Inequality, Mobility, And Growth

Incentives to move: An overview of economic growth, inequality and social mobility

Andrew Cote, McGill University

"Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man or order of men." -Adam Smith, The Wealth of Nations, 1776 "The writer must earn money in order to be able to live and to write, but he must by no means live and write for the purpose of making money" -Karl Marx, Capital, 1846

Adam Smith praised capitalism, for he thought that if each person were free to pursue their own interests it would be for the betterment of the whole. Karl Marx was not so enthusiastic, for capitalism can cleave society on the basis of ownership, forcing some to work like the "writer" tirelessly just to survive. They both agreed, however, on this: capitalism allows for the production of goods on a scale never before seen. Henry Ford's insight was that if one pays their workers enough to afford the goods they make, there will always be a market for your goods. While assembly line production was more alienation than the free pursuit of one's own interests, it at least afforded a decent standard of living and own a house, buy a car, even if one could not save up to buy their own factory. As the proverbial land of opportunity, much of American culture has as its central claim: work hard, take risks, be smart, and you will find success. This paper will explore the issue of economic inequality and its effects on social mobility, focusing on trends and data since 1950. The outline is roughly as follows: economic inequality is often argued as an important incentive structure for people to work hard and invest in skills. This incentive structure depends on social mobility. Competing views of the effects of inequality on economic growth will be presented, with an emphasis on inequality and mobility. Next is an assessment of changes in the economic equality of the United States and some competing explanations for its cause. The effects of inequality on social mobility are most prone to be felt in the unequal access to education, as such the next section takes up the issue of differing education rates for wealthy and poor. Social mobility itself is not an easy thing to measure; sociologists disagree on everything but the fact that it should be measured, yet economists display much more consensus in their findings. Sociological and Economic accounts of mobility will be offered before a final conclusion that draws these lines of argumentation together.

Equality of Conditions and Equality of Opportunities Economic Inequality: The Boom or Bane of Growth? High mobility coupled with some amount of inequality is considered a winning combination in capitalism; direct material motivation for investing in one's skills harnesses selfish rationality to encourage the accumulation of human capital and in doing so increases labor productivity. This is the advantage of upward mobility, yet downward mobility might also be an equally important incentive. Downward mobility forces the well-off to "stay on their toes" - continually improving, competing and innovating lest they be outdone and run out of business. A lack of downward mobility implies systematic - and unfair - advantages for the rich, in some eyes this amounts to automatically collecting rents on the basis of privilege without regard to the incumbent's ability (Sorenson 1996). Views differ as to the necessity and impact of inequality on capitalist growth. Echoing the classic Keynesian motto, Reich (2010) argues that concentrated income hurts the economy because the rich can't spend enough of their income. The "paradox of thrift" implies excessive savings reduce the amount of money in circulation which lowers aggregate demand, and therefore employment as "sticky wages" push firms to produce less, laying-off workers rather than lower their pay (Reich 2010: 32). Furthermore, a redistribution of income from the wealthiest to the poorest increase the amounts spent on essential goods and services, the demand for which is the cornerstone of a growing economy. Citing Jeremy Bentham as a supporter, Reich also implies moral gains on redistribution, "taking a thousand dollars from the very rich and giving it to the very poor would cause a net increase in happiness" (2010:35). Reich is a former policy advisor for several democratic administrations; as such his arguments might have a slight left-bias. Nonetheless, some modern economists are in agreement with the basic proposition that inequality hurts growth, especially in democratic countries. Persson and Tabellini (1994) explain that the incentives to develop human and physical capital hinge on the ability to appropriate the fruits of such investment, therefore democratic societies with large conflicts over distribution hurt incentives for growth when they implement policies that appropriate personal gains. Reviewing data from 8 European countries and the U.S., Persson and Tabellini (1994) find that higher initial inequality leads to lower rates of long-run growth. An important note is that this holds true for democratic countries only, the stark contrast of high inequality and high growth in a non-democracy can be seen in China. Benabou (1996) corroborates Persson and Tabellini's (1994) claim by summarizing the results of 23 previous studies analyzing the linkages between inequality, growth and investment. Benabou finds that a one-standard deviation decrease in Gini-coefficient measured inequality raises the annual growth rate of GDP per capita by .5-.8 percentage points, a "small change" that accounts for 30-45% of the standard deviation in growth rates across countries (1996:13). Though these statistical results may be telling, they are superficial in that they ignore the underlying national differences in the sentiments of citizens. Whereas the view that large-scale inequality is "unacceptable" in European countries may be common, only one in four Americans agree (Burtless and Jencks 2003: 61).

