Thomas Sowell on the myths of economic inequality

Peter Robinson at Uncommon Knowledge of the Hoover Institution interviews Thomas Sowell about the myths of economic inequality.

Thomas Sowell discusses economic inequality, racial inequality, and the myths that have continued to falsely describe the system of poverty among different racial and economic classes. He explains the economic theories behind these pervasive myths and proposes fact-based solutions for seemingly intractable situations.

Sowell discusses his early life as a high school dropout and his first full-time job as a Western Union messenger delivering telegrams. He admits to flirting with Marxism in his early twenties as he first tried to grapple with the housing inequality he saw across the neighborhoods of New York City. Marxism, he says, was the only explanation he could find at the time. He went on to serve in the Marine Corps before continuing his education in economics at Harvard and earning a master’s at Columbia and a PhD at the University of Chicago.

Sowell’s first job after his receiving his PhD in economics was working for the Department of Labor, and he says it was there that he realized Marxism was not the answer. He argues that the government has its own institutional interests in inequality that cannot be explained through Marxism. He began to be discouraged by Marxism and the government in general and began searching for better economic ideas and solutions (the free market).

Robinson and Sowell discuss Sowell’s written works, his ideas of racial and economic inequality, the state of the United States today, and much more.

How much should we care about inequality?

In this podcast from the IEA, Dr Steve Davies, Head of Education at the IEA, and News Editor Kate Andrews examine this question.

How much should we worry about inequality?

With ongoing Corbyn-mania in UK politics, and the popularity of books like Thomas Piketty’s Capital in The 21st Century, it seems like we’ve never cared more about promoting equality of outcome. But is our concern justified? Is economic disparity a characteristic of modernity - or a persistent feature of human civilization?

As Steve explains, inequality - and public concern about it - has been a feature of societies around the world, for centuries.

They also challenge the commonly held view that inequality has been rising in recent years - and examine whether people care more about some kinds of inequity than others.

Is the concept of inequality the best way of thinking about our economic problems?

This question is asked by Tyler Cowen in a chapter in a new book The US Labor Market: Questions and Challenges for Public Policy, edited by Michael Strain, which is freely available online from the American Enterprise Institute. The issues raised in the book are relevant to more countries than just the US.

Cowen opens by making an interesting comparison,

I find it useful to compare the productivity slowdown and the increase in income inequality. It seems the productivity slowdown has been of much greater consequence for human welfare, including for lower-income groups. For instance, if American productivity growth had not slowed after 1973, today the median household would earn $30,000 more each year. Alternatively, if income inequality had not accelerated after 1973, today the median household would earn an extra $9,000 more. That is less than one-third of the loss from the productivity slowdown.

One question I would ask is why income inequality and not consumption inequality? Consumption seems more relevant to people's well being.

Cowen goes on to say,

I wish to suggest a simple hypothesis: income inequality (or for that matter wealth inequality) is not the real problem. Rather, the problem is that many Americans are not seeing their lives improve as much as we would like. This is a problem whether or not the top 1 percent is seeing big gains. The problem has to do with the low level of earnings or health or well-being or opportunity for some individuals, not the disparity per se. That is a simple point, but it is difficult to communicate in today’s discourse on these issues, and it turns out to have significant concrete implications for how we should seek remedies.

Later Cowen notes,

Practically speaking, that conceptual mistake misdirects the focus to making people or their outcomes more alike, rather than elevating opportunity for those at the bottom and also in the middle. In fact, opening up enterprise and opportunity for large numbers of people often increases measured income inequality, even when it makes life better for most people, including those at the bottom. Let’s say for instance that global markets were opened up to additional trade, or occupational licensure were relaxed and new commercial opportunities were created. Some people could use these new opportunities to earn much more than others, perhaps millions or even billions more. Probably most people would be better off, but since measured inequality might well rise, analysts who focus on inequality are likely to overlook or undervalue these potential remedies. Keep in mind that the larger a market economy, the larger a country, and the higher the level of aggregate wealth, the higher the level of inequality is likely to be for purely natural reasons; if everything and everyone is clustered at or near zero, inequality just can’t get very high.

Relevant to my question about consumption inequality Cowen points out that,

If we look at the inequality of consumption, rather than income, and count government benefits as a relevant part of income, it turns out actual inequality is considerably lower than many popular or even academic discussions might indicate.

If global inequality is part of the inequality we are worried about, then we should worry less.

