legal rights and state ownership of capital. Certainly, the most important socialist societies, namely the Soviet Union (and its satellite states) and China, were far from democratic. Democracy does not ensure equality and Daron Acemoglu et al. (2015) find no clear relation of inequality to democracy.
As made clear in the introduction, high inequality does not imply low wages for the poor.
The ratio of wages of the rich to the poor may be rising at the same time that the poor’s wage level is rising. There is little evidence on this. Instead, some have examined direct transfers and income redistribution and its relation to inequality. For example, Jonathan Ostry, Andrew Berg, and Charalambos Tsangarides (2014) find that richer and more unequal societies tend to engage in more redistribution. They also find that growth is negatively correlated with inequality and that growth does not seem to suffer from efforts toward redistribution. There are obvious well-known cases that support this claim. Ireland, which experienced very high growth in average income and GDP over the past three decades, is also one of the most redistributive countries. A counterexample is New Zealand in the 1970s and 1980s, which had high redistribution and low growth both in GDP and income, especially for the poor. This led to the mid-to-late-1980s “Rogernomics” reforms.
The connection between productivity and wages seems clear and has been documented recently by Anna Stansbury and Lawrence Summers (2017) and at a more disaggregated level by Lazear (2019). If it is necessary to raise productivity in order to raise wages, particularly the wages of the poor, which systems are more likely to lead to productivity growth? Acemoglu and James Robinson (2012) argue that the Soviet Union was successful in producing economic and productivity growth by having a powerful central state that allocated resources toward industry. The major failing, as a result of deficient incentives, was innovation in industry, which led to stagnation. Yet the Soviet Union used its command structure to direct resources to specific activities and innovated in both defense and space technology. Ladislav Rusmich and Stephen Sachs (2004) argue that the failings of the socialist system have to do with the lack of feedback mechanisms that allow inefficient organizations to fail. The absence of the natural selection that capitalism ensures results in low growth, less change, slower productivity growth, and therefore stagnant wages.
China, another prominent socialist economy, is the best evidence for a successful transition from a complete command economy to a more market-oriented economy. During the twenty-five years between 1985 and 2010, average income rose at an unprecedented annual rate of 9.6 percent. The Fraser index of economic freedom, described in more detail below, uses an average of other measures such as private ownership, small government, low taxes, and property rights, which matches the dictionary definition of capitalism given below. The highest-ranking countries on the index are Hong Kong, Singapore, New Zealand, Switzerland, Ireland, the United States, and the United Kingdom. At the low end are modern-day Venezuela, pre-reform China, Algeria, Republic of Congo, Central African Republic, Syrian Arab Republic, Libya, and Argentina. The index, which has a scale of 0 to 10 and a mean level of 6.54, rates China as 3.59 in 1980 and 6.42 in 2017.
The Scandinavian experience is important and is sometimes viewed as a middle ground. Some proponents of socialism point to Scandinavia as what they have in mind. Indeed, Scandinavia has had high growth, has high standards of living, but also has a large government sector, sometimes viewed as a defining feature of socialism. Scandinavia is known not only for the size of the state but also—and perhaps primarily—for its welfare programs like generous child care benefits in Sweden and “flexicurity” in Denmark. The Scandinavian countries are in the top 20 percent of countries in terms of transfers and subsidy payments according to the Fraser index. They share this characteristic with other wealthy European countries, the highest of which are Austria, Belgium, Germany, France, and the Netherlands, countries which rank even higher than Scandinavia on the amount of transfers and subsidies.
Others might deny that Scandinavia is socialist on a number of grounds. Non- Scandinavian countries, specifically, France, Belgium, Austria, Greece, and Italy, have comparable or larger state sectors as measured by government expenditures as a share of GDP. Sweden, Finland, and Denmark have less state ownership than the median country in the world and all the Scandinavian countries rank high (in the top fifth of all countries) for general economic freedom.
The Scandinavian and larger European experience suggests that transfers are an important issue to consider when evaluating systems. It may be that inherently capitalist economies choose low transfers while inherently socialist ones choose high transfers. It might also be expected that transfers have effects on the distribution of living standards within a country as well as growth.
The past century witnessed transitions from capitalism to socialism and back again. The historical record provides evidence on how countries have fared under the two extreme systems as well as under intermediate cases, where countries adopt primarily private ownership and economic freedom but couple that with a large government sector and transfers. The general evidence suggests that both across countries and over time within a country, providing more economic freedom improves the incomes of all groups, including the lowest group. As countries liberalize their economic environment, incomes, including those of the lowest decile, grow. The evidence supports the view that moves away from socialism and toward free-market capitalism may affect the rich and poor differentially. There are some examples of this, the most important of which is China since the 1980s, where income of the poor rose dramatically but, at the same time, inequality skyrocketed.
The Chinese case is evidence that growing inequality does not imply falling incomes among the poor. Beyond China, there is general evidence on the issue derived from many countries and over a number of years. The results of that analysis can be summarized.
First, there is no evidence that, as a general matter, high-income groups benefit more from a move toward capitalism than low-income groups. The effect of changing state ownership and economic freedom on income is not larger for the rich than for the poor. Second, income growth is positively correlated across deciles. The situation is closer to a rising tide lifting all boats than to the fat man becoming fat by making the thin man thin. Finally, there is no consistent evidence across the large number of countries and time periods examined of any strong and widespread link between income growth and inequality. There are examples, like China, where income growth was coupled with large increases in inequality, but others like Chile, where strong income growth came about without much change in inequality, and South Korea, where inequality declined slightly as economic freedom and income grew over time.
Transfers and redistribution present the most complex picture of state involvement.
Transfers from rich to poor through the tax system are a luxury that only rich countries seem to be able to afford and are not a product of socialism per se. There is a very high correlation (-.67 in 2010) between contemporaneous median income and the low transfer index across countries.
High transfer countries like those in Scandinavia and other rich parts of Europe have primarily private ownership and economic freedom more like what prevails in the United States than in socialist countries. The poor definitely—and unsurprisingly—seem to benefit from higher transfers at a point in time. But the high taxes that generally go along with transfers do result in low income growth for median and high-income groups within a given country over time.
A similar pattern exists with respect to rule of law. The contemporaneous relation of rule of law to income is strong, but this seems to reflect the fact that countries that are wealthy demand rule of law rather than the reverse. Low state ownership at a point in time is a more consistent predictor of income growth within a country over the following decade than is rule of law at that same point in time.
Finally, not all transitions are alike. The Eastern European countries and the former Soviet Union saw large transitory declines in incomes for all groups during their transition to the market and the poor were more adversely affected than the rich. In China, and to a lesser extent India, market reforms brought about almost uninterrupted income growth. Venezuela provides an opposite example, moving from a more market-oriented economy to a socialist one.
Inequality fell slightly, but income growth was low for all groups and the poor have not regained the income levels that they had at the peak during the 1990s. The evidence suggests that it is economic shocks rather than transitions that disproportionately affect the poor. Transition from a command structure to the market is but one example of such a shock.
In sum, most income groups benefit from moves away from socialist command structures to free-market capitalism, but transfers can at least in the short run improve the well-being of those worst off.