Citing the same mechanisms as Persson and Tabellini (1994), Burtless and Jencks (2003) argue that reducing inequality is at odds with growth so long as generous unemployment benefits reduce incentives to look for a new job, and higher marginal tax rates decrease hours worked by lowering the relative opportunity cost of leisure time. It is possible, though, that workers will just work more to make up for the lost income, though many have strong conviction that generous unemployment schemes breed idleness, and with it, vice (Burtless and Jencks 2003). In a more formal mathematical model, Phelan (2005) argues that inequality gives a familial incentive to work harder and produce more to increase the opportunities available for one's children. Interestingly Phelan links income to opportunities, indicating that inequality of opportunity as well as in condition is desirable for growth; indeed, he does not put it mildly when concluding that "unequal opportunity and social mobility are necessarily characteristics of an optimal allocation" of resources and incentives in a capitalist economy (2005:492). However, it is assumed that a family can simply increase opportunities for children by working harder and "outputting" more, and Phelan does not consider that earnings are as linked to strategic locations in occupational structures as much as they are to "output". Breen (1997) takes strategic location into account when formulating a model of inequality, social mobility, and growth. The positive incentives of inequality are limited by the extent that some positions are systematically over-rewarded at the expense of others, which particularly occurs when interest groups can shape the reward distribution in their favour . However, some degree of social mobility and inequality are necessary for growth, but each comes at the expense of the other. Inequality is only excessive when it limits the meritocratic assignment of individuals to positions, yet Breen also explains that large social mobility is not necessarily tied to economic growth as cross-national comparisons show divergent rates of mobility with similar rates of growth (1997:44). Clearly, views differ as to the importance of inequality for growth: evidence shows negative correlations but formal economic models show it to be an important incentive, so long as mobility is present that allows actors to appropriate gains of investment. Breen (1997) takes a moderate position, claiming both inequality and mobility are necessary for growth but each comes at the expense of the other. Before looking at rates of mobility it becomes necessary to understand the economic context; that is, the recent history of economic inequality in the US.

Trends and Explanations for Inequality in the US Trends in inequality in the US are clear-cut, but there are a number of competing explanations of its cause, each with its own economic flavour - credit, skills, productivity, globalization, and so on. This section gives an overview of inequality trends and it's most popular explanations, though it is by no means exhaustive. Inequality in the US was high at the outset of the 20th century, though dropped precipitously during and after WW1 (Levy and Murnane 1992). By 1929 inequality had regained its pre-war levels, though the Great Depression started a 20 year period where inequality fell sharply. By 1950 declining inequality had ceased, and inequality remained low but stable until 1982 (Levy and Murnane 1992). In terms of income distribution, before WW2 the top 10% of earners took 40-45% of all income, but between 1952 and 1982 the top 10% took only 33% of all income (Burtless and Jencks 2003:64; see Figure 1). The "U-shaped" trend in inequality can largely be attributed to changing rates of growth for high and low-income workers. Between 1947 and 1973 real incomes rose faster at the bottom than the top, but after 1973 growth in earnings tended to slow for all portions of workers, though especially for those at the bottom (Burtless and Jencks 2003: 64). Levy and Murnane (1992), summarizing numerous studies on inequality during this period, remarks that though 1973 was the end of earnings growth, and even stagnation, it was 1979 that marked the beginning of real acceleration in the growth of earnings inequality. Male earnings became polarized during the 1980s as numbers of workers at the high and low ends of earnings distribution increasing greatly.

Shifts in the Lions Share Figure 1: Inequality Trends in the United States 1917-2006, taken from Emmanuel Saez 2006, "Striking it Richer: The Evolution of Top Incomes in the United States". The y-axis denotes percentage of total income taken by top 10% of earners. In 1981 Congress passed the Economic Recovery and Taxation Act, the hallmark beginning of "Reagonomics," a supply-side economic theory of growth that promoted lesser taxes on the wealthy to promote savings and investment (Levy and Murnane 1992). Although the 1980s saw an economic recovery from the "stagflation" of the 1970s, inequality took a drastic upswing, in part because of the spectacular increase in the earnings of the top 1% of Americans whose after-tax income increased from 7.5% of all earnings in 1979 to 13.6% by 1997 (Burtless and Jencks 2003). During this period inequality increased yet the median wage remained stagnant, implying that the rich were getting richer while the poor's pay stayed the same - in the face of inflation this meant their real purchasing power was declining, indicating that many young workers were worse off than their counterparts in the mid 1960's (Levy and Murnane 1992). Women experienced a similar trend but they were able to offset it by working more hours, indeed the entrance of women into the labour force during this period did much to offset the declining male wage and mitigate the damage done to working-class families (Reich 2011:54). Numerous academics claimed that this was the end of "middle class jobs", or jobs paying 25-30,000 per year and requiring little education (Levy and Murnane 1992). Indeed, the earnings for year-round full time male workers was "hollowed out", indicating a growing number of workers in the tail-ends of earning distribution (Ibid.). 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