Another striking and under-discussed feature of the inequality debates is that global income inequality has been going down for over 20 years. The very poorest people in the world are now much wealthier than before, and significant portions of China, India, Africa, and other developing parts of the world now belong to a growing global middle class. Several billion people have been lifted out of extreme poverty into better circumstances, and over time we can expect the emerging economies to grow at faster rates than the wealthy ones, which will limit inequality all the more. At the same time, scourges such as malaria, polio, and other diseases have for the most part lost ground, most of all in poorer countries. The last 20 to 30 years are probably the most egalitarian time, in terms of income, the world has ever seen. So to the extent income equality is important, we should be celebrating like never before. More specifically, every discussion of income inequality, if it is to be accurate and scientific, should open by framing its worries in the context of a time that has made unparalleled strides toward limiting income inequality overall. Of course for political reasons that is not a popular presentation, but it is an accurate one.

Cowen then looks at key drivers of the increase in inequality. He shows that it makes sense to disaggregate "the inequality problem," as a lot of it isn’t a problem at all, or again it is a problem of some kind other than an inequality problem.

Take as an example one issue you see much discussed which is skills-biased technical change. And there could be a problem here. It is bad that some individuals do not work well with information technology, which is becoming so much more important to most people's work, and this does harm their wages and future opportunities. But the problem part of that equation is not an inequality problem; it is an education problem and a retraining problem. Cowen also discusses issues to do with global markets and rent-seeking.

Cowen sums up this section by saying,

In sum, America [and likely New Zealand] has serious problems of inadequate education, lack of retraining, and some quite bad policies in particular areas. In most cases that disaggregation is a better way of understanding what is going on rather than emphasizing inequality at the macro-economic level. The gap between rich and poor is neither the major driver of the actual problems nor the most important symptom of the most significant problems. Lack of opportunity in absolute terms is the main symptomatic problem.

In the last section of his chapter Cowen looks at the question, How Should Policy Respond? He briefly discusses five areas, Health Care, Occupational Licensing, Education Cheaper Rent and Lower Home Prices, Discontinue or Ameliorate the War on Drugs and End Crony Capitalism.

With regard to house prices and rents, an issue New Zealanders can relate to, Cowen writes,

These days it is harder for Americans to migrate successfully to some of the most economically dynamic American cities, in large part because of high rents and restrictive building codes, stemming from the NIMBY mentality. For a low-skilled worker, the higher wages in New York or San Francisco do not always make up for the much higher rental costs. In the 1950s, a typical apartment in New York City rented for about $60 a month, or adjusting for inflation about $530 a month; today that is closer to the cost of a parking space in Manhattan. If it were cheaper to move into major American cities, more Americans would have an easier path toward a higher salary and a brighter future. Economists Chang-Tai Hsieh and Enrico Moretti have argued that the American economy could become much richer if more workers could move from the low-productivity cities to the high-productivity cities; that would increase income mobility, too. Hsieh and Moretti estimate that lower rents, through building deregulation, could increase American GDP by almost 10 percent. A lot of those gains would go to Americans who cannot currently afford to move to San Francisco and other high-productivity cities.

The size of the effect on GDP of having people move from low-productivity areas to high-productivity areas did come as a surprise to me.

Cowen ends by saying that the United States has some very real and obvious problems, many of which impact the low- and middle-income earners of America in particular, but the concept of inequality is not the best conceptual starting point for finding or evaluating potential solutions.

There are many other interesting points made in Cowen's chapter and it is well worth the read, no matter what your current view of inequality.

The book containing Cowen's chapter also has many other useful chapters on a variety of issues to do with labour markets. Anyone interested in such markets should give it a read.

The New Zealand Initiative on inequality and poverty

As most readers will be aware the New Zealand Initiative recently published a second report on inequality and poverty. This report, The Inequality Paradox: Why inequality matters, follows on from their earlier report, Poorly Understood: The state of poverty in New Zealand.

Now at the Sand Pit blog  they have listed 21 major messages and arguments from their research. (The references in parenthesis are to the Inequality Paradox report, unless otherwise stated.)

