Wednesday, January 5, 2011

The Income Distribution

This piece by Mark Thoma is a strange one, but it at least got me thinking. Mark starts with:
There is an equivalent of a Laffer curve for inequality, but the variable of interest is economic growth rather than tax revenue. We know that a society with perfect equality does not grow at the fastest possible rate. When everyone gets an equal share of income, people lose the incentive to try and get ahead of others. We also know that a society where one person has almost everything while everyone else struggles to survive – the most unequal distribution of income imaginable – will not grow at the fastest possible rate either. Thus, the growth-maximizing level of inequality must lie somewhere between these two extremes.
The "Laffer curve for inequality" is new to me, so I was hoping for a little more in terms of theory, but I guess the rest of the paragraph will have to do. Here's what Mark might have in mind here, though it's hard to tell. From standard neoclassical growth theory, we know that growth in our standard of living is driven by growth an aggregate TFP (total factor productivity), which in turn depends on technological innovation, and the efficiency with which factor inputs are allocated across productive units. Suppose we focus only on technological innovation. Innovators of course need incentives. Innovation is costly, and the reward needs to be sufficient to make it worthwhile. Now, imagine a population of identical people who have two choices: they can engage in risky innovation, or they can engage in subsistence farming. Also, suppose that there is one person - call him Kim Jong-Il - in this society, who has the power to redistribute income at will.

Suppose, on the one hand, that Kim Jong-Il is an egalitarian, and chooses to equalize income across the population. Then, there is no innovation, and this economy will be stuck in subsistence farming forever. On the other hand, suppose that Kim Jong-Il is, well, Kim Jong-Il. He starves the population, actually keeping them below what we would think of as subsistence, but still healthy enough to produce some extra stuff for the dear leader. There is no innovation in this society either, and it remains stuck.

So, now we have two points on the Laffer curve for inequality. What happens in between? Well, there are many ways in which we can redistribute income. We can provide some minimum quantity of a particular service - e.g. health care - for everyone; we can provide insurance against bad events - e.g. unemployment; we can tax some people and use the proceeds to provide public education for anyone who wants it. The effects on innovation will of course have a lot to do with how we do the redistribution. For example, unemployment insurance and welfare could have the effect of deterring innovation through poor incentives, but if the risk of innovation is difficult or impossible to insure through private financial markets, social insurance might actually increase innovation.

This certainly seems interesting. Now, where is Mark going with this? He drops this one:
We may be near or even past the level of inequality where growth begins falling.
So, Mark's concern is that we are entering Kim Jong-Il territory, which would certainly be distressing. What's the evidence for this?
The evidence on this is highly uncertain, so it’s difficult to say.
So Mark admits to not knowing what is going on, but he's quite willing to bull ahead with a policy recommendation:
But increasingly I am of the view that even if we could level the domestic playing field, it still won’t solve our wage stagnation and inequality problems. Redistribution of income appears to be the only answer.
Basically, Mark wants to throw in the towel on education and embark on an income redistribution project. Though the details of the redistribution are critical, Mark avoids specifics.

What do I think? What anyone can see with their own eyes in American cities is appalling. Many of our graduate students come from countries where people are much less well-off than is the average American, and they find it appalling. In many cases, for example here in St. Louis, the first world lives comfortably a short distance from the third world. The dispersion in income across the population in the US is large relative to what it is in other wealthy countries, and that dispersion has increased over the last few decades. Maybe we would not be too bothered by that if we thought that there was high mobility among income classes over time, but we know that there is a significant fraction of the population that is stuck near the bottom.

What's to be done? I'm certain that dumping cash in the inner cities will not promote economic growth in the United States, just as dumping cash in sub-Saharan Africa will not increase world economic growth. The answer has to be education. Here's an example of a sharp economist who has not thrown in the towel. Art Rolnick, recently retired from the Federal Reserve Bank of Minneapolis, has been an advocate of early childhood education. He uses economic evidence, including work by Heckman, to argue that the benefit/cost ratio for funds spent on early childhood education is very large. Further, he puts his time and effort where his mouth is. Indeed, Art embodies what is best in the economics profession: productive work toward a better society using a solid foundation of theory and empirical evidence.


