Challenges for Youth

Part 2: Inequality

By Dr. Ed McKenna

“Challenges for Youth – Part 1: On Climate Change” was featured in Issue 49 of Gurukula Network

The Covid-19 crisis has revealed in stark detail the extent to which inequality characterizes most of the world. People of color and people living in poverty have been much more severely affected by the virus. Amazingly, in the United States, one in 1000 African-Americans has been killed by the virus

Yet, prior to 2011, there was very little discussion concerning the idea of economic inequality in the media and in professional economic forums. Economists devoted very little study to the topic, and the general belief was that inequality was diminishing in significance over time. Then, seemingly from nowhere, there arose the Occupy Wall Street movement, a movement devoted to the issue of economic inequality. Two years later, Thomas Piketty published his groundbreaking work “Capital in the 21st Century”, a book that definitively presented the facts regarding the enormous increase in inequality that had been taking place over the previous 35 years. Suddenly, the topic of economic inequality rose to the top of the economic agenda.

What exactly do economists mean when they say inequality has risen dramatically? Why has this increase taken place over the past several decades? And, if there has been an increase, why does it matter? These are the questions I will address in this article.

I. Different Ways to Look at Inequality

There are several different perspectives that we can utilize to study the issue of inequality. One perspective deals with the question of what is happening with respect to inequality of income among countries. So, for example, we can ask whether the average income of the different countries in the world are coming closer together or moving further apart. The evidence suggests that inequality among countries is, to a certain extent, decreasing. This is largely the result of the tremendous growth of China, and, to a lesser extent, India.

While this decrease is encouraging, there are several reasons why we should nevertheless be concerned. First, major parts of the world, in particular Latin and South America and Africa, are not seeing the same progress with respect to incomes that countries such as China are experiencing. Second, it is quite possible for income to become more equitably distributed among countries, while at the same time becoming more unequal with respect to individuals. To take an extreme example to illustrate this, suppose that all of the gains in income that China has made over the past several decades have gone to one individual in China. Then while China’s income may have moved closer to income levels in advanced economies, income inequality within China would have increased.

And this is exactly what the work of Piketty has discovered. In country after country, what we find is that income is becoming concentrated in the hands of fewer and fewer people. And, the likelihood is that this concentration is likely to become even more severe in the future. In some countries, such as the United States, the concentration of income is so severe that almost all of the gains in income each year go only to people at the very top of the income scale. Indeed, in the United States the concentration of income at the very top threatens to entirely eliminate the existence of a middle-class, a result that social scientists believe will result in widespread social unrest.

Another perspective dealing with the growth of inequality seeks to ask what the source of this income inequality is. Broadly speaking, we can say that income can be divided into two categories, wage income, and profit income. Wage income is simply what a worker makes from the labor he/she performs. Profit income is the income that the owners of capital, which consists of such things as the machines used to produce output, receive as a result of utilizing their capital.

One source of inequality occurs when the share of income going to profit rises as the share going to wages falls. Inequality results because the ownership of things such as capital is very unequal, even more unequal than the distribution of income. So, when profit income rises relative to wage income, this results in a relatively larger portion of income going to a relatively small number of people, resulting in an increase in inequality.

A second source of inequality occurs when the distribution of wage income itself becomes more unequal. In this case, while the overall share going to wages remains constant, the wage income going to people at the very top increases, while wages going to people in the middle and bottom decline. This results, for example, when the salary of a corporate CEO rises, while the salary of the company’s production workers declines. This is exactly what has been occurring in many countries, with the United States again being at the extreme end of this process. In the 1970s, it was common for a CEO to make approximately 35 times what a production worker would make. Now, the same ratio is closer to 350. One important reason why the income of production workers has not kept up is because many workers receive a minimum wage, a wage that is determined by the passage of laws. If this wage does not keep up with inflation, then over time workers are receiving less and less of the output produced in the economy. In the United States, for example, the minimum wage today buys less than it did in 1969. The fact that these workers receive less is what makes it possible for CEOs to receive more.

Now Piketty’s work again shows us what is actually occurring. In most countries that he has studied, what Piketty finds is both profit income gaining at the expense of wage income, and wage income becoming more concentrated in the hands of those at the very top. And this is why it is the case that income inequality is rising so dramatically.

There is one other important fact that Piketty’s work has revealed. As income becomes more concentrated at the very top, those at the very top have more that they can leave to their children in the form of inheritance. Over time, income from inheritance comes to dominate income received from work. This has pernicious effects both because the incentive to work is reduced when the major way in which one can become wealthy is through inheritance, and because inherited income is much more difficult to justify than income that is earned through work. As a result, over time income not only becomes more unequally distributed, but the unequal distribution itself becomes more difficult to justify in the eyes of the populace.

II. Why Does Inequality Grow Under Capitalism?

That inequality has grown under capitalism over the past several decades is beyond question. Exactly why this has been the case is what we now need to address. We can broadly discuss the factors that have led to the growth of inequality under two broad categories: 1) Economic factors, and 2) Social-Political factors. I begin with the economic factors

One of the disturbing factors that we have witnessed over the last several decades is the growth in the size and power of corporations. Economists have long known that as firms grow in size, they are often able to reduce the cost of producing output, which in turn enables them to make more profit. There are many reasons why the cost of production may fall as a firm grows. It may be the case that the actual carrying out of production enables those who govern the firm to learn new ways of producing output, and these new ways utilize resources more efficiently, lowering cost. It may also be the case that as output grows, certain factors do not need to increase concomitantly. For example, a firm may be able to maintain the same size of its management of whether the firm is producing 1000 units, or 100,000 units, thus reducing managerial costs as production increases.