1. Increased housing costs are hitting those on low incomes hardest, and to a very severe degree. (Figure 28.) Getting more houses built is a critical issue, regardless of economic inequality.
2. There is substantial material hardship in New Zealand households. Specifically, around 4% of the population are “doing without” to a severe degree and 11% to a less severe degree. For children the proportions are higher, at 8% and 18% respectively. For the elderly they are lower, at 1% and 3% respectively. The overall proportions are similar to an average for a group of EU countries. (Table 5 of the Poorly Understood report.)
3. It is wrong and potentially counter-productive to conflate relatively low incomes with poverty or hardship. Claims that quarter of a million of children or more (25%+) are living in poverty because they are in relatively low income households are gross exaggerations.
4. Economic inequality rose markedly from the mid-1980s to the mid-1990s on all three of the main measures: pre-tax market income, disposable income and consumer spending. The share of the top 1% rose sharply in particular. Changes in household structure, socio-demographic attributes, employment outcomes and economic returns could account for perhaps 50% of the rise in disposable income inequality during this period.
5. Current income is a poor indicator of hardship. Specifically, only around 40-50% of those experiencing relatively low current incomes are also experiencing hardship, and some on higher incomes are experiencing hardship.One reason is that low income is a temporary situation for a considerable proportion of households, another is that the elderly can be asset rich but income poor.But a real difficulty is that unanchored relative income measures don’t tell us anything about actual living standards, eg poverty. Our Poorly Understood report shows that current welfare benefits are much higher, inflation adjusted, than what was deemed to be an adequate wage for a labourer to earn in order to be able to support a dependent spouse and three children back in 1936. The Ministry of Social Development’s authoritative annual statistical reviews of well-being and inequality show that real income growth has markedly reduced the proportion of households falling below an earlier real income threshold.
6. Consumer spending is a better indicator of living standards. More recent Motu research has found that it is also a much better indicator of self-assessed well-being.
7. Consumer spending inequality rose from the mid-1980s to the mid-1990s, but by 2013 it had returned to around its mid-1980s level, despite the housing cost issue. (Figure 9)
8. Contrary to what the public is continually told, disposable income inequality has not trended up since the mid-1990s on the most commonly cited measure (the Gini coefficient). Market income inequality has actually trended down. (Figures 4 and 5.) The paradox is that newspaper headlines featuring inequality have risen more than 8-fold in the last decade.
9. Much market income inequality arises from substantial differences in hours of paid work and wage differentials that are related to differences in educational achievement (a proxy for skill) and age (a proxy for experience and responsibility). (Figures 23-27.) What else would we expect?
10. The share of top income earners in private income was much higher in the first half of the last century than it is today. A long decline occurred from the 1950s to the late 1980s. (Figure 3.)
11. The big rise in the pre-tax income share of the top 1% of income earners in the late 1980s occurred at a time of severe recession, major company collapses and tax reforms that sharply increased the tax take from top income earners overall while reducing the tax rate on the last dollars of their income. (Figures 3 and 10.) It is implausible that the real pre-tax market incomes of this group accelerated upwards during this period. It is plausible that a lot more of their incomes became taxable. The real rise in income inequality in New Zealand could be overstated to some degree for this reason. The (more modest) rise in spending inequality might be a better indicator. Moreover, since the mid-1990s the income share of the top 1% has, if anything, trended down not up. (Figure 1.) Since the early 1990s household income growth has been reasonably proportionately shared on MSD’s calculations. (Figure 8.)
12. The proportion of top income earners in New Zealand who are salary and wage earners, has risen in the last decade, contrary to the Thomas Piketty thesis of a growing dominance by the passive income of inherited wealth.
13. Our report is dubious about the quality of wealth distribution measures. For a start the measures ignore human capital and the net present value of NZS. But for what it is worth, the wealth share of the wealthiest 1% in New Zealand is not out of line with that in the member countries of the OECD. (Figure 15.) It is actually right at the bottom end of the spectrum for estimates that adjust for the under-reporting of wealth by the richest. (Figure 36.)
14. It is ridiculous to attribute the sharp 1988-1991 rise in the share of the top 1% to the decline in unionisation in the years following the Employment Contracts Act 1991
15. Our top executives are only paid a small fraction of what top Australian executives and their pay is a lower multiple of worker pay. (Table 1 and text.)
16. On the limited evidence available, income mobility in New Zealand is comparable to that in other countries. (Figures 21 and 22.)
17. One response to the call that the rich should be “asked” to pay more in tax is that they already do. Indeed, on Treasury numbers the top 40% of households by income are the only ones that pay any income or GST over and above what they receive in return through the welfare system and health and education benefits in kind.
18. It is very important that market incomes are fairly earned and are seen to be fairly earned. Anything else corrodes community trust and cohesiveness. There should be a strong presumption against corporate welfare, including bail-outs for bankers.
19. Survey evidence for New Zealand suggests that it is widely held that beneficiaries are responsible for their own situation and that high incomes in New Zealand are a reward for talent. (Table 4.) But there is also considerable concern about the degree of economic inequality in New Zealand. (Table 2.)
20. Survey evidence globally and in New Zealand also indicates that the public is widely ignorant concerning the degree of economic inequality and that people’s policy preferences tend to reflect their perceptions rather than reality, where there is a difference. (Figure 36.)
21. An ongoing public debate about economic inequality is important so that valid concerns are addressed and invalid concerns are identified.

