President Obama can’t run again, as he noted in the State of the Union last month, but he sought to use his address to set the tone for the 2016 campaign. His repeated references to “middle-class economics” were tactful code, speaking in front of a Republican-controlled Congress, for that perennial Democratic favorite, the inequality debate.
High and rising levels of inequality will doubtless resound in the politicking leading up to the presidential election. In fact, likely Republican contenders focused on it in their responses to the president’s address. “Income inequality has worsened under this administration. And tonight, President Obama offers more of the same policies—policies that have allowed the poor to get poorer and the rich to get richer,” Sen. Rand Paul declared. Jeb Bush had the same reaction: “While the last eight years have been pretty good ones for top earners, they’ve been a lost decade for the rest of America.” And Sen. Ted Cruz said, “We’re facing right now a divided America when it comes to the economy.”
Recent data show the Gini coefficient for (pre-tax) income distribution in the United States—the most-used measure of inequality—at its highest level since 1985: tenth out of 31 countries in the Organization for Economic Cooperation and Development. (Income distribution in China and most other less-developed countries is still more unequal than in the United States.)
Another indicator of inequality—the ratio between average CEO compensation in the United States and average workers’ wages—conveys a similar picture: CEOs’ average pay is 331 times workers’ pay. The corresponding ratios are between 15 and 20 times less unequal in Japan, Germany, Canada, and Britain.
Concerns about inequality and efforts to reverse or at least mitigate its rise derive partly from its causes—whether they’re deemed legitimate, attributed to differences in productivity and “value-added,” or illegitimate, attributed instead to discrimination, favoritism, unfairness, or some other corruption—and partly from its effect on social stability. The two are intimately linked. To the extent inequality is seen as legitimate, its adverse effects on social harmony are minimized: People generally focus on enhancing their own living standards rather than comparing themselves with the “super-rich” 1 percent or “rich” 5 percent. But if inequality is deemed illegitimate, unfair, discriminatory, or due to corruption, its impact on social harmony is magnified. Countervailing interventions—protests, laws, and regulations—become unavoidable, as well as warranted.
Conservatives and liberals, unsurprisingly, differ over those interventions. Conservatives focus on supply-side measures, favoring economic growth by reforming and lowering taxes, lighter and smarter regulations, and a business-friendly environment. The accompanying rhetoric intones that “a rising tide lifts all boats”; critics assail this as “trickle-down economics,” expressing concerns about those who are left behind—-the boats left on the beach.
Liberals focus on demand-side measures, invoking neo-Keynesian economics and redistribution. They advocate increased taxes on the rich and government borrowing to subsidize lower-income recipients, expanding entitlements and thereby stimulating demand. The accompanying rhetoric extols a more egalitarian society and economy. Critics assail this as mortgaging future generations, calling the approach “sleight-of-hand” and “bubble-up” economics.
Neither side is devoid of merit—each suggests what’s lacking in the other. But both views reflect wishful, rather than realistic, thinking. They fail to confront the reality of a daunting tradeoff between economic growth and income equality. Growth has been and increasingly is causally associated with less equality, greater equality with slower growth.
The ineluctable connection between growth and inequality lies in the crucial role of innovation in driving growth in technologically advanced economies. The enormity of rewards garnered by the innovators and their close associates creates a strong tilt toward increased inequality of income and wealth.
Economists refer to an economy’s maximum output level as defining its “production-possibility frontier.” Expanding the frontier depends on one or more “game-changing” innovations. In the recent past, these have mainly been in information technology. In the future they may emerge from other technologies: biogenetic and stem-cell technology, nanotechnology, robotics, or something else. The effect on growth will likely be large, as will the ensuing disproportionate rewards for the innovators and their close associates—leading to greater inequality.