  1. This recent IMF paper - (via Thoma a couple of weeks ago) at least tries to consider the dynamical implications of inequality and non-stationary distributions of income - which is part of the problem.

    Perhaps their model would give clues as to an optimum distribution.

    No doubt that improving educational opportunities would be helpful, but what happens when power elites insist that such education be privatized and only available to those that can afford it. Just having educational equal opportunity implies some redistribution of income.

  2. 1. I hadn't seen the IMF paper. There are clearly distributional issues related to the financial crisis. There is a big debate about this. One group (apparently Republicans on the Financial Crisis Inquiry Commission) claims that the financial crisis was produced by an attempt to use credit market policy to redistribute income. Others claim that is overblown.
    2. Yes, this is an old story. If I send my kids to private schools I might feel I have no stake in public education. The people arguing this line also seem to like incarceration, which is more costly per head than public education.

  3. There is a literature on this issue, which has been active since the 1990s, and which uses calibrations of dynamic GE models to provide quantitative answers.

    Roland Benabou, for example, has a nice paper in Econometrica in 2002, where credit constraints play a key role. The idea in that paper is that poor households are unable to borrow to invest in the human capital of their children. Redistribution can help, but also generates tax distortions. Hence, a trade-off exists. In some cases, the growth-maximizing (and the welfare-maximizing)level of redistribution is positive.

    Benabou calibrated his model to the US economy of the time, and argued that too much redistribution was going on at the time. It turns out, though, that he messed up the calibration part of his paper and, when the error was corrected, the existing level of redistribution in the US (pre-Bush) was just about optimal. (See Tang and King, Econometrica, 2005.)

  4. "I'm certain that dumping cash in the inner cities will not promote economic growth in the United States,"

    but I don't care. Over the last three+ decades there has been great economic growth in the US. However, the people I care about are those at the median (typical Americans) and the bottom (the poor). These people haven't seen any rewards from this growth.

    As long as the rewards of growth go almost entirely to a tiny group at the top growth is meaningless. But an immediate welfare improvement could be obtained with redistribution.

    Moreover, the long-run effects could well be positive for growth. In particular, families would be more able to invest in e.g. education for their children. Having more money also insulates children from various other bad things.

    I myself am not in the "broaden the base and lower marginal rates" school. Rather, I favor "broaden the base and raise marginal rates." I find the thesis that raising marginal rates at the very top will lose anything worth keeping most unconvincing.

  5. It looks like my comment about retirement was deleted. If so, why?

  6. "but I don't care. Over the last three+ decades there has been great economic growth in the US. However, the people I care about are those at the median (typical Americans) and the bottom (the poor)."

    At least you admit it -- your preferred welfare function gives zero weight to certain people. Mine gives zero weight to the people you give positive weight to.

    And your failure to understand economics is distressing but not surprising.

  7. I always found the inequality reasoning flawed. I.e. you always hear 'if everyone was equal, the growth would be bad'. However zero redistribution doesn't necessarily imply that everyone just cannot be equal.

    What the person is doing is basically 'if we set the rules in such a way that anything you earn is redistributed' than you will get probably negative growth; but if you have rules 'evryone retains what he earns', and by a stroke of chance the society ends up perfectly equal, than you will get probably very good 'growth'.

    The implication is that the question 'how does the productivity change with changes in income distribtion' doesn't make any sense, because the income distribution is reflection of productivity of different people. What these people actually ask is 'how does productivity change if we start to redistribute'.

