Income and wealth inequality continue to increase around the world. And though our economies continue to generate enormous wealth, it is increasingly channeled to the richest 1 percent.
A quote from Social Enterprise UK:
Since the turn of the century, the poorest half of the world’s population has received just 1 percent of the total increase in global wealth. Meanwhile, half the new wealth has gone to the richest 1 percent. As a result, the richest 8 people now own as much wealth as the poorest half of the world. Something is not quite right in how we have structured our economies.
This has not only meant entrenching global poverty (according to World Bank projections) but also rising political and economic instability. Inequality creates conditions in which crime and corruption thrive. In more unequal societies, rich and poor alike have shorter lives, and live with a greater threat of violence and insecurity. Rising inequality is a problem for us all.
Business structure as a cause of inequality
There are many drivers of income and wealth inequality, but among the most underrated might be business structure.
The business world is diverse, but in most countries it is dominated by businesses that exist primarily to grow the capital of their investors. This is especially the case for larger companies. Profit [maximization] does have incidental positive impacts: it drives investment and leads to innovation.
But it also means that business is geared to extract as much value as possible, and distribute this value proportionately to people based on the capital they have to invest. In a world where unequal distribution of capital is the key driver of inequality (according to the World Inequality Report), this essentially supercharges business to drive up inequality. While anyone can be a shareholder (through a pension fund for instance), if economic spoils are shared according to the size of capital people had to begin with, we give a growing share of the pie to the people who have the most to invest.
Laws, financial markets and industry policies have made this the dominant model in many countries. But it contains a fatal design flaw if we don’t want to see spiraling inequality.
Image source: Oxfam GB
It is true that on a simplified basis, each person’s share in a company grows at the same rate. So a person owning 10% of a firm vs. a person owning 90% of the same firm can expect their rates of return to be the same. At the end of any period of time, each person will still own his same percentage.
But the nominal difference in each person’s value is what changes dramatically. Assuming this same scenario and a 5% annual growth rate in a company starting with a value of $1,000,000, the first person will grow his share from $100,000 to $162,889 over 10 years. The second person grows his $900,000 to $1,466,005 over the same period.
The split by year 10 is still 10%/90% for the two investors. But the second person can now buy 3 times more goods he was able to in year 1, compared to the first person who can now buy 0.34 times more goods (assuming 2% inflation).
It is clear when you look at the numbers that everyone can own shares in public enterprise. But the nominal growth owed to differences in ownership percentages creates a massive equality gap in terms of real dollars.
So why is this bad for the economy?
In the example above, the presumably affluent executive owning 90% of the entity clearly takes a strong majority of the gains from that company’s productivity.
A person who views this as unfair might be less motivated to work, decreasing productivity. As Wallace Hopp says in The Conversation:
The demotivating impact of income inequality occurs when workers see the gains of productivity going almost entirely to executives.
Since 1973, productivity has increased by over 73 percent, while (inflation-adjusted) hourly worker pay has risen by only about 11 percent and CEO compensation has soared by 1,000 percent.
Who can blame people for being reluctant to work harder when they know the proceeds will go to someone else? Extensive behavioral research has shown that people will forego personal gain to prevent outcomes they perceive as unfair. In work settings, this leads to demotivated workers working below their potential, even when it leads to smaller raises or bonuses. The result is reduced productivity, lower quality and less creativity, all of which undermine corporate profit and economic growth.
Any gains in productivity are distributed disproportionately to owners. And as a result, these gains (which are converted to cash) are spent much less quickly than had they been distributed to the workers and lower-percent owners.
Another way inequality affects the economy is by reducing the velocity of money by shifting cash to people who spend it more slowly. Working-class people who are stretching to make ends meet spend their income quickly – usually pretty much all of it – while wealthy people whose resources exceed their immediate needs tend to save substantial portions of their income.
Consequently, whenever a company takes a dollar out of the hands of a worker and puts it into the hands of an executive or investor, the number of times that dollar will be spent in the economy is reduced. The result is less business for capitalists and less employment for workers.
How can we tackle economic inequality?
Society cannot simply redistribute ownership in all enterprises to the masses to solve this problem. Ownership represents the risk of capital, that someone takes on, to potentially earn a higher return than could be had by keeping his cash in the bank.
Dissolving ownership and spreading it evenly across all workers would provide no incentive for anyone to accumulate wealth and invest in new businesses, ideas, or programs. Innovation would stall and productivity would decline.
There needs to be some sort of balance between distribution of upside in economic scenarios (addressing the bottom of business structure) with incentivizing good ideas and innovative collaboration (addressing the top).
If we look at the top of the business structure to fix inequality
One option is to implement more progressive tax systems. Because top marginal tax rates have a very strong impact on pre- and post-tax income inequality, this is one obvious step that can be taken.
Source: AccurateTax.com
Progressive tax rates contribute to the reduction of post-tax income inequality at the top of the distribution via their highest marginal tax rates. Indeed, if an individual earns $2 million and if the top marginal tax rate is 50% above one million dollars, this individual will net out only $500,000 on the second million. If the top marginal tax rate is 80% above one million dollars, then the earner will net out only $200,000 on the second million. The reduction of inequality can be further enhanced if the public spending funded by this tax revenue is aimed at fostering economic growth.