The nature of information technology has led to another reason why the size of a firm is likely to grow over time, and this relates the idea of network externalities. Suppose we ask why people join a platform such as Facebook. The whole point of Facebook is to be able to communicate with your friends and relatives, or to reach out to as many people as you can possibly reach with whatever message you wish to broadcast. So, you want to join the platform that already has the largest numbers of members. Thus, once a platform reaches a certain size, the likelihood is that it will continue to grow in size. This makes it difficult for new competitors to be successful, for it is more difficult for them to attract new members when their current number of members is so small that new members have little incentive to become part of the new platform.

So what we see is that there are a variety of reasons why firms tend to grow in size. But given that markets are limited in their overall size, this means that there will be a relatively small number of firms in any given industry. And, it will be difficult for new firms to enter into this industry. Both of these factors mean that existing firms will acquire economic power, the power to charge a higher price and hence to increase the size of its profits. Moreover, large firms often have the ability to limit the opportunities of workers, which enables firm’s profits to grow at the expense of wages i.e., inequality rises.

But there is another economic factor that also enables the growth of profits at the expense of wages. As Piketty’s work has conclusively demonstrated, it is usually the case under capitalism that the rate of return to capital exceeds the rate of growth of output in the economy. Exactly why this is the case can be disputed, but Piketty’s evidence demonstrates that it is almost always true. Why does this matter? When the rate of return to capital exceeds the rate of growth of output, then capital grows relative to output. Suppose you have $100 worth of capital, and the rate of return is 10%. This means you have 10 additional dollars that makes it possible to increase capital to $110. If output was $200, and grows at only 5%, then output grows to $210. Notice that originally capital constituted one half of output, but after the growth is now more than half of the output. But as we have already seen, if capital grows relative to output, then wages must be falling relative to output, i.e. the profit share has grown. And since profits are distributed to a relatively small group of people, inequality grows as well.

As important as the economic factors are, they are not the only factor generating increasing inequality. Social and political factors are also leading to the growth of inequality. Consider 2 reasons why wage growth has been less than profit growth over the past several decades in the United States. If we look at the history of the minimum wage, which is an amount legislated by Congress, what we find is that the minimum wage reached its peak in terms of its buying power in 1969. Ever since then, the minimum wage has been declining in terms of what it can purchase. This means that all those workers who receive the minimum wage are receiving a smaller fraction of the output produced in the economy. But why has the minimum wage failed to grow over this time horizon? Well, this is largely the result of political forces, political forces that have been championed by Corporations and the political Right Wing in the United States. And while there has been a growing political movement to increase the minimum wage to $15 per hour, (which by the way would merely restore purchasing power to the 1969 level!), this movement has only been partially successful at the State level, and not at all successful at the Federal level. As a result, millions of workers struggle with wages that at best support their minimum needs.

Consider a second political factor. It is well-known that union membership has declined drastically in the United States over the past 5 decades. But this decline is not due to some natural process leading workers to choose not to become union members. Rather, the laws and the legal process in the United States have made it difficult for workers to organize while making it easier for businesses to threaten workers who attempt organization, for example by firing them. This again is due to the fact that political forces have largely been controlled by the Right Wing, and members of the Right Wing invariably rule in the interest of corporations. But as union membership has declined, the ability of unions to offset the power of increasingly large business firms has diminished, resulting in a smaller wage share for workers, and an increase in inequality. Since none of the factors we have discussed above are likely to abate anytime soon, further increases in inequality will almost certainly take place.

III. Why Do Increases in Inequality Matter?

I began by noting the differential impact that the Covid virus has had on the poor and on people of color. And this is not accidental, for the lack of resources lies at the root of this differential impact. While inequality and poverty are not identical, it is certainly the case that increasing inequality can be the cause of increasing poverty. And even if we choose to view this as only a moral concern, should we not be outraged by the magnitude of the suffering we see happening around ourselves at this moment?

But we cannot view this as only a moral concern. Increasing economic evidence demonstrates that countries with higher levels of inequality grow at lower rates, making it even more difficult to solve the problems of poverty and inequality itself. And as inequality grows, both the economic and the political power of those receiving the most grows exponentially. Evidence also demonstrates that social mobility is declining dramatically in many Western countries. If you are born into poverty, you will almost certainly remain in poverty. If you are fortunate to be born into wealth, you will remain wealthy. In a sense, your life path has been determined at the moment of your birth. But as the great mass of people come to understand this social fact, frustration and anger also grows. People in many countries no longer believe that democracy works for them, or that democracy even exists for them. Many social scientists now describe the United States as a plutocracy, i.e. a system ruled by the rich, rather than a democracy. In such situations, the threat of violent instability grows and the likelihood of the replacement of democracy by authoritarian regimes becomes more likely. In his recent book , The Great Leveler: Violence and the History of Inequality, Walter Scheidel notes that history demonstrates that great increases in inequality have only been brought to an end by natural calamity or violent uprisings. Will we once again follow the same path, or have we perhaps learned enough that today’s youth will find a way to avoid the suffering of the past?

Ed McKenna, Ph.D., is Professor of Economics at Connecticut College in New London, CT, USA. He specializes in macroeconomics and econometrics. His work lies at the intersection of economics and philosophy. He is particularly interested in the relationship between philosophical conceptions of justice and fairness and economic theories that explain the distribution of income.