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Wednesday, January 05, 2011

"The Income Distribution"

Stephen Williamson takes issue with my column on inequality. He says education rather than redistribution of income is the answer:

The Income Distribution, by Stephen Williamson: 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.

I hope people realize that I have space constraints in the column, so I can't cover every point in depth.

Williamson is wrong to assert that I advocate "throwing in the towel" on education. But I don't think we should exaggerate our ability to make progress in this area either. Let me repeat something I wrote recently in response to a Mankiw column making the same argument as Williamson:

No disagreement on the need to provide better education. But to suggest that we can somehow fix education and solve the problem -- something we've been trying to do without success for decades now -- is wishful thinking. And even if we could somehow fix the education problem, it will be decades before it brings results, it does nothing to resolve existing problems that have built up over time due to our failure to provide a level playing field (which extends well beyond just education). For those who are worried about losing their "hard-earned cash," this is a convenient argument for forestalling redistributive policies that might correct for past inequities. But practically we shouldn't expect that somehow we are going to magically transform education and solve these problems. We need much more than that, and it will require those who have benefited so much from our economic system in the past several decades to help those who have seen their incomes stagnate.

And let me add one more argument from the past -- even if we could improve education overnight, it is not the answer for everyone:

[W]hen the private sector finally begins reabsorbing the unemployed, the underemployed, and the discouraged, we want people to be able to find jobs with decent wages and benefits -- jobs that are as good or better than the jobs they had before.

But where, exactly, will those jobs come from? I wish I had the answer.

Education is part of it, better education means better jobs on average, and it's easy to imagine a substantial fraction of the population benefiting from an educational advantage. So I won't back off prior calls to improve education at all levels.

But even if we substantially improve education, it won't fully solve the problem. There will still be a need for quality jobs that are not all that dependent upon knowledge based skills. However, it's harder to imagine an emerging set of industries that will provide the large number of quality jobs that we need to replace those lost from industries in decline.

If these jobs fail to be created in the next years and decades, the result will be an ever widening gap in the distribution of income with, as now, a group at the top doing relatively well, and everyone else treading water at best.

Is it overly pessimistic to worry that we may be headed in that direction?

    Posted by on Wednesday, January 5, 2011 at 11:43 AM in Economics, Income Distribution | Permalink  Comments (108)


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