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Economic inequality (also described as the gap between rich and poor, income inequality, wealth disparity, wealth and income differences or wealth gap) is the state of affairs in which assets, wealth, or income are distributed unequally among individuals in a group, among groups in a population, or among countries. The issue of economic inequality can implicate notions of equity, equality of outcome, and equality of opportunity.
Opinions differ on the importance of economic inequality and its effects. Some studies have emphasized inequality as a growing social problem. While some inequality may promote investment, too much inequality may be destructive. Income inequality can hinder long term growth. Statistical studies comparing inequality to year-over-year economic growth have been inconclusive; however in 2011, researchers from the International Monetary Fund published work which indicated that income equality increased the duration of countries' economic growth spells more than free trade, low government corruption, foreign investment, or low foreign debt.
Economic inequality varies between societies, historical periods, economic structures and systems. The term can refer to cross sectional distribution of income or wealth at any particular period, or to the lifetime income and wealth over longer periods of time. There are various numerical indices for measuring economic inequality. A widely used one is the Gini coefficient, but there are also many other methods.
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A study entitled "Divided we Stand: Why Inequality Keeps Rising” by the Organisation for Economic Co-operation and Development (OECD) reported its conclusions on the causes, consequences and policy implications for the ongoing intensification of the extremes of wealth and poverty across its 22 member nations (OECD 2011-12-05).
A study by the World Institute for Development Economics Research at United Nations University reports that the richest 1% of adults alone owned 40% of global assets in the year 2000. The three richest people in the world possess more financial assets than the lowest 48 nations combined. The combined wealth of the "10 million dollar millionaires" grew to nearly $41 trillion in 2008. A January 2014 report by Oxfam claims that the 85 wealthiest individuals in the world have a combined wealth equal to that of the bottom 50% of the world's population, or about 3.5 billion people. According to a Los Angeles Times analysis of the report, the wealthiest 1% owns 46% of the world's wealth; the 85 richest people, a small part of the wealthiest 1%, own about 0.7% of the human population's wealth, which is the same as the bottom half of the population. Oxfam Executive Director Jeremy Hobbs said that "We can no longer pretend that the creation of wealth for a few will inevitably benefit the many – too often the reverse is true."
According to PolitiFact the top 400 richest Americans "have more wealth than half of all Americans combined." According to the New York Times on July 22, 2014, the "richest 1 percent in the United States now own more wealth than the bottom 90 percent". Inherited wealth may help explain why many Americans who have become rich may have had a "substantial head start". In September 2012, according to the Institute for Policy Studies, "over 60 percent" of the Forbes richest 400 Americans "grew up in substantial privilege".
Although a discussion exists about the recent trends in global inequality, the issue is anything but clear, and this holds true for both the overall global inequality trend and for its between-country and within-country components. The existing data and estimates suggest a large increase in international (and more generally inter-macroregional) component between 1820 and 1960. It might have slightly decreased since that time at the expense of increasing inequality within countries.
The United Nations Development Programme in 2014 asserted that greater investments in social security, jobs and laws that protect vulnerable populations are necessary to prevent widening income inequality....
There is a significant difference in the measured wealth distribution and the public’s understanding of wealth distribution. Michael Norton of the Harvard Business School and Dan Ariely of the Departement of Psychology at Duke University found this to be true in their research, done in 2011. The actual wealth going to the top quintile in 2011 was around 84% where as the average amount of wealth that the general public estimated to go to the top quintile was around 58%.
There are many reasons for economic inequality within societies. Recent growth in overall income inequality, at least within the OECD countries, has been driven mostly by increasing inequality in wages and salaries. Economist Thomas Piketty, who specializes in the study of economic inequality, argues that widening economic disparity is an inevitable phenomenon of free market capitalism when the rate of return of capital (r) is greater than the rate of growth of the economy (g).
Common factors thought to impact economic inequality include:
A major cause of economic inequality within modern market economies is the determination of wages by the market. Some small part of economic inequality is caused by the differences in the supply and demand for different types of work. However, where competition is imperfect; information unevenly distributed; opportunities to acquire education and skills unequal; and since many such imperfect conditions exist in virtually every market, there is in fact little presumption that markets are in general efficient. This means that there is an enormous potential role for government to correct these market failures.
