Inequality from a slightly different angle

According to economist Emmanuel Saez, the top 10% of US households claimed 45.6% of total income excluding capital gains in 2008.  This huge percentage, however, is understated since it excludes not only capital gains but also retained corporate earnings.  Bear with me here or skip immediately to the next paragraph.  Reported pre-tax profit margins for the S&P 500 are currently about 13% of revenue and the tax return data that Saez uses would reflect only paid dividends.  Dividends represent about 30% of after tax earnings or about 20% of pre-tax earnings if we were to make the unlikely assumption that corporate taxes are about 32%.  Undistributed retained pre-tax earnings would then be calculated at 10.4% of total revenue.

Lots of assumptions, but based on this data, we should add an additional 10.4% to the income received by the top tier, which brings them to a whopping 56% of total income.  And even this number is certainly understated as it fails to include tax evasions which must be rampant given the many tempting offshore domiciles.

Be that as it may, let’s use 56% as our number.  When we talk about inequality, it’s normally presented as an issue of fairness which, though appropriate, seems to miss an important element.  Adam Smith wrote in the Wealth of Nations “Wherever there is great property there is great inequality. For one very rich man there must be at least five hundred poor, and the affluence of the few supposes the indigence of the many.”  Smith captures the point perfectly – for 10% of the population to be rich, it necessarily requires the remainder to be poor.

I think we can see this more clearly if we flip our perspective from income to price in a similar way we do with our national income accounts.  Just as GDP is, roughly speaking, equivalent to national income, we can say that, roughly speaking, the top 10% of households account for 56% of the price of all goods and services produced.  There would be potential exceptions but few.  Certainly the pay of top executives, profit margins of productive firms, top professional salaries and bonuses, etc. are included in our prices.  One can argue whether, say, a hedge fund manager who does nothing other than speculate on arbitrage effects the price of goods but overall the equivalence between income and price must hold.

When we look at inequality numbers in this manner, I think we see more clearly that inequality is a direct charge on the lower tiers.  It’s not an abstract issue of fairness, it’s the direct cause of lower standards for the majority.  The vast majority, in this case the bottom 90%, are in a very real sense paying a tribute to the top tier in the amount of 46% (56% less the 10% they would otherwise earn based on their percentage of the population) and it’s paid in the form of vastly higher prices for goods and services.  The greater the inequality, the greater the tribute.  And the lower one sits in the hierarchy of tiers, the more one pays.

The argument that tax progressivity offsets some of this inequality is highly dubious.  Billionaire Warren Buffet writes today that his tax rate is only 17.4%, far lower than anyone else in his office.  And we can’t assess the fairness of the tax code unless we also consider for whose interests the government spends.  If we back out health care and pensions from the federal budget, costs that are paid directly by worker taxes, we find that 55% goes to the military and another 11% to wealthy bond holders as interest.  Neither federal taxes nor federal spending can be considered progressive.

The standard argument, of course, is that those with higher incomes earn their pay through greater contributions to society.  This is a subject worthy of a full post but this view should be summarily rejected.  All important psychological research rejects the claim that money is a primary motivator.  Higher incomes are almost entirely due to either the power of monopoly distortions or to historically inherited views on the prestige and status of certain positions.  If pure supply and demand operated in our political economy, competition would wipe out virtually all profit, prestigious positions would easily be filled at average or even sub-average pay, and the most unpleasant jobs would yield a premium.  We don’t operate under the laws of economics 101 – we operate in a hierarchical society.

The bottom line is that the cause of inequality is nothing other than inequality itself.  It’s the natural result of a hierarchical society where individuals sitting at the top are able to charge those below them a tributary tax.  The rich are rich because they are institutionally empowered to assess this charge and the majority are struggling because they must pay it.