America risks becoming a Downton Abbey economy

Via Tyler Cowen, this Lawrence Summers' article on income inequality in the United States (behind a required Financial Times account registration, but it's free).

It is certainly true that there has been a dramatic increase in the number of highly paid people in finance over the last generation. Recent studies reveal that most of the increase has resulted from an increase in the value of assets under management. (The percentage of assets that financiers take in fees has remained roughly constant.) Perhaps some policy could be found that would reduce these fees but the beneficiaries would be the owners of financial assets – a group that consists mainly of very wealthy people.

Good point, it can be infuriating to look at the money being made on Wall Street and wonder how anyone can justify making so much money, no matter how many sleepless nights they spend in Microsoft Excel, but as Summer notes most reform proposed their just moves money from one group of wealthy people to another.

Is the answer in tax policy?

It is not enough to identify policies that reduce inequality. To be effective they must also raise the incomes of the middle class and the poor. Tax reform has a major role to play. The current tax code is so badly designed that it is very likely to be having the effect of reducing economic growth. It also allows the rich to shield a far greater proportion of their income from taxation than the poor. For example, last year’s increase in the stock market represented an increase in wealth of about $6tn, of which the lion’s share went to the very wealthy.

It is unlikely that the government will collect as much as 10 per cent of this figure. That is because of a host of policies that favour the rich, such as the capital gains exemption, the ability to defer tax on unrealised capital gains, and the fact that gains on assets passed on at death are not taxed at all. Similarly, the corporate tax system allows value to flow through it like a sieve. The ratio of corporate tax collections to the market value of US corporations is near a record low. The estate tax can be more or less avoided with sophisticated planning.

Closing loopholes that only the wealthy can enjoy would enable taxes to be cut elsewhere. Measures such as the earned income tax credit can raise the incomes of the poor and middle class by more than they cost the Treasury, because they give people incentives to work and save.

What's more interesting is to ask why we worry about the uneven distribution of income instead of just focusing on improving the financial lot of the poor. Isn't getting them out of poverty a worthwhile goal regardless of what's happening to incomes of the 1%? It turns out there's a name for this school of thought: prioritarianism. It's an alternative to egalitarianism.

Whether income inequality is inherently wrong is a question many people smarter than myself have already contemplated. Some of the arguments against income inequality that are most persuasive to me:

Extreme inequality ruins democracy

It's no secret money rules politics in America. Team Obama spent $1.1 billion to win the 2012 presidential race. When inequality becomes extreme, it undermines democracy, as the late philosopher John Rawls and others have argued, because it creates unequal access to the political system and to positions of power.

One person, one vote -- yeah. But one person with millions to spend has much more influence. "What is problematic in the United States is the political system ... is one that is quite substantially dominated by those people that have money," said Pogge, the Yale professor. "They can, in the American system, yield a substantial amount of influence on the legislation through lobbying and therefore expand their advantaged position."

That is, income inequality can become self-perpetuating because the wealthy wield such political and media power in the U.S. democracy that they make it impossible, for example, to pass tax reform like the type outlined by Summers above. That, in turn, can damage economic mobility. The rich continually redefine the rules of the game.

Inequality isn't a moral problem; opportunity is

In this school of thought, it doesn't matter if the mayor of New York City is worth $27 billion (he is) as long as everyone in the city has an equal chance to succeed. That's the view of Brooks, from the American Enterprise Institute. I asked him about that city, which is more unequal than any other metro in the U.S.

"The truth is there are a lot of really, really wealthy people there. Great! That's a morally neutral concept," he said. But not all of them have an equal opportunity at success, he said, in part because schools don't perform well in all neighborhoods. That's morally bankrupt. (Check out this wild map that shows the chances a kid at the bottom of the income ladder would have of climbing to the top. In Atlanta, where I live, a kid in the bottom fifth of income earners has only a 4% chance -- 4%! -- of making it into the top fifth of income earners.) Fix economic mobility, Brooks said, not inequality. And let the rich do their thing.

Is there an optimal level of wealth inequality?

The size of the rich-poor gap matters

Some inequality is acceptable to pretty much everyone these days. No one is arguing for a fully equal society. But the degree of inequality really does matter when you're trying to determine whether inequality is moral or amoral, said Pogge, the Yale professor. When extreme inequality sets in, that's when social and political problems follow.

His best estimate for a fair distribution is the Palma Ratio, which measures how much income the top 10% earns compared to the bottom 40%. Ideally, those amounts would be equal, meaning the country would have a Palma Ratio of one. According to a calculation cited by the Danish Institute for International Studies, the United States has a 2010 Palma Ratio of 1.852, which is about the same as Burkina Faso but not as bad as China or South Africa. (In an earlier version of this column, I incorrectly estimated the U.S. Palma Ratio based on wealth instead of income. I should have let the experts handle that, and I regret the mistake). By Pogge's assessment, that means inequality here is too high. Negative consequences for our society will result.

At some level of inequality, why would the poor or even middle class choose to play by the rules as defined by the wealthy? Is there a Palma Ratio beyond which we see a sharp increase in social unrest, crime, and other indicators of people opting out from the system?

On a recent Philosophy Bites podcast Nigel Warburton interviewed Harvard philosopher TIm Scanlon on this topic. It's well worth a listen. One passage from Scanlon that stuck with me.

Adam Smith famously said in The Wealth of Nations that it's an objection to a society if it forces some people to live in such a way that they can't go out in public without shame. Now that happens when the standard of acceptable dress, acceptable appearance, acceptable house, or whatever, is set at a certain level by the way most people live so it's humiliating for people to have to live in a different style.

The Wealth of Nations contains multitudes, so many of which I've forgotten.

It's difficult not to contemplate the moral dimension of income inequality everyday living in San Francisco. I've never lived any place where the difference between the lot of any two people confronts me more on a daily basis. I can't remember the last time I walked around San Francisco without walking past many homeless people. It's difficult not to feel that something is not just wrong but deeply broken.

This brings me back around to the moral dimension of income inequality. When it comes to this issue, as the Atlantic notes, the giant is economist John Rawls.

Rawls argues that when we think of how to create a just society, we need to imagine that we are all placed under a "veil of ignorance," where we don't know anything about the various advantages - social or natural - that we are born into. What principles of society would we then agree to? Rawls builds a strong case for two:

Principle 1: "Each person has the same indefeasible claim to a fully adequate scheme of equal basic liberties, which scheme is compatible with the same scheme of liberties for all."

Principle 2: "Social and economic inequalities are to satisfy two conditions: first, they are to be attached to offices and positions open to all under conditions of fair equality of opportunity; and second, they are to be to the greatest benefit of the least-advantaged members of society."