In a purely capitalist mode of production (i.e. where professional and labor organizations cannot limit the number of workers) the workers wages will not be controlled by these organizations, or by the employer, but rather by the market. Wages work in the same way as prices for any other good. Thus, wages can be considered as a function of market price of skill. And therefore, inequality is driven by this price. Under the law of supply and demand, the price of skill is determined by a race between the demand for the skilled worker and the supply of the skilled worker. "On the other hand, markets can also concentrate wealth, pass environmental costs on to society, and abuse workers and consumers." "Markets, by themselves, even when they are stable, often lead to high levels of inequality, outcomes that are widely viewed as unfair." Employers who offer a below market wage will find that their business is chronically understaffed. Their competitors will take advantage of the situation by offering a higher wage to snatch up the best of their labor. For a businessman who has the profit motive as the prime interest, it is a losing proposition to offer below or above market wages to workers.
A job where there are many workers willing to work a large amount of time (high supply) competing for a job that few require (low demand) will result in a low wage for that job. This is because competition between workers drives down the wage. An example of this would be jobs such as dish-washing or customer service. Competition amongst workers tends to drive down wages due to the expendable nature of the worker in relation to his or her particular job. A job where there are few able or willing workers (low supply), but a large need for the positions (high demand), will result in high wages for that job. This is because competition between employers for employees will drive up the wage. Examples of this would include jobs that require highly developed skills, rare abilities, or a high level of risk. Competition amongst employers tends to drive up wages due to the nature of the job, since there is a relative shortage of workers for the particular position. Professional and labor organizations may limit the supply of workers which results in higher demand and greater incomes for members. Members may also receive higher wages through collective bargaining, political influence, or corruption.
These supply and demand interactions result in a gradation of wage levels within society that significantly influence economic inequality. Polarization of wages does not explain the accumulation of wealth and very high incomes among the 1%. Joseph Stiglitz believes that "It is plain that markets must be tamed and tempered to make sure they work to the benefit of most citizens."
Another cause is the rate at which income is taxed coupled with the progressivity of the tax system. A progressive tax is a tax by which the tax rate increases as the taxable base amount increases. In a progressive tax system, the level of the top tax rate will often have a direct impact on the level of inequality within a society, either increasing it or decreasing it, provided that income does not change as a result of the change in tax regime. Additionally, steeper tax progressivity applied to social spending can result in a more equal distribution of income across the board. The difference between the Gini index for an income distribution before taxation and the Gini index after taxation is an indicator for the effects of such taxation.
There is debate between politicians and economists over the role of tax policy in mitigating or exacerbating wealth inequality. Economists such as Paul Krugman, Peter Orszag, and Emmanuel Saez have argued that tax policy in the post World War II era has indeed increased income inequality by enabling the wealthiest Americans far greater access to capital than lower-income ones.
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An important factor in the creation of inequality is variation in individuals' access to education. Education, especially in an area where there is a high demand for workers, creates high wages for those with this education, however, increases in education first increase and then decrease growth as well as income inequality. As a result, those who are unable to afford an education, or choose not to pursue optional education, generally receive much lower wages. The justification for this is that a lack of education leads directly to lower incomes, and thus lower aggregate savings and investment. In particular, the increase in family income and wealth inequality leads to greater dispersion of educational attainment, primarily because those at the bottom of the educational distribution have fallen further below the average level of education. Conversely, education raises incomes and promotes growth because it helps to unleash the productive potential of the poor.
In 2014, economists with the Standard & Poor's rating agency concluded that the widening disparity between the U.S.'s wealthiest citizens and the rest of the nation had slowed its recovery from the 2008-2009 recession and made it more prone to boom-and-bust cycles. To partially remedy the wealth gap and the resulting slow growth, S&P recommended increasing access to education. It estimated that if the average United States worker had completed just one more year of school, it would add an additional $105 billion in growth to the country's economy over five years.
During the mass high school education movement from 1910–1940, there was an increase in skilled workers, which led to a decrease in the price of skilled labor. High school education during the period was designed to equip students with necessary skill sets to be able to perform at work. In fact, it differs from the present high school education, which is regarded as a stepping-stone to acquire college and advanced degrees. This decrease in wages caused a period of compression and decreased inequality between skilled and unskilled workers. Education is very important for the growth of the economy, however educational inequality in gender also influence towards the economy. Lagerlof and Galor stated that gender inequality in education can result to low economic growth, and continued gender inequality in education, thus creating a poverty trap. It is suggested that a large gap in male and female education may indicate backwardness and so may be associated with lower economic growth, which can explain why there is economic inequality between countries.
