Capitalism and Inequality
A starting point for a broader inquiry on reforming our economic institutions.
The United States has the highest income inequality of all post-Industrial economies, reaching a record high in 2018 when for the first time in US history, billionaires paid a lower effective tax rate than the working class (23% for the richest 400 families vs. 24.2% for the bottom half of American households).
I spent a good part of the last month researching the drivers behind the graph above, learning a ton along the way. Underpinning this exploration is a deeper desire to parse out to what extent the outcomes of capitalism that we experience today are fundamental, vs. a consequence of the specific equilibrium we’ve evolved to over the past half century. This foundational understanding in turn will inform a perspective on what reforms are needed to yield economic institutions that are better aligned with our broader social objectives. This blog post is the first of many related to this inquiry.
It’s worth noting that income inequality in the US is comparable to other post-Industrial economies before taxes and transfers; the reason the US is the most unequal advanced economy is because other high income countries have more progressive tax and redistribution regimes. This indicates there is something inherent to capitalism as it’s practiced globally today that leads to inequality, vs. something specific to the US economy.
I initially thought the question to ask was, “What has driven the rise in inequality over the past fifty years?” But it turns out the first relevant question is instead, “What drove the decline in inequality in the middle of the 20th century?” Early industrialization was marked by worker exploitation — low wages, long hours, no labor laws, and the suppression of union organizing. Absent regulation, unequal distribution is a natural outcome of capitalist economies. So what happened?
The decline in income inequality that occurred from 1940–1980 was a consequence of the the Great Depression and subsequent New Deal, the shock of World War II, strong economic growth, improved political and bargaining power of the working class, and the establishment of the welfare state. Importantly, this was an era where political polarization largely fell on class lines, leading to leftist policies improving outcomes for the working class.
The precipitous rise of inequality over the past fifty years has been driven by a confluence of factors. Politically and ideologically, the period has been marked by neoliberalism, political capture by corporations and elites, a shift from class-based political polarization to issue-based political polarization, and less progressive tax and transfer policies. Low and even high skilled labor has been adversely affected by structural changes to the US economy due to globalization and automation, exacerbated by a decline in unionization rates. Immigration of very high and low skilled labor put pressure on both ends of the wage spectrum. Skyrocketing executive compensation rapidly increased returns to labor at the very top of the income distribution.
But it is capital that has been has been the real winner, with its returns outpacing economic growth, the central thesis driving Thomas Piketty’s landmark book Capital. This has been a consequence of the growth and diversification of the finance industry, a view of the firm holding returns to shareholders as the primary objective (thanks Friedman), and the practice of stock buybacks returning profits to shareholders instead of reinvesting them in the long term growth of the firm.
I found the story of the rise of money manager capitalism in the 1980s to be particularly fascinating. Prior to the 1980s, equity trading was dominated by individuals who were the asset owners themselves. Likewise, investment capital came from investment banks that were private partnerships, meaning it was the partner’s own money that was at stake. But in the 1980s three new sources of capital flooded the US financial sector: pension funds looking to diversify and decrease the risk associated with a reliance on single company performance, university and nonprofit endowments, and foreign investors who, having benefited from rapid global economic growth abroad and having a high propensity to save, sought secure investments in US dollars. Wall Street banks transformed themselves from partnerships to publicly traded companies, becoming financial intermediaries acting as agents on behalf of asset owners, rather than being the principles themselves. Partner and employee compensation was tied to returns on investment, thus quarterly reporting and short term profit optimization over long term growth was born.
As a consequence of all of these trends, between 1979 and 2007 inflation adjusted after tax income grew 275% for the top 1% but just 18% for the bottom 20%. The richest 0.1% saw their share of American wealth grow nearly 3x from 7% to 20% from the late 1970s to 2016, while the bottom 90% saw its share decline from 35% to 25% during the same period. Inequality hit a record high in 2018, with a Gini Coefficient of 0.49.
It’s clear that this an unsustainable state of affairs, if not from a fundamental theory of justice perspective, from a practical social stability one.
How to address it then? I distinguish between four categories of interventions:
- Tax and redistribute, e.g. policies that reduce the gap between capital gains and income tax rates and programs like Universal Basic Income. Here market outcomes for income distribution remain the same and are then adjusted for (Piketty’s call for a global wealth tax falls into this grouping).
- Marginal regulation such as raising minimum wage, limiting executive compensation, or better regulations for the gig economy. These interventions lead to less unequal distributions before taxes and transfers, but the system is more or less the same as it is today.
- Structural reforms that change the rules of the game and result in more equitable distribution fundamentally, potentially precluding the need for marginal regulatory measures. These are things like campaign finance reform and the adoption of alternative governance models that shift us away from the shareholder return optimizing model of the firm.
- Policies addressing inequality of opportunity such as investments in education (note this category resides on the assumption America is a meritocracy which is pretty clearly far from the case). These types of interventions leave economic institutions intact, and instead addressing initial conditions for human capital.
Thanks to Piketty’s work it seems fairly clear that a spectacular degree of inequality is a feature of capitalism, not a bug. I’m sold on more progressive taxation and Universal Basic Income (post on this one coming soon). But I also don’t believe that what we have today is capitalism doing what is best and therefore the right response to inequality is to just redistribute on the back end, as Piketty proposes. Elite capture of politics is unquestionably undermining democracy and campaign finance reform needs to be part of the solution. Workers need more protections, especially with the rise of the gig economy. And it’s hard to believe that exec compensation at 250+x the average worker is entirely justifiable.
While all of the above is surely part of the solution, I still see them as band aid solutions and marginal reforms. I can’t help but be most interested in deeper structural change that addresses the failings of capitalism in its current form to align with the social good.
Next up is an investigation of the history of the shareholder maximizing view of the firm and the current thinking and practices of stakeholder capitalism. Hopefully some of my readers will be interested in coming along for the ride.