  8. The last anonymous has hit the nail on the head as to why the literature on this kind of question hasn't gotten very far. Both TFP and inequality are endogenous variables. We need a convincing model that explains the feedback between the two. Given that empirical results (growth regressions, dynamic panels, etc.) are mixed, it seems likely that the relationship between TFP and inequality varies with the levels of those varaibles (and others as well).

  9. Interested Party:

    Thanks for the references. Some people, including Heckman, think the credit constraints are not important and there is more bang for the buck, for example, in Rolnick's early childhood education rather than credit programs. I'm sure there is plenty of other work on income distribution and growth, but it's not my specialty. There is of course the "Kuznets curve." Kuznets had the idea that, as development occurs, income inequality increases, then decreases. Some people have tried to model that, e.g. Greenwood and Jovanovic.

    "However, the people I care about are those at the median (typical Americans) and the bottom (the poor). These people haven't seen any rewards from this growth."

    Of course if you gave more to the poor they would not be so poor. Would you then like them less?

    Last anonymous and Joe: Yes, exactly. Everything is endogenous. You really need a serious model to evaluate these things. Not only do you have to worry about the interrelationship between TFP and the income distribution, but the fact that there is mobility within the distribution.

  10. Deleted comment anonymous:

    I could not make sense out of your comment, and thought you might have something nefarious in mind. Sometimes I get people who are being nasty or otherwise badly-behaved, and I delete their comments. I thought that's what was going on. Feel free to post your comment again if you're innocent.

  11. How about a view from a less lofty position. I always bought the theories about how bad redistribution is and its negative effects on innovation. I also bought into the education is the solution theory. In the real world a lot of people work ordinary and sometimes menial jobs. Over the past couple of decades we have allowed those at the top to accumulate more and more, prices of everything have gone up, and these people are much worse off than before. We can't educate away these jobs (and there are a lot of people in these positions). Experience shows that increasing wealth to those who are supposed to "innovate" and create jobs (kind of a trickle down thesis) don't hold up their end. Instead they want to pass the wealth/capital down to their heirs while lower and middle class Americans need health care and retirement security. If government doesn't figure out how to ensure that the riches are distributed equitably we will end up with even worse off than now. I'm not an economist just an observer from flyover country.

  12. David,

    As economists, we recognize a role for government in stepping in where private markets do not work well. There is wide agreement that the private market will not provide us with national defense, law enforcement, and in all developed countries governments see it as useful to provide opportunities through public education. The private market may also not provide adequate insurance, for example against unemployment, but here there is more disagreement about why and how the private market fails and the best way to correct the problem. To some extent some people are rich through sheer good luck, and others are poor through sheer bad luck. The private market does not provide insurance against the bad luck, and therefore it makes sense to do some redistribution, by way of social programs. In Scandinavia they do a lot of this redistribution, in the US we don't do so much, and countries like Canada are somewhere in between. The financial crisis has made us aware that some people can get very rich through what appears to be theft. Possibly some financial innovations were designed just to obfiscate and allow theft; possibly some CEOs are effectively stealing from shareholders. There are remedies for that through the legal and regulatory system. That said, as economists we don't like to make value judgements. Who is to say what the distribution of income "should" be? Who should be rich and who should be poor? In a free society, that isn't something we want the government to decide. Ultimately, once we fix the market failures, we have to let the market decide who gets what. We know that Marxism doesn't work. That's been tried on a grand scale, and it makes people miserable. This Randy Newman song says it nicely:

  13. ELIE taxes:

    I had never heard of this and had to look it up. It's "Equal-Labor Income Equalization" taxes - an incentive compatible tax scheme which some have argued gives optimal outcomes.

  14. 'Who is to say what the distribution of income "should" be? Who should be rich and who should be poor? In a free society, that isn't something we want the government to decide.'

    You realize the irony of this, right?

    Let me rephrase what you said:

    "In a free society, we SHOULD not let the government decide."

    There's that word again...turns out your normative judgment is no less arbitrary or valid than the original commenter's.

    Maybe you SHOULD work harder on "not making value judgments."