So those who wish to complain about the great evils of the New Zealand Institute's research but can't be bothered actually reading it now have a nice numbered list of things to get all hot and bothered about.

A response to the latest NZI report by Max Rashbrooke is available here. He argues that the most fundamental omission in the report is its failure to deal in any significant way with the long-running consequences of widened inequality. But I find myself asking, Why do we care if inequality has increased, assuming it in fact has? Is poverty not the real problem? The two are not necessarily the same thing. He does agree however that "housing costs are a big problem, particularly for lower earners". As point 1 above says "Getting more houses built is a critical issue, regardless of economic inequality".

Inequality v's crony capitlism

At his Stumbling and Mumbling blog, everybody's third favourite Marxist, Chris Dillow says Yes, Inequality Matters. Dillow writes,

A free market society in which high incomes arise from the free choices of consenting adults – as in Robert Nozick’s Wilt Chamberlain parable – might have the same Gini coefficient as a crony capitalist society. But they are two different things. A good reason to be worried about current inequality – even if it hasn’t changed – is that it is a symptom of market failures such as corporate welfare, regulatory capture or the implicit subsidy to banks.

Here I think Dillow is right .... and wrong. He is right that crony capitalist societies are bad, but he wrong to tie this to inequality.

The reasons for disliking crony capitalism is the inefficiencies, via things like rent seeking, corporate welfare, subsidies to favoured industries etc, that such a system invariably results in. But these outcomes are independent of the level of inequality.

Even if inequality was low under a crony capitalist system, that system would still be in need of change and if a (truly) free market society has greater inequality it would not justify the transformation that the crony capitalist system would. Inequality is not the reason for worrying about crony capitalism, there are many other, better, justifications for doing so.

Not everything that is thought wrong in this world is due to inequality, no matter what some people will tell you.

Harford on inequality

At his blog Tim Harford has been writing on The truth about inequality. He says,

How serious a problem is inequality? And if it is serious, what can be done about it?

Myths abound. Many people seem to believe that Thomas Piketty’s Capital in the Twenty-First Century showed that wealth inequality is at an all-time high; instead, his data show that wealth inequality has risen only slowly since the 1970s, after falling during the 20th century. In Europe we are thankfully nowhere near the wealth inequality of the past.

Another common belief is that the richest 1 per cent of the world’s population own half the world’s wealth (almost true) and that their share is inexorably increasing (not true). The richest 1 per cent had 48.2 per cent of the world’s wealth in the year 2014, according to widely cited research from Credit Suisse, but that share has fallen and risen over the past 15 years. It is lower now than in 2000 and 2001.

Neither is it clear that global inequality is rising. Average incomes in China and India have risen much faster than those in richer countries; this is a powerful push towards equality of income. But inequality within many countries is rising. Research from Branko Milanović, author of The Haves and the Have-Nots, suggests that the two forces have tended to balance out roughly over the past generation.

One final myth is that inequality in the UK has risen since the financial crisis. In fact, it has fallen quite sharply. “Inequality remains significantly lower than in 2007-08,” said the Institute for Fiscal Studies last summer. That conclusion is based on data through April 2013. The IFS did add, though, that “there is good reason to think that the falls in income inequality since 2007-08 are currently being reversed.”

Harford then makes an important point about the need to take income redistribution into account when looking at inequality.

The UK already redistributes income extensively. As Gabriel Zucman of the London School of Economics points out, the UK’s richest fifth had 15 times the pre-tax income of the poorest fifth, but after taxes and benefits they had just four times as much.

I would think that if we were to look at consumption, which to me seems the important thing, the gap between "rich" and "poor" would decrease even more.

Of course there are those who would have the government redistribute even more but my previous post on To eat the rich, first they must stay still should act as a warning as to what could happen when the top income rates are raised.

I would suggest there is one addition question Harford did not ask: Is inequality a problem at all? Only after having answered that question yes should we ask how big the problem is and what can we do about it.