More of Barro studies also find that female secondary education is positively associated with growth. His findings show that countries with low female education; increasing it has little effect on economic growth, however in countries with high female education, increasing it significantly boosts economic growth. More and better education is a prerequisite for rapid economic development around the world. Education stimulates economic growth and improves people's lives through many channels.
By increasing the efficiency of the labour force it create better conditions for good governance, improving health and enhancing equality. Labor market success is linked to schooling achievement, the consequences of widening disparities in schooling is likely to be further increases in earnings inequality
John Schmitt and Ben Zipperer (2006) of the CEPR point to economic liberalism and the reduction of business regulation along with the decline of union membership as one of the causes of economic inequality. In an analysis of the effects of intensive Anglo-American neoliberal policies in comparison to continental European neoliberalism, where unions have remained strong, they concluded "The U.S. economic and social model is associated with substantial levels of social exclusion, including high levels of income inequality, high relative and absolute poverty rates, poor and unequal educational outcomes, poor health outcomes, and high rates of crime and incarceration. At the same time, the available evidence provides little support for the view that U.S.-style labor-market flexibility dramatically improves labor-market outcomes. Despite popular prejudices to the contrary, the U.S. economy consistently affords a lower level of economic mobility than all the continental European countries for which data is available."
Trade liberalization may shift economic inequality from a global to a domestic scale. When rich countries trade with poor countries, the low-skilled workers in the rich countries may see reduced wages as a result of the competition, while low-skilled workers in the poor countries may see increased wages. Trade economist Paul Krugman estimates that trade liberalisation has had a measurable effect on the rising inequality in the United States. He attributes this trend to increased trade with poor countries and the fragmentation of the means of production, resulting in low skilled jobs becoming more tradeable. However, he concedes that the effect of trade on inequality in America is minor when compared to other causes, such as technological innovation, a view shared by other experts. Lawrence Katz estimates that trade has only accounted for 5-15% of rising income inequality. Robert Lawrence argues that technological innovation and automation has meant that low-skilled jobs have been replaced by machine labor in wealthier nations, and that wealthier countries no longer have significant numbers of low-skilled manufacturing workers that could be affected by competition from poor countries.
In many countries, there is a gender income gap which favors males in the labor market. For example, the median full-time salary for U.S. women is 77% of that of U.S. men. Several factors other than discrimination may contribute to this gap. On average, women are more likely than men to consider factors other than pay when looking for work, and may be less willing to travel or relocate. Thomas Sowell, in his book Knowledge and Decisions, claims that this difference is due to women not taking jobs due to marriage or pregnancy, but income studies show that that does not explain the entire difference. A U.S. Census's report stated that in US once other factors are accounted for there is still a difference in earnings between women and men. The income gap in other countries ranges from 53% in Botswana to -40% in Bahrain.
Gender inequality and discrimination is argued to cause and perpetuate poverty and vulnerability in society as a whole. Gender Equity Indices seek to provide the tools to demonstrate this feature of equity.
19th century socialists like Robert Owen, William Thompson, Anna Wheeler and August Bebel argued that the economic inequality between genders was the leading cause of economic inequality; however Karl Marx and Fredrick Engels believed that the inequality between social classes was the larger cause of inequality.
Economist Simon Kuznets argued that levels of economic inequality are in large part the result of stages of development. According to Kuznets, countries with low levels of development have relatively equal distributions of wealth. As a country develops, it acquires more capital, which leads to the owners of this capital having more wealth and income and introducing inequality. Eventually, through various possible redistribution mechanisms such as social welfare programs, more developed countries move back to lower levels of inequality.
Plotting the relationship between level of income and inequality, Kuznets saw middle-income developing economies level of inequality bulging out to form what is now known as the Kuznets curve. Kuznets demonstrated this relationship using cross-sectional data. However, more recent testing of this theory with superior panel data has shown it to be very weak. Kuznets' curve predicts that income inequality will eventually decrease given time. As an example, income inequality did fall in the United States during its High school movement from 1910 to 1940 and thereafter. However, recent data shows that the level of income inequality began to rise after the 1970s. This does not necessarily disprove Kuznets' theory. It may be possible that another Kuznets' cycle is occurring, specifically the move from the manufacturing sector to the service sector. This implies that it may be possible for multiple Kuznets' cycles to be in effect at any given time.