One often-neglected role of top marginal tax rates is their ability to reduce pre-tax income inequality. This can occur via two channels. The most obvious one is that when top marginal income tax rates are high, top earners have less money to save and accumulate wealth, and therefore potentially less income from capital next year.
Another way to understand the impact on top income tax rates on income inequality is to focus on rich individuals’ bargaining incentives. When top marginal tax rates are low, top earners have high incentives to bargain for compensation increases – for instance, by putting a lot of energy into nominating the right people to the compensation committees who decide on pay packages. Alternatively, high top marginal tax rates tend to discourage such bargaining efforts. Reductions in top tax rates can thus drive upwards not only post-tax income inequality but pre-tax inequality, as well.
Top tax rates in the U.S. and U.K. reached 90% in the era between 1940 and 1970. And this did not appear to harm growth in these countries. Interestingly, all rich countries have grown at roughly the same pace over the past 50 years, despite vastly different approaches to income taxation.
Relationship between effective marginal tax rate on capital income and economic growth, 1954-2006
Source: EPI
Furthermore, changes in top marginal tax rates and top income shares in rich countries since the 1970s suggest the following:
– That top tax rates play a key role in moderating pre-tax top incomes
– That there was no significant impact on growth
The simplified answer would seem to say there is opportunity to employ a more progressive tax system to address income inequality due to business structure.
If we look at the bottom of the business structure to fix inequality
Another way would be finding a way to provide more equal access to education and good-paying jobs.
The United States has mobility levels lower than other countries. Fewer than eight Americans born in the 20% poorest families will eventually rise to the top 20% of earners as adults. This compares to 12 in Denmark and 13 in Canada. Similarly, only 30% of children born in the bottom 10% income bracket will go to college. This compares to 90% of those born in the top 10% income bracket.
Source: Statista
In the case of the United States, strong geographic inequalities also interact with educational inequalities. In geographical areas with the highest mobility, a child born in a family from the bottom 20% of the income distribution has a 10% to 12% chance of reaching the top 20% as an adult (that is about as much as in the highly mobile countries of Canada or Denmark).
Examples of highly mobile places include the San Francisco Bay and Salt Lake City in Utah. In areas with low intergenerational mobility, a child born in a family from the bottom 20% of the income distribution has only a 4% to 5% chance of reaching the top 20% as an adult. No advanced economy for which we have data has such low rates of intergenerational mobility. Cities in the US south (such as Atlanta) or the US rust belt (such as Indianapolis and Cincinnati) typically have such low mobility rates.
Income inequality at the local level, school quality, social capital, and family structure are also important factors. Higher income inequality among the poorest 99% of individuals is associated with lower mobility. Meanwhile, a larger middle class stimulates upwards mobility. Higher public school expenditures per student along with lower class sizes significantly increase social mobility. Higher social capital also favors mobility (for example, areas with high involvement in community organizations).
Finally, family structure is also a key determinant; upward mobility is substantially lower in areas where the fraction of children living in single-parent households, or the share of divorced parents, or the share of non-married adults is higher.
If social and geographical reasons explain the disproportion of children attending college, then the solution would involve making higher education more accessible to those currently missing out. Channeling more funds into primary education systems would strengthen a child’s chances of going to college. Establishing accredited online or local universities that are subsidized by similar funds would help attract those who don’t think college is an option thanks to their social upbringing.
To enable these outcomes, you first need to ensure more people can get into college—the problem of improving primary and secondary education. You then need to ensure students climb to higher income brackets as a result—the problem of improving higher education efficiency.
If funding can be obtained to make all educational institutions as efficient as the highest 10% in terms of social mobility, then mobility in the United States would be perfect. Children’s outcomes would be completely independent and unrelated to their parents.
Conclusion
The business environment is inherently biased toward accumulating wealth among the few and increasing inequality among the haves and have nots.
As a result, workers (rather than owners) become less motivated to work. This leads to lower productivity, quality and creativity, all of which undermine corporate profit and economic growth.
Additionally, as gains are distributed disproportionately to owners, these gains when converted to cash, are spent much less quickly than had they been distributed to the workers and lower-percent owners.
This is a problem that can be tackled several different ways, two of which approach it from opposite ends of the spectrum:
From the top – via progressive tax reform and more equal distribution of income.
From the bottom – via greater access to education and career opportunities.
By progressively taxing economic gains, income is effectively more evenly distributed between owners and workers, creating more opportunity for innovation and investment into new ideas that would spur growth.
By providing greater access to education and career opportunities, you channel the largest resource in a country – its labor pool – into areas that are growing and profitable and away from areas that are depressed and low paying. Similarly, this solution would ensure more economic gains are put in the pockets of lower class workers which leads to investment, innovation and so on.
Source: International Monetary Fund
Whatever we do, it is likely we can’t overhaul the entire business environment. But we can address some of the context within which it operates. Our economy is one that incentivizes wealth creation and innovation, and to remove this incentive would have dramatic impacts on productivity and growth. If we can instead improve the foundation on which this is all nurtured, we have a better chance of continuing to improve economic conditions while shrinking the gap between the rich and the poor.
Note: The quotes for both solutions presented above are from the World Inequality Lab’s World Inequality Report 2018.