How much inequality is too much?

This is part two in a series of posts trying to answer the question, “Should Billionaires exist?

Part 1: Why focus on billionaires?

In a speech in 2013, Obama referred to inequality as the defining challenge of our time – claiming it as the reason he ran for president. More recently, the Covid-19 pandemic has both highlighted and increased the economic inequalities that permeate society. Some of the most wealthy have seen their wealth increase at staggering rates while millions have lost their jobs.

These inequalities offend my moral intuitionsas they do for so many others. How can it be fair for billionaires to accrue even more wealth while so many struggle to get by due to a lack of economic resources?

However, I also worry that focusing solely on inequality is a red-herring. We could reduce inequality by getting rid of billionaires but would this guarantee a reduction in poverty? I’m not so sure. If the wealth of the very rich were constrained but millions still lacked resources, the more important problemimproving the standard of living for as many people as possiblewould be left unsolved.

Everyone with a conscience wants to eliminate poverty and raise the standard of living for all. It’s how to achieve these lofty goals where disagreements arise. Debates around the topic often devolve into arguments about capitalism vs. socialism. These are broad, idealistic categories but I still find them useful for understanding the arguments.

The capitalist argument is that inequality is good for society. This is partly a moral argumentpeople should be rewarded for the effort they put in. If there is an unequal distribution of effort and risk then an unequal distribution of outcomes is a just distribution.

But the crux of the capitalist case in favour of inequality has to do with incentives. Society benefits from the value created from people following these incentivesdespite their for-profit motives. So many of the things we appreciate about our lifestylesgrocery stores, smart phones, the internet, affordable travel, endless entertainmentare thanks to businesses competing for customers and trying to increase their profits.

“It is not from the benevolence of the butcher, the brewer or the baker that we expect to eat our dinner, but from their regard to their own interest.”

– Adam Smith, The Wealth of Nations

If we enforced equal economic outcomes, these incentives would vanish. Even economist Paul Krugman, arguing for higher taxes on the very rich, admits that taxing billionaires too much would eliminate any incentive to do whatever it is they do and hurt the economy.

And an injured economy does not just affect billionaires. It impacts the tax revenue that governments can collect, which limits spending on social-welfare programs. There is a famous graph in economics known as the Laffer curve, which illustrates that government tax revenue would eventually be reduced by increasing tax rates too much.

A hypothetical Laffer curve

Knowing the actual shape of this curve between the two extremes is almost impossible, but it demonstrates an important point. Increasing tax rates too high would be counter productive because nobody would end up working to earn any income to tax.

But this argument can be exploited by conservatives trying to cut taxes by claiming it will lead to more tax revenue. We should be skeptical of these claims. Not accounted for in the Laffer curve is the multi-dimensional reality of taxation. There are estate taxes and capital gains taxes, to name a few, and not all incomes are taxed at the same rate. There are complex trade-offs to be made when tuning all of these rates. But it’s possible that the optimal tax policesthe ones that maximize tax revenuecould result in a society where billionaires continue to exist.

To be fair, it’s also possible that the optimal tax policies would tax billionaires out of existence (the topic of a debate I recently attended). In this scenario, inequality would be reduced and the government would have more money to spend on social-welfare. But is taxing and redistributing incomes the best way to combat poverty?

This is where the socialism vs. capitalism debate becomes increasingly relevant. Socialists have faith in governments to distribute resources fairly and effectively while capitalists view governments as inefficient and corrupt. Even with increased tax revenue raised from taxing the rich more, could government spending alone alleviate poverty?

Most capitalists would say no. Planning an economy is difficult. Deciding who needs which resources, how much, and when is a complex problem. For this reason, centrally planned economies tend be rigid and do not adapt well to change. They also provide a system ripe for corruption. Give a small group of people the power to distribute wealth and there’s a good chance much of it will go to their friends with deep pockets.

The best way to improve the standard of living for everyone, say the capitalists, is to let market competition do its thing. Free marketswhere the complex dynamics of supply and demand are communicated through pricing signalsare very good at allocating resources without the need for a central authority.

Without an effective market to coordinate supply with consumer demand, the consequences are typically huge surpluses of goods that no one wants, and huge shortages of products that people do want.

– Alan Greenspan, The Age of Turbulence

Along with better resource allocation, capitalism’s claim to victory comes from its role in fueling economic growth. Though it results in some very big winners, this economic growth has not been not zero-sum. It’s the reason we’ve seen a declining share of the world living in extreme povertyeven as the global population has exploded. For the average citizen, incomes are going up and quality of life along with it. If capitalism leads to both extreme wealth and less poverty, then perhaps billionaires are a byproduct we should learn to accept.

Share of the world population living in absolute poverty. Source: Our World in Data

Free market capitalists worry that too much effort to equalize outcomes will put the brakes on economic growth and put an end to the rising tide that has been lifting all boats. But does growth always have to be sacrificed for reducing inequality? Maybe not.

We can either have faster growth and higher incomes by allowing the market to reward individual effort, however unequal the distribution, or we can have a more equal distribution …. [But] at some point, more inequality stops producing a bigger pie and begins to slow economic growth, and that, under such circumstances, redistribution might actually enhance growth rather than diminish it.

– Stephen Pearlstein, Can American Capitalism Survive

In his book Can American Capitalism Survive?, Stephen Pearlstein, argues that rising inequalityin America, especiallywill lead to slower economic growth. He demonstrates this with a spin on the Laffer curve, with inequality on the x-axis and output on the y-axis.

The Pearlstein Curve (recreated hastily in PowerPoint)

Like the Laffer curve, the Pearlstein curve is not meant to be an accurate model, but to demonstrate a point. Economic growth vanishes at both extremesabsolute equality and absolute inequality. It’s the shape of the curve in between the two extremes that matters.

So we’re left with some tough questions. What is the optimal amount of inequality? It’s probably not zero. Does it allow for billionaires to exist? We need economic growth to continue lifting folks out of poverty. But that growth is not helpful if it is increasingly concentrated in the hands of a few. Is taxing and redistributing the incomes of the rich the best way to combat poverty? Or should regulations be relaxed to let free markets allocate resources in the most efficient way?

In the next post, I’ll try and explore the driving forces behind increasing inequality. Is it capitalism run amok? Or stifling government regulation?

Part 1: Why focus on billionaires?

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