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News & Analysis US

An Uncomfortable Discussion

April 15, 2014, Tuesday, 09:30 GMT | 04:30 EST | 13:00 IST | 15:30 SGT
Contributed by Raymond James

Income inequality is a touchy subject. It’s hard to have a polite conversation, but like it or not, we are going to have a discussion this year. I will not take a position here (this is largely a political question). Rather, I will try to illustrate what the data say and to present the different points of view.

In the fall of 2013, Thomas Piketty, a French economist, published a book titled “Capital in the 20th Century.” The English translation arrived in March. It’s been suggested by those on the left that the book may be the most important economic book of the year, if not the decade (just as Marx’s “Das Kapital” was in the 19th century). Piketty is not some lunatic radical. He is a well-respected scholar and has spent a considerable amount of time assembling an historical database of the distribution of income for several countries. The key point of the data is that there has been a sharp rise in income inequality over the last three decades and the distribution is increasingly more skewed the higher you go up the income scale. In the U.S., the top 10% of income earners account for 50% of national income. The top 1% account for 45% of the top 10%, the top 0.1% account for about half of the 1%, and the top 0.01% account for half of the 0.1%. Income inequality has risen in most advanced economies and is currently at or near record highs.

One of the key ideas in Piketty’s book is that if the rate of return on capital, r, is greater than the growth rate of the economy, g, then capital ownership will become increasingly more concentrated. He suggests that this has been the case throughout history, with the exception of the last 100 years. Piketty notes that this is not a market failure – it is the fundamental nature of capitalism. This turns one long-standing view in economics on its head. Starting from the 1950s and 1960s, it had generally been believed that economic prosperity benefits everyone across the income scale.

The question is whether rising income inequality is bad for economic growth overall, and if so, what can be done about it. Research by the IMF suggests that countries with higher income inequality tend to have slower economic growth. Piketty proposes that rising income inequality can be addressed through higher tax rates, not just in the U.S., but worldwide (otherwise investors would simply move to countries with lower taxes). This is where conservatives are going to draw the line. The right has long argued that low taxes encourage business investment. Raising taxes would reduce incentives. The left argues that tax rates have been a lot higher than they are now and the economy prospered just fine. Regardless, given the current composition of Congress, it would be extremely difficult to raise taxes and it would be virtually impossible to do so on a coordinated basis across countries.

It’s worth noting that the recession has added to income inequality. As Fed Chair Yellen has indicated, the lower trend in labor compensation suggests that there is a large amount of slack in the labor market. A tighter labor market would lead to faster growth in wages, which would help support faster growth in spending, and stronger growth would then lead to more jobs, etc. However, we still seem to be far from that point.

In the U.S., there is currently an active debate about whether to raise the federal minimum wage. While a higher minimum wage will have an impact on labor-intensive firms (restaurants, for example), it’s unlikely to have a significant effect on overall employment. Many states have minimum wages that are higher than the federal and studies show that there is relatively little impact on employment when the minimum wage rises. On the other hand, those on the left who argue that raising the minimum wage will reduce poverty will be disappointed – the research suggests that a higher minimum wage has little impact.

This week, Thomas Piketty will be in Washington and the income inequality discussion is expected to pick up.