UNDERCOVER ECONOMIST

August 15, 2013 6:43 pm

How the wealthy keep themselves on top

By Tim Harford

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The more unequal a society, the greater the incentive for the rich to pull up the ladder behind them

When the world’s richest countries were booming, few people worried overmuch that the top 1 per cent were enjoying an ever-growing share of that prosperity. In the wake of a depression in the US, a fiscal chasm in the UK and an existential crisis in the eurozone – and the shaming of the world’s bankers – worrying about inequality is no longer the preserve of the far left.

There should be no doubt about the facts: the income share of the top 1 per cent has roughly doubled in the US since the early 1970s, and is now about 20 per cent. Much the same trend can be seen in Australia, Canada and the UK – although in each case the income share of the top 1 per cent is smaller. In France, Germany and Japan there seems to be no such trend. (The source is the World Top Incomes Database, summarised in the opening paper of a superb symposium in this summer’s Journal of Economic Perspectives.)

But should we care? There are two reasons we might: process and outcome. We might worry that the gains of the rich are ill-gotten: the result of the old-boy network, or fraud, or exploiting the largesse of the taxpayer. Or we might worry that the results are noxious: misery and envy, or ill-health, or dysfunctional democracy, or slow growth as the rich sit on their cash, or excessive debt and thus financial instability.

Following the crisis, it might be unfashionable to suggest that the rich actually earned their money. But knee-jerk banker-bashers should take a look atresearch by Steven Kaplan and Joshua Rauh, again in the JEP symposium. They simply compare the fate of the top earners across different lines of business. Worried that chief executives are filling their boots thanks to the weak governance of publicly listed companies? So am I, but partners in law firms are also doing very nicely, as are the bosses of privately owned companies, as are the managers of hedge funds, as are top sports stars. Governance arrangements in each case are different.

Perhaps, then, some broad social norm has shifted, allowing higher pay across the board? If so, we would expect publicly scrutinised salaries to be catching up with those who have more privacy – for instance, managers of privately held corporations. The reverse is the case.

The uncomfortable truth is that market forces – that is, the result of freely agreed contracts – are probably behind much of the rise in inequality. Globalisation and technological change favour the highly skilled. In the middle of the income distribution, a strong pair of arms, a willingness to work hard and a bit of common sense used to provide a comfortable income. No longer. Meanwhile at the very top, winner-take-all markets are emerging, where the best or luckiest entrepreneurs, fund managers, authors or athletes hoover up most of the gains. The idea that the fat cats simply stole everyone else’s cream is emotionally powerful; it is not entirely convincing.

In a well-functioning market, people only earn high incomes if they create enough economic value to justify those incomes. But even if we could be convinced that this was true, we do not have to let the matter drop.

This is partly because the sums involved are immense. Between 1993 and 2011, in the US, average incomes grew a modest 13.1 per cent in total. But the average income of the poorest 99 per cent – that is everyone up to families making about $370,000 a year – grew just 5.8 per cent. That gap is a measure of just how much the top 1 per cent are making. The stakes are high.

I set out two reasons why we might care about inequality: an unfair process or a harmful outcome. But what really should concern us is that the two reasons are not actually distinct after all. The harmful outcome and the unfair process feed each other. The more unequal a society becomes, the greater the incentive for the rich to pull up the ladder behind them.

At the very top of the scale, plutocrats can shape the conversation by buying up newspapers and television channels or funding political campaigns. The merely prosperous scramble desperately to get their children into the right neighbourhood, nursery, school, university and internship – we know how big the gap has grown between winners and also-rans.

Miles Corak, another contributor to the JEP debate, is an expert on intergenerational income mobility, the question of whether rich parents have rich children. The painful truth is that in the most unequal developed nations – the UK and the US – the intergenerational transmission of income is stronger. In more equal societies such as Denmark, the tendency of privilege to breed privilege is much lower.

This is what sticks in the throat about the rise in inequality: the knowledge that the more unequal our societies become, the more we all become prisoners of that inequality. The well-off feel that they must strain to prevent their children from slipping down the income ladder. The poor see the best schools, colleges, even art clubs and ballet classes, disappearing behind a wall of fees or unaffordable housing.

The idea of a free, market-based society is that everyone can reach his or her potential. Somewhere, we lost our way.

‘The Undercover Economist Strikes Back’ by Tim Harford is published this month in the UK and in January in the US