Undercover Economist

March 21, 2014 5:51 pm

Four steps to fixing inequality

‘As the example of Finland makes clear, it is possible to change income distribution dramatically’
Illustration by Toby Leigh of a hand opening a tap of water©Toby Leigh

By most measures, and in many countries, income inequality has been increasing for a generation. Some people don’t care, so here’s another way to look at the problem: over the past 20 years, the pre-tax incomes of the poorest 99 per cent in the US grew by just 6.6 per cent after adjusting for inflation. That is a pathetic one-third of 1 per cent per year. Those who aren’t worried about increasing inequality should still be concerned at such widespread stagnation of living standards.

So what is the solution? Here is a modest proposal to fix inequality in four easy steps.

The first step is to be precise. Are we using the Gini coefficient or the share of the top 1 per cent to measure inequality? Wealth, consumption or income? Before taxes and benefits or after?

This last question is often ignored but it makes a big difference. Consider Finland, France and Japan. Looking at pre-tax household incomes, Finland is the most unequal of the lot. But after the tax system has done its work, Finland is the least unequal. (My source here is a database compiled by the political scientist Frederick Solt.)

Finland’s market economy delivers outcomes roughly as unequal as those of the UK and the US but the tax system is far more redistributive. In contrast, Japan is more equal than the UK and US despite a tax system that redistributes less than theirs, because the country’s economy delivers more egalitarian outcomes.

The second step is to look at underlying causes rather than symptoms. As the philosopher Robert Nozick forcefully observed, there is something strange in worrying about income distribution without considering what processes, just or unjust, produced that distribution.

This isn’t just a philosophical argument – there are practical implications. Consider JK Rowling who is extremely rich because every time someone buys a Harry Potter book, she gets a cut – and a very large number of people have bought Harry Potter books. Unless Bill Gates is out shopping, every time a Potter book is purchased income inequality increases.

Rowling’s wealth is underpinned not only by Harry Potter’s commercial success but by copyright laws which ensure she reaps the benefits of that success. Rowling is not yet 50, so with luck she will still be with us in 2050, and her books will continue to generate inequality-increasing copyright revenue for the rights holders until 2120. A different set of rules might have produced a result that was more equitable yet perfectly efficient. Rowling did not need several hundred million pounds to persuade her to tell us what happens to Hermione in the end.

My point is not to single out Rowling for any criticism but to point out that fortunes do not accumulate through skill and luck alone – there is always a particular underpinning of laws and regulations that could, if we wish, be changed. Carlos Slim’s América Móvil and Gates’s Microsoft could have been broken up by antitrust authorities.

Chief executives enjoy inexplicably large – and often opaque – remuneration packages. Oversight could be tightened, shareholders given teeth.

When we look directly at the sources of high incomes we will sometimes discover policies that would be a good idea in their own right and might reduce inequality only as a side effect.

The third step is to reform redistribution. As the example of Finland makes clear, it is possible for a rich and successful nation to change its income distribution dramatically through the tax system. (A recent and celebrated research paper from the International Monetary Fund adds some more careful empirical backing to this intuitive idea – although there are too many imponderables in such an analysis for it to clinch any argument.)

. . .

Not only must we ask how much to redistribute – largely a political question – we must also ask how to do it. Tax codes are riddled with loopholes and special cases, and under the pressure of the deep recession, such tangles appear to be proliferating. The British system has two nationally levied income taxes and in recent years has introduced a new (and gyrating) tax band for high earners; a separate band over which allowances are withdrawn arbitrarily; and a third band over which child benefit payments are withdrawn. Further crenellations are promised if the Labour party is elected.

However much redistribution we might feel is just, it’s certainly clear that we could redistribute for less trouble if our politicians paid more attention to sensible tax design and less attention to crowd-pleasers.

Step four is to remember the small stuff. Inequality is a consequence of countless policy choices too trivial to trouble finance ministers: whether there are good teachers in most classrooms; whether poorer areas of town are safe at night and have access to affordable public transport; whether toddlers are receiving stimulating childcare; whether the pension system encourages savers without making millionaires out of slick middlemen. We should gather better evidence on such questions and act on that evidence.

A final, fifth piece of counsel: don’t for a moment think this is a problem that can be solved in four easy steps.

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Twitter: @TimHarford; Tim Harford’s latest book is ‘The Undercover Economist Strikes Back’
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