Commentary: Income inequality rewards creativity
This article first appeared in the St. Louis Beacon, Aug. 20, 2013: The disparity in income between the top 1 percent and the other 99 percent fueled the Occupy Wall Street movement and gave momentum to the ongoing push to raise taxes on the rich. As important as this is both as a social topic and an economic policy issue, there is much confusion that hinders rational debate.
The data do not lie: Over the past several decades the percent of total market income (the sum of labor income, business income, capital income and capital gains) that has accrued to the top 1 percent has increased. Although reduced by the Great Recession, in 2010 the top 1 percent of income earners in the United States accounted for about 20 percent of the total income.
Though often publicized, such a figure is somewhat misleading. Based on total income, it ignores the effects of taxes on the upper income earners and transfers on the lower income side of the distribution. A more correct measure accounts for these factors.
Steven Kaplan and Joshua Rauh of the University of Chicago compare the history of such a measure to the popular, unadjusted data in a recent study. After accounting for taxes and transfers, the share of income going to the top 1 percent in 2009 (the most recent data available from the Congressional Budget Office) was about the same as in the mid-1980s and 1990s and the early 2000s. While a slight upward trend remains, it is much less pronounced than the unadjusted market income data suggests.
Though smaller, the share of adjusted income going to the top 1 percent is still higher than in the past. Some would argue that this illustrates the lack of fairness in the system. Their solution: Tax the rich more than the rest of us.
This approach ignores the most critical question: Are there reasonable explanations to describe the observed trend in income dispersion? For many economists, the answer lies in how talent, inventiveness and productivity are rewarded.
Greg Mankiw, the Harvard professor and author of a best-selling economics text, suggests the following thought experiment:
A society exists in which there is perfect income equality. This distribution of income arose not because of government transfer programs but because the demands for and supplies of different labor happen to produce equal incomes. Into this society introduce someone who invents a product that everyone wants. Buyers part with their income and the entrepreneur parts with her product. The exchange is mutually beneficial. This event has made everyone better off — they now have the product they desired — and it has made the entrepreneur very rich relative to everyone else in society. There is now significant income inequality.
The government could raise income taxes on the entrepreneur and distribute the tax revenues back to the people who bought her product. This may recapture income equality, but it crushes any economic incentive to innovate or create. Taxing away rewards to innovation or risk-taking in favor of equal incomes ultimately shrinks everyone’s slice of the economic pie.
The evidence indicates that the income disparities observed over the past few decades probably result more from how talent is rewarded than anything else. The outcome is not the result of malicious manipulation of the market or political system but from the basic economic fact that those who are more productive or more talented are rewarded to a greater degree than others. In an increasingly knowledge-based society, those who obtain an advantage in knowledge reap proportionally greater rewards. Indeed, a preponderance of evidence points to educational attainment as a much better indicator of economic success than other factors.
Equalizing incomes across society may seem just or fair to some, but it comes with a significant cost. A ham-handed redistribution of income that dissuades a future Edison or Ford or Gates or Jobs from pushing forward and improving our lives harms everyone.
R.W. Hafer is a distinguished research professor of economics and finance at Southern Illinois University-Edwardsville and a research fellow at the Show-Me Institute.