Wealth Inequality: an Impediment to Democracy?

The United States of America is, as measured by nominal GDP, the wealthiest nation in the world. However, Senator Bernie Sanders does not see this statistic as a beacon of hope and prosperity. In fact, the Senator for Vermont is more inclined to talk about the disappearance of the ‘Great Middle Class’ and how the USA currently fosters the highest income and wealth inequality in its history. Presently, the top 1% owns 38% of financial wealth and the bottom 60% owns a measly 2.3%. One family-The Walton family – with a net worth of $148bn has more money than the bottom 40% of American society. In a global context, the richest 85 people in the world own more wealth than roughly 3.5bn people who make up the poorest half of the world’s population. The exponential growth of income and wealth disparity between the very richest and the rest has incited widespread political debate as well as reconsiderations of traditional economic theories concerning income disparities and economic growth.

Image courtesy of Stephen Melkisethian, © 2013, some rights reserved.
Image courtesy of Stephen Melkisethian, © 2013, some rights reserved.

Senator Sanders, who was addressing the House of Representatives, quoted a statistic that between 2009-2012, 95% of all new income created in America went to the top 1%. This is a particularly chilling statistic, as it essentially voids the traditional notion of economic growth and its consequences. Economic growth as defined by an increase in real GDP will not be translated into increases in living standards for the majority of Americans, which according to Mr Sanders is the cause of widespread poverty. The mainstream Economic growth theory proposed by Robert Solow in 1956 states that economies progress along  “balanced growth paths” with shares of income among the owners of capital remaining constant. Indeed, the assumption of a constant income distribution is very much the foundation of the model. However, as the US is demonstrating, the reality of the situation is very much to the contrary.

To emphasise the gross income disparities Mr Sanders states how 25 hedge fund managers last year took home $24bn, enough money to pay the salaries of over 425,000 public school teachers. This is not only harrowing in a moral sense, but in an economic one too, as it plagues the potential for future growth in America. In reflecting on The Great Recession, many prominent economists have pointed to widening income disparities as a driver of the downturn.  Professor Raghuram Rajan, the incumbent Governor of the Reserve Bank of India and a professor at the University of Chicago, is an advocate of this line of thinking. He believes that as income inequality increased and the middle class stagnated, the US government responded with expansionary monetary policy mainly by increasing the availability of credit for the middle class. In the short run, the policy was effective, consumption and economic growth increased, and the middle class was quiet as diminishing incomes were masked with increasing consumer debt. Once time took its toll the middle class consumption bubble burst, as did the Wall Street bubble it helped to finance. The rest, as they say, was history. This illustrates an often-overlooked consequence of rising inequality-instability.

French Economist Thomas Piketty has spent the last few of decades researching the causes and consequences of the ever-rising income inequality. Piketty, who is seen as a revolutionary in this particular topic, has turned away from classical theorists such as John Stuart Mill, David Ricardo and Karl Marx. Piketty has widened the traditional definition of capital to encompass any asset that generates a monetary return. “Capital in the Twenty-first Century,” Piketty’s most influential body of work offers a critique of the notion – initially formalised by Simon Kuznets – that as economies develop inequality falls. According to Piketty the ‘Kuznets Curve’ is fundamentally flawed, policy such as progressive tax systems in the years after World War II were only partly responsible for the fall in inequality.  Equally important for Piketty was the destruction of inherited wealth, whereas America today is in a process of rebuilding inherited wealth and so called, “patrimonial capitalism.”

Piketty attributes the exponential growth in income inequality between the top 1% and the rest not down to the rise of ‘superstars’ but rather to the increased remuneration of ‘supermanagers.’ Falls in marginal tax rates are incentivising top bosses to bargain for higher pay. Piketty rejects the counterargument that asserts that marginal productivity amongst CEO’s is increasing, mainly because it is impossible to measure the degree to which productivity is increasing amongst such people. To put this in perspective, consider this: In the 1950s the average US CEO was paid about 20 times as much as his typical employee, nowadays the pay ratio between the top dog and the average worker is in excess of 200 to 1. In 2011, Apple CEO Tim Cook took home $378m, 6258 times the average wage of an Apple employee.

Inequality in America is exploding and without targeted policy America’s future economic potential is in danger. However, Nobel Laureate Robert Shiller has a solution for the growing trend in income inequality. Shiller believes that it is “time-past time” to act. He feels that if we allow inequality gaps to continue to widen the new class of “superrich” will probably feel entitled to their wealth and have means to defend via influence in the corridors of power. Senator Sanders also describes how the Koch Brothers have enough political power to curtail policy to their financial advantage.

Shiller and Leonard Burman proposed in 2006 a means of indexing tax brackets to inequality measures in very much the same way as inflation indexing. Shiller summed up Burman’s stance… ‘His idea was to integrate inequality indexing with inflation indexing: Instead of just linking tax brackets to inflation as measured by the Consumer Price Index, as we have done for years, he proposed that the adjustments also take account of rising inequality, in the event of it’s occurrence. He proposed a system to offset the loss in tax revenue that inflation indexing would produce, in a way that would get us closer to a target distribution of after-tax income; if inequality worsened, higher tax brackets would bear a bit more of the burden, and people at the bottom would bear less.’

Inequality is on a moral plane unjust. On an economic plane, it damages the future potential of a state and induces widespread instability. And on the political plane it is in the words of Bernie Sanders ‘A threat to American democracy.’  The solution is a more targeted tax system that effectively redistributes income and wealth from the wealthiest billionaires to those most vulnerable in American society. It’s now time to stop the simultaneous rise of the superrich and fall of the middle class and improve America’s extremely inequitable distribution of income and wealth.

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