We have to do better on inequality

The principal problem facing the US and Europe for the next few years is an output shortfall caused by a lack of demand. Nothing would increase the incomes of all citizens – poor, middle-class and rich – as much as an increase in demand and associated increases in incomes, living standards and confidence in institutions and the future.

It would, however, be a serious mistake to suppose that our problems are only cyclical or amenable to macroeconomic solution. Just as the evolution from an agricultural to an industrial economy has far-reaching implications for almost all institutions, so too does the evolution from an industrial to a knowledge economy. Trends that pre-date the Great Recession will be with us long after any recovery.

The most important of these is the strong shift in the market reward for a small minority of citizens relative to the rewards available to most citizens. According to a recent Congressional Budget Office study, the incomes of the top 1 per cent of the US population, after adjusting for inflation, rose by 275 per cent from 1979 to 2007. At the same time, the income for the middle class grew by only 40 per cent. Even this dismal figure overstates the case of typical Americans, as the number unable to find work or who have abandoned the search has risen. In 1965, only 1 in 20 men between 25 and 54 was not working; by the end of this decade it will probably be 1 in 6, even if the full cyclical recovery is achieved.

Those who remain serene in the face of these trends or favour policies that would disproportionately cut taxes at the high end assert that snapshot inequality is acceptable as long as there is social mobility within lifetimes and across generations. The reality is that there is too little of both. Inequality in lifetime incomes is only marginally smaller than inequality in a single year. According to the best available information, intergenerational mobility in the US is now poor by global standards and probably for the first time no longer improving. Take just one statistic: the share of US college students that comes from families in the lowest quartile has fallen over the last generation while that from the richest has increased.

Why has the top 1 per cent of the population done so well relative to the rest? The answer probably lies substantially in changing technology and globalisation. When George Eastman revolutionised photography, he did very well and, because he needed a large number of Americans to carry out his vision, the city of Rochester had a thriving middle class for two generations. By contrast, when Steve Jobs revolutionised personal computing, he and the shareholders in Apple (who are spread all over the world) did very well but a much smaller benefit flowed to middle-class American workers both because production was outsourced and because the production of computers and software was not terribly labour intensive.

There is no question that this will be more important to the politics of the industrialised world than its response to a market system that distributes rewards increasingly inequitably. To date the debate has been distressingly polarised.

On one side it is framed in zero-sum terms and the disappointing lack of income growth for middle-class workers is blamed on the success of the wealthy. Those with this view should ask themselves whether it would be better if the US had more entrepreneurs like those who founded Apple, Google, Microsoft and Facebook, or fewer. Each contributed significantly to rising inequality but it bears emphasising that companies with a single owner, such as a private equity firm, pay successful CEOs more than public companies do. Where great fortunes are earned by providing great products or services that benefit large numbers of people, they should not be denigrated.

At the same time, those who are quick to label any expression of concern about rising inequality as misplaced or a product of class warfare are even further off base. The extent of the change in income distribution is such that it is no longer true that the overall growth rate of the economy is the principal determinant of middle-class income growth – how the growth pie is distributed is at least as important. That most of the increase in inequality reflects gains for those at the very top at the expense of everyone else further belies the idea that simply strengthening the economy will reduce inequality.

Indeed, focusing on American competitiveness could exacerbate inequality, if that means corporate tax cuts or the protection of intellectual property for the benefit of companies that are not primarily producing in the US.

What then is the right response to rising inequality? There are too few good ideas in current political discourse and the development of better ones is crucial. Here are three.

First, government must be careful that it does not facilitate increases in inequality by rewarding the wealthy with special concessions. Where governments dispose of assets or allocate licences, there is a compelling case for more use of auctions to which all have access. Where government provides insurance implicitly or explicitly, premiums must be set as much as possible on a market basis rather than in consultation with the affected industry. A general posture for government of standing up for capitalism rather than particular well-connected capitalists would also serve to mitigate inequality.

Second, there is scope for pro-fairness, pro-growth tax reform. When there are more and more great fortunes being created and the government is in larger and larger deficit, it is hardly a time for the estate tax to be eviscerated. With smaller families and ever more bifurcation in the investment opportunities open to those with wealth, there is a real risk that the old notion of “shirtsleeves to shirtsleeves in three generations” will become obsolete, and those with wealth will endow dynasties.

Third, the public sector must insure that there is greater equity in areas of the most fundamental importance. It will always be the case in a market economy that some will have mansions, art and the ability to travel in lavish fashion. What is more troubling is that the ability of the children of middle-class families to attend college has been seriously compromised by increasing tuition fees and sharp cutbacks at public universities and colleges.

At the same time, in many parts of the country a gap has opened between the quality of the private school education offered to the children of the rich and the public school educations enjoyed by everyone else. Most alarming is the near doubling over the last generation in the gap between the life expectancy of the affluent and the ordinary.

Neither the politics of polarisation nor those of noblesse oblige will serve to protect the interests of the middle class in the post-industrial economy. We will have to find ways to do better.

The writer is Charles W. Eliot university professor at Harvard, and a former US Treasury secretary (1999-2001) and director of the National Economic Council (2009-10).