To eat the rich, first they must stay still

Taxation is always a problematic issue but the taxation of very high income earners is becoming an even more controversial subject in a number of countries. One problem with high tax rates is that it could lead high earners to move abroad. A new column at VoxEU.org suggests that top-tier inventors are significantly affected by top tax rates when deciding where to live. It is argued that the loss of such highly skilled agents could entail significant economic costs in terms of lost tax revenues and less overall innovation.

There is much debate, but little evidence, about the effects of high tax rates on high earners. The anti-tax side argue that higher top tax rates will cause an exodus of valuable, high income and highly skilled economic agents. They claim that high tax rates will unavoidably lead to a brain drain and an exodus of the most qualified people, especially as barriers to labour mobility between developed countries are reduced. The pro-tax side maintain that migration decisions are driven by other (possibly non-economic) considerations and would not respond very much to higher taxes.

It is generally acknowledged that non-human capital is highly mobile in a globalised world. This fact is used to justify lower taxation on capital. Much less is known about the mobility of human capital in response to taxation.

In their article, The effects of top tax rates on superstar inventors, Ufuk Akcigit, Salome Baslandze and Stefanie Stantcheva argue that inventors are highly valuable economic agents as creators of innovations and potential drivers of technological progress.

A group of highly valuable economic agents that policymakers perhaps might worry about is inventors, the creators of innovations and potential drivers of technological progress. Inventors may well be important factors for a country’s development and competitiveness – highly skilled migration has been shown to be both beneficial for a receiving country’s economy and to disproportionately contribute to innovation [...].

Consider Alexander G Bell, the inventor of the telephone; James L Kraft, who patented a pasteurisation technique and founded Kraft Foods; Ralph Baer, the inventor of the first home video gaming console that contributed to the expansion of the video gaming industry; or Charles Simonyi, a successful product developer at Microsoft. In addition to being very prolific inventors, they had something else in common: they were all immigrants. This is not very surprising given that migration rates increase in skill [...] and inventors are ranked very highly in the skill distribution.

It’s true, however, that inventors vary vastly in their quality and innovativeness. The big question is to do with the behaviour of the 'superstars': Do 'superstar' inventors respond to top tax rates?

In recent research (Akcigit, Baslandze, and Stantcheva 2015) we study the international migration responses of superstar inventors to top income tax rates for the period 1977-2003 using data from the European and US Patent offices, as well as from the Patent Cooperation Treaty [...]. Our focus is on migration across eight technologically advanced economies: Canada, France, Germany, Great Britain, Italy, Japan, Switzerland, and the US. To abstract from capital and corporate taxes as much as possible, we restrict our attention to inventors who are company employees and are not the owners (‘assignees’) of their patents.

Superstar inventors are those in the top 1% of the distribution of citations-weighted patents in a given year and ‘stars’ are inventors who are just below superstars in terms of quality and are in the top 1-5% of the citations-weighted patent distribution.

From outside survey evidence, we know that superstar inventors are highly likely to be in the top tax bracket and, hence, directly subject to top tax rates. Stars or inventors of lower quality are much less likely to be in the top bracket. The top tax rate, which can also be viewed as a ‘success tax’ can also have either an indirect motivating or discouraging effect on inventors in general, even on those who are not yet in the top bracket.

There has is a strong and significant correlation between top tax rates and those inventors who remain in their home countries. The relation is strongest for superstar inventors. [Results] show that superstar inventors are highly sensitive to top tax rates. The elasticities imply that for a ten percentage point reduction of top tax rates from 50% to 40%, a country would be able to retain on average 3.3% more of its top 1% superstar inventors. This relation weakens as one moves down the quality distribution of inventors – the top 25-50% or the bottom 50% of inventors are no longer sensitive to top tax rates.

[...]

At the individual inventor level, we have developed a detailed model for location choice. This wasn’t easy for two reasons. First, location choices are clearly also driven by factors other than taxes – such as language, distance to one’s home country, and career concerns – for which we include controls. Second, inventors may earn different pre-tax wages in different countries. This is a counterfactual we cannot observe and have to control for through a detailed set of proxy measures.

The results highlight that superstar top 1% inventors are significantly affected by top tax rates when deciding where to live. For instance, our results suggest that, given a ten percentage point decrease in top tax rates, the average country would be able to retain 1% more domestic superstar inventors and attract 38% more foreign superstar inventors.

[...]

We also consider long-term mobility, defined as a one-way move abroad. It turns out that long-term mobility is still affected by taxes, but to a lesser extent. This seems to imply that there are some adjustment costs to moving that might prevent inventors from moving back once they leave due to higher taxes.