Related to cultural issues, diversity of preferences within a society may contribute to economic inequality. When faced with the choice between working harder to earn more money or enjoying more leisure time, equally capable individuals with identical earning potential may choose different strategies. The trade-off between work and leisure is particularly important in the supply side of the labor market in labor economics.
Likewise, individuals in a society often have different levels of risk aversion. When equally-able individuals undertake risky activities with the potential of large payoffs, such as starting new businesses, some ventures succeed and some fail. The presence of both successful and unsuccessful ventures in a society results in economic inequality even when all individuals are identical.
Wealth concentration is a according to whom?] process by which, under certain conditions, newly created wealth concentrates in the possession of already-wealthy individuals or entities. According to this theory, those who already hold wealth have the means to invest in new sources of creating wealth or to otherwise leverage the accumulation of wealth, thus are the beneficiaries of the new wealth. Over time, wealth condensation can significantly contribute to the persistence of inequality within society. Piketty in his book Capital in the 21st Century argues that the fundamental force for divergence is the usually greater return of capital (r) than economic growth (g), and that larger fortunes generate higher returns [pp. 384 Table 12.2, U.S. university endowment size vs. real annual rate of return][
Economist Joseph Stiglitz argues that rather than explaining concentrations of wealth and income, market forces should serve as a brake on such concentration, which may better be explained by the non-market force known as "rent-seeking". While the market will bid up compensation for rare and desired skills to reward wealth creation, greater productivity, etc., it will also prevent successful entrepreneurs from earning excess profits by fostering competition to cut prices, profits and large compensation. A better explainer of growing inequality, according to Stiglitz, is the use of political power generated by wealth by certain groups to shape government policies financially beneficial to them. This process, known to economists as rent-seeking, brings income not from creation of wealth but from "grabbing a larger share of the wealth that would otherwise have been produced without their effort"
Rent seeking is often thought to be the province of societies with weak institutions and weak rule of law, but Stiglitz believes there is no shortage of it in developed societies such as the United States. Examples of rent seeking leading to inequality include
Since rent seeking aims to "pluck the goose to obtain the largest amount of feathers with the least possible amount of hissing" – it is by nature obscure, avoiding public spotlight in legal fine print, or camouflaged its extraction with widely accepted rationalizations (markets are naturally competitive and so need no government regulation against monopolies).
Countries with a left-leaning legislature have lower levels of inequality. Many factors constrain economic inequality – they may be divided into two classes: government sponsored, and market driven. The relative merits and effectiveness of each approach is a subject of debate.
Typical government initiatives to reduce economic inequality include:
Market forces outside of government intervention that can reduce economic inequality include:
Effects of inequality researchers have found include higher rates of health and social problems, and lower rates of social goods, a lower level of economic utility in society from resources devoted on high-end consumption, and even a lower level of economic growth when human capital is neglected for high-end consumption. For the top 21 industrialised countries, counting each person equally, life expectancy is lower in more unequal countries (r = -.907). A similar relationship exists among US states (r = -.620).
2013 Economics Nobel prize winner Robert J. Shiller said that rising inequality in the United States and elsewhere is the most important problem. Increasing inequality harms economic growth. High and persistent unemployment, in which inequality increases, has a negative effect on subsequent long-run economic growth. Unemployment can harm growth not only because it is a waste of resources, but also because it generates redistributive pressures and subsequent distortions, drives people to poverty, constrains liquidity limiting labor mobility, and erodes self-esteem promoting social dislocation, unrest and conflict. Policies aiming at controlling unemployment and in particular at reducing its inequality-associated effects support economic growth.
The economic stratification of society into "elites" and "masses" played a central role in the collapse of other advanced civilizations such as the Roman, Han and Gupta empires.
British researchers Richard G. Wilkinson and Kate Pickett have found higher rates of health and social problems (obesity, mental illness, homicides, teenage births, incarceration, child conflict, drug use), and lower rates of social goods (life expectancy by country, educational performance, trust among strangers, women's status, social mobility, even numbers of patents issued) in countries and states with higher inequality. Using statistics from