February 16, 2014 5:28 pm

America risks becoming a Downton Abbey economy

Inequality must be addressed, with free markets playing a pivotal role

Inequality has emerged as a major issue in the US and beyond. A generation ago it could reasonably have been asserted that the overall growth rate of the economy was the main influence on the growth in middle-class incomes and progress in reducing poverty. This is no longer a plausible claim.

The share of income going to the top 1 per cent of earners has increased sharply. A rising share of output is going to profits. Real wages are stagnant. Family incomes have not risen as fast as productivity. The cumulative effect of all these developments is that the US may well be on the way to becoming a Downton Abbey economy. It is very likely that these issues will be with us long after the cyclical conditions have normalised and budget deficits have at last been addressed.

President Barack Obama is right to be concerned. Those who condemn him for “tearing down the wealthy” and engaging in un-American populism are, to put it politely, lacking in historical perspective. Presidents from Franklin Roosevelt to Harry Truman railed against the excesses of a privileged few in finance and business. Some have gone beyond rhetoric. Confronted with rising steel prices, John Kennedy sent the FBI storming into corporate offices and is widely thought to have ordered the authorities to audit executives’ personal tax returns. Richard Nixon used the same weapon in 1973, announcing tax investigations “of the books of companies which raised their prices more than 1.5 per cent above the January ceiling”. All were reacting in their own way to a phenomenon that Bill Clinton has described best: “Although America’s rich got richer ... the country did not ... the stock market tripled but wages went down.”

Given the widespread frustration with stagnant incomes, and an increasing body of evidence suggesting that the worst-off have few opportunities to improve their lot, demands for action are hardly unreasonable. The challenge is knowing what to do.

If income could be redistributed without damping economic growth, there would be a compelling case for reducing incomes at the top and transferring the proceeds to those in the middle and at the bottom. Unfortunately this is not the case. It is easy to think of policies that would have reduced the earning power of Bill Gates or Mark Zuckerberg by making it more difficult to start and profit from a business. But it is much harder to see how such policies would raise the incomes of the rest of the population. Such policies would surely hurt them as consumers by depriving them of the fruits of technological progress.

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.

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.

It is ironic that those who profess the most enthusiasm for market forces are least enthusiastic about curbing tax benefits for the wealthy. Sooner or later inequality will have to be addressed. Much better that it be done by letting free markets operate and then working to improve the result. Policies that aim instead to thwart market forces rarely work, and usually fall victim to the law of unintended consequences.

The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary

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Letter in response to this column:

Change markets to rein in inequality / From Prof Robert H Wade

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