What is the influence of companies on inventors’ migration responses to taxes?

One would expect companies to have an important influence on the inventor’s decision to move abroad. For instance, working for a multinational company might facilitate an international move, both directly within the company and indirectly by providing international exposure. Depending on the bargaining power between employer and employee, the relocation decision might well be driven by the former rather than by the latter. In that case, and if the employer has other considerations than personal income tax, we would observe a dampened migration effect of taxes in the data. Note, nevertheless, that employers should take personal income taxes into account to some extent, if competition for superstar inventors forces them to pay higher wages as a compensation for higher taxes.

We find that inventors who have worked for a multinational company are more sensitive to tax differentials in their location choice. On the other hand, inventors whose company has a significant share of its innovative activity in a given country are less sensitive to the tax rate in that country. This seems to suggest that career concerns can outweigh tax considerations. It could also signal that companies with very geographically localised research and development activities will strongly prefer to keep their superstar inventors at the main research location and dissuade them from moving to lower tax countries.

The upshot of all of this is that labour, like capital, might be internationally mobile and respond to tax incentives. The loss of highly skilled agents such as inventors might entail significant economic costs, not just in terms of tax revenues lost but also in terms of reduced positive spillovers from inventors and, ultimately, less innovation in a country.

Ref.:

• Akcigit, U, S Baslandze and S Stantcheva (2015), “Taxation and the International Mobility of Inventors”, Working Paper 21024, National Bureau of Economic Research.

Wage inequality and firm growth

At VoxEU.org Holger Mueller, Paige Ouimet and Elena Simintzi look at the relationship between Wage inequality and firm growth. Rising wage inequality has received much attention recently and this column describes new evidence on the determinants of the 'skill premium'.

There are two basic findings:

1) larger firms have grown substantially and
2) skill premia are larger at larger firms.

They therefore conclude that the growth of larger firms could help explain growing wage inequality.

To get to these results first it is necessary to identify the 'skill premium' and know how to measure it. The 'skill premium' is simply the wage difference between high and low skill workers. Defining the skill premium is one thing, measuring it is another.

Existing measures of skill premia, such as education, experience, or even occupations, are not adequate as they do not reflect a one-to-one mapping between job tasks and skill requirements. [...].

In our data, provided by Income Data Services (IDS), we observe how much a firm pays workers employed in different occupations and, crucially, how these occupations map into broader ‘job level’ categories which are comparable across firms. Since job levels are determined based on the skills required for the job, comparing wages for a worker classified at a high job level to a worker classified at a low job level allows us to more directly measure the skill premium. Moreover, since we have these data for a broad cross-section of firms measured at multiple points in time, we can observe within-firm and across-time patterns in the skill premium.

To provide further detail, consider a cleaner and a finance director. The cleaner corresponds to job level 1, work that “requires basic literacy and numeracy skills and the ability to perform a few straightforward and short-term tasks to instructions under immediate supervision”. The finance director corresponds to our highest skill category – job level 9 and involves “very senior executive roles with substantial experience in, and leadership of, a specialist function, including some input to the organisation’s overall strategy”. We measure skill premium using a ratio of a high-skill to low-skill job, at the same firm, in the same year.

Importantly,

When examining ‘top-bottom’ wage ratios in our sample (e.g., the wage associated with job level 8 divided by the wage associated with job level 1 within the same firm and year), we find they increase with firm size. A similar, albeit weaker, relationship arises when we look at ‘top-middle’ wage ratios (e.g. the wage associated with job level 8 divided by the wage associated with job level 4 within the same firm and year). In contrast, ‘middle-bottom’ wage ratios (e.g. the wage associated with job level 4 divided by the wage associated with job level 1 within the same firm and year) stay flat, or if anything slightly decrease with firm size.

• What is interesting is that when low job levels (1 to 5) are compared to one another, an increase in firm size has no effect on within-firm skill premia.
• In contrast, when high job levels (6 to 9) are compared to either one another or low job levels, an increase in firm size widens the wage gap between higher and lower skill categories.

The question this give rise to is Why do wages in high-skill job categories increase with firm size but not wages in low- and medium-skill job categories?

We provide two possible explanations.

• First, larger firms invest more in automation which allows them to replace labour with technology in certain routine jobs [...].

Consistent with this hypothesis, we find that wages associated with routine jobs decline relative to those associated with non-routine jobs as firms become larger, especially in medium-skill job categories.

• Second, larger firms may pay relatively lower entry-level managerial wages in return for providing better career opportunities [...].

