Is 'Income Inequality' a Legitimate Worry?

In his 1996 book, Hidden Order: The Economics of Everyday Life, polymath economist David Friedman wrote:

When a psychiatrist wants to get his audience’s attention, he talks about sex. Economists talk about the income distribution. In both cases the audience’s interest is prurient (what are other people doing?), puritanical (that they shouldn’t be?), and personal (how am I doing?). In both, there is the thrill of violating taboo; although sex is gradually becoming an accepted topic of conversation, asking how much money someone makes is still beyond the pale (p. 195).

Though asking about someone’s income is still not permitted in polite conversation, it is not forbidden in political discourse. So it should come as no surprise that congressional Democrats have made income distribution the centerpiece of their legislative program in the early days of their new majority.

Both the House and the Senate have passed minimum wage legislation, which is one way to redistribute income. (It is also a way to deny employment to poor minority youth, but that is a column for another day.)

Under the leadership of Senator Charles Schumer (D-New York), the Joint Economic Committee sponsored a hearing about income inequality in which the “bad guys” are corporate executives with generous pay packages made up of salaries, bonuses, and stock options, and the “good guys” are federal legislators claiming to look out for the poor and middle class.

The Washington Post reported on February 1, referring to testimony from Princeton University economist Alan Blinder,

"The basic story is very clear," Blinder said. "Inequality was mostly falling for 30 or 35 years or so until the late 1970s and has been mostly rising since then." He offered a vivid example: In 1979, the average taxpayer in the top one-tenth of 1 percent earned about as much as 44 average taxpayers in the bottom half. In 2001, the rich taxpayer earned as much as nearly 160 less affluent people.

Is “income inequality” something that should worry us? Even President Bush seems concerned, telling a Wall Street audience on January 31 that "income inequality is real -- it's been rising for more than 25 years” – though the larger thrust of his remarks were about how strong the U.S. economy is.

George Mason University economist Tyler Cowen put the question in perspective in a recent article for the New York Times:

What matters most is how well people are doing in absolute terms. We should continue to improve opportunities for lower-income people, but inequality as a major and chronic American problem has been overstated.

Fears about income inequality stem from a pre-modern understanding of economics, in which because some people “have,” others “have not.” In the pre-industrial, pre-capitalist world, this was sometimes true. If Midas had a lot of gold, it meant he was taking it from his subjects, who had no gold. (He and other ancient rulers used force to pry the gold from the hands of people who had genuinely earned it, through slavery and confiscation.)

But the fabled Midas hoarded his gold; he neither spent it nor invested it. The “affluent people” of Alan Blinder’s illustration both spend and invest their earned incomes. They don’t hide it under their mattresses. As a consequence, they create products that fulfill our needs and wants, hire workers, and make other people wealthy in the process – or at least more wealthy than they would have been in the absence of spending and investment.

In his influential treatise, Human Action, Austrian economist Ludwig von Mises wrote:

The inequality of incomes and wealth is an inherent feature of the market economy. Its elimination would entirely destroy the market economy.

What those people who ask for equality have in mind is always an increase in their own power to consume. In endorsing the principle of equality as a political postulate nobody wants to share his own income with those who have less. When the American wage earner refers to equality, he means that the dividends of the stockholders should be given to him. He does not suggest a curtailment of his own income for the benefit of those 95 per cent of the earth’s population whose income is lower than his (third revised edition, p. 840)

In other words, “more wealth for me, but not for thee” is the principle at play.

Redistributing unequally distributed wealth would require one of two things:

One option is passing laws that forbid businesses from paying their employees – including high-level management, rock stars, baseball players, and Oscar-winning actors and actresses – what they (the businesses) and the market think they are worth. That is, set legal ceilings on earnings.

The other option is to establish a system of confiscatory taxation that would take earnings from the person who earned it, in order to bring their income beneath an arbitrary ceiling, and give it to the government, which in turn will spend it on goods and services provided by other rich individuals and the companies they own. That is, rob Peter to pay Paul.

Commenting on the “economic consequences of confiscatory policies,” Mises wrote that

in the long run such policies must result not only in slowing down or totally checking the further accumulation of capital, but also in the consumption of capital accumulated in previous days. They would not only arrest further progress toward more material prosperity, but even reverse the trend and bring about a tendency toward progressing poverty (Human Action, third revised edition, p. 844).

Put more simply, by constricting the capacity of the affluent to create jobs and buy things, one ends up creating more unemployment and ultimately punishing the poor and middle classes.

In the recent PBS documentary film about his life, The Power of Choice, the late Milton Friedman said, “The society that puts equality before freedom will end up with neither. The society that puts freedom before equality will end up with a great measure of both.”

That is a lesson well-learned by policymakers on Capitol Hill and at the other end of Pennsylvania Avenue.