Consistent with this hypothesis, we find that managerial wages in low- to medium-skill job categories are relatively lower in larger firms, while those in high-skill job categories are relatively higher in larger firms.

Is there a third factor here? We know that the division of labour is limited by the extent of the market and bigger firms have larger internal labour markets which gives raise to a greater levels of specialisation with some areas of specialisation being more valuable than others. These higher value jobs receive greater remuneration.

The last question is, What do the results say about overall wage inequality?

An increasing skill premium at larger firms will lead to greater wage inequality inside those firms. But how has the size of the median employer changed over the last two decades? US firms with 500 or more employees accounted for 51.5% of all employment in 2011. As such, we measure firm size by focusing on the largest firms and find evidence of strong firm growth among larger firms in practically all of the developed countries in our sample. These results suggest that part of what may be perceived as a global trend toward more wage inequality may be driven by an increase in employment by the largest firms in the economy.

So the upshot of this is that the growth of larger firms in the economy may partially explain the rise in wage inequality seen over the last few decades.

Two interesting looking recent working papers

First a paper on Thomas Piketty's recent book:

The Rise and Fall of General Laws of Capitalism
Daron Acemogluy James A. Robinsonz

Abstract
Thomas Piketty's recent book, Capital in the Twenty First Century, follows in the tradition of the great classical economists, Malthus, Ricardo and Marx, in formulating "general laws" to diagnose and predict the dynamics of inequality. We argue that all of these general laws are unhelpful as a guide to understand the past or predict the future, because they ignore the central role of political and economic institutions in shaping the evolution of technology and the distribution of resources in a society. Using the economic and political histories of South Africa and Sweden, we illustrate not only that the focus on the share of top incomes gives a misleading characterization of the key determinants of societal inequality, but also that inequality dynamics are closely linked to institutional factors and their endogenous evolution, much more than the forces emphasized in Piketty's book, such as the gap between the interest rate and the growth rate.

and then one on free banking and economic growth in Quebec:

Free Banking and Economic Growth in Lower Canada, 1817–1851
Mathieu Bedard and Vincent Geloso

Abstract
Generally, the historical literature presents the period from 1817 to 1851 in Lower Canada (modern day Quebec) as one of negative economic growth. This period also coincides with the rise of free banking in the colony. In this paper we propose to study the effects of free banking on economic growth using theoretical and empirical validations to study the issue of whether or not economic growth was negative. First of all, using monetary identities, we propose that given the increase in the stock of money and the reduction in the general price level, there must have been a positive rate of economic growth during the period. We also provide complementary evidence drawn from wages that living standards were increasing. It was hence impossible for growth to have been negative. Secondly, we propose that the rise of privately issued paper money under free banking in the colony had the effect of mitigating the problem of the abundance of poor quality coins in circulation which resulted from legal tender legislation. It also had the effect of facilitating credit networks and exchange. We link this conclusion to the emergence of free banking which must have been an important contributing factor. Although we cannot perfectly quantity the effect of free banking on economic growth in Lower Canada, we can be certain that its effect on growth was clearly positive.

Tyler Cowen on inequality and what really ails America

Eduardo Porter writes-up an email interview he had with economics professor Tyler Cowen on the subject of inequality.

A few interesting questions:

Q: Inequality is running amok. The richest one percent of Americans pull more than a fifth of the nation’s income. The top 10 percent take half, more than during the Roaring Twenties. President Obama seems to believe this is “the defining issue of our time.” Is it?

A: “Income inequality” consists of at least three separate issues: 1) the top one percent is earning more; 2) the relative return to education is rising; and 3) economic growth is slow, and thus many lower- and middle-income groups are not seeing their incomes rise very much over time. The third of these is arguably the defining issue of our time. Grouping these issues all together under the broad heading of “income inequality” I view as a big intellectual mistake.

Q: So should we worry at all about the chasm opening up between the income of the rich and the rest?

A: I worry about stagnation in the middle and towards the bottom, not the income gap per se. A lot of the income growth at the top has come from globalization; for instance, Apple now sells a lot of iPhones to China. That’s not something we should be worried about. Rather, we should celebrate it.

Q: So, your conclusion is we should obsess less about rising inequality in America.

A: We should focus policy on increasing the quality and affordability of housing, health care and education, and on raising the rate of technological advancement. If we did that, we wouldn't have to worry about this red herring of “inequality” writ large any more.

By the way, the biggest inequalities are those across borders. So if we are talking policy, how about a more liberal immigration policy for the United States? That should be the No. 1 priority for anyone concerned about income inequality.

Acemoglu on inequality

From the Economist back in 2011 comes this comment by Daron Acemoglu about why inequality matters:

THERE are three main reasons why society may care about inequality. First, people's well-being may directly depend on inequality, for example, because they view a highly unequal society as unfair or because the utility loss due to low status of the have-nots may be greater than the utility gain due to the higher status of the haves. Second and more importantly, equality of opportunity may be harder to achieve in an unequal society. Many economists have, by and large rightly, focused more on poverty than inequality. Poverty not only causes low standards of living and poor health but damages both individuals and society by preventing those at the bottom from realising their potential, perhaps because they are unable to obtain a decent quality of education to prepare them for competition in the labour market. While poverty is clearly the more important factor in creating a non-level playing field, inequality may also be a nontrivial factor: those with greater wealth provide to their children resources and thus opportunities that the less wealthy cannot, and this may make it more difficult for society to achieve equality of opportunity.

Third and most importantly, inequality impacts politics. Economic power tends to beget political power even in democratic and pluralistic societies. In the United States, this tends to work through campaign contributions and access to politicians that wealth and money tend to buy. This political channel implies another, potentially more powerful and distortionary link between inequality and a non-level playing field. It may also create pathways from inequality to instability, because both the economic and political implications of inequality can create various backlashes.

The first argument may be true, but so could the opposite argument. And how could we ever measure people's utility anyway? The second argument is more about poverty than inequality per sec while the third is more a political argument than an economic one. You could imagine a state of the world where such an argument would hold but equally you could imagine ones in which it doesn't. A strong 'politics of envy' type effect could generate instability. But isn't instability more likely to be driven by poverty and people's react to that? Consider two economies, one where the four people in it have incomes of 1,1,1 and 1 and the other where incomes of these people are 100, 1000, 5000 and 7000. Further assume that incomes have been scaled so that 0 is the least acceptable level of income, say, for argument's sake that 0 means you are dead. Which of the two economies is more likely to be stable, the equal but poor one  or the wealthier but more unequal one?

But why does inequality matter? 2 (updated)

Brennan McDonald offers an answer to the question from my previous blog posting here. Brennan writes

• Inequality is on the agenda because the media are writing about it
• The media are writing about it because envy is as old as the hills and journalists earn rubbish wages so anyone on a higher income is a fair target for them
• Most journalists’ eyes glaze over when they see numbers so clear discussion is not possible
• So despite a lot of evidence to suggest that maybe income and wealth inequality in New Zealand isn’t as bad as it’s made out to be, that conclusion doesn’t get page views so emotive language rules how the discussion is framed

I fear that to a large degree he is right, but this just moves the problem back one stage, Why are the media talking about it? A some point I assume its because they think something bad is caused by inequality so I ask what is the something and what is the evidence that inequality caused that something?

Also I would like to think well of my fellow economists so I hope they have a better reason for worrying about inequality than envy and that their eyes don't glaze over at the sight of numbers and thus they can undertake a clear and rational discussion of the topic. Starting with why they are concerned with the topic at all.

Update: Matt Nolan writes Are we all confusing status competition and ‘inequality’: Short answer, yes

But why does inequality matter?

There seems to be lots of talk on the blogs these days about inequality (e.g. here, here and here), but no one bothers to explain why we should care about it, it just seems to be taken as a given that we should care. Over at the The Fly Bottle blog Will Wilkinson writes,

I’m tired of arguing about inequality. It’s frustrating. It’s unproductive. Nobody is really interested in the analytical arbitrariness and moral insidiousness of measuring intra-national economic inequality. Nobody is really interested in the fact that multiple mechanisms–some good, same bad, some neutral–can produce the same level of measured inequality, rendering the level of inequality, taken in isolation, completely useless as a barometer of social or economic justice. Nobody really cares. Because many different combinations of causes can produce the same level of inequality, it’s not so clear that high inequality, as such, can reliably cause anything. The consequences of inequality depend on the mechanisms driving inequality. Nobody cares.

To Will I say, some people seems to care, at least people writing New Zealand based economics blogs seem to care, but they don't tells us why. The highlighted bits in the Wilkinson quote seems to me to make a couple nice points in that it seems to me that inequality is a useless measure of anything that matters and its not clear, to me at least, what exactly inequality causes.

So will those bloggers among you who are so fired up about the evils of inequality please explain why you are so agitated about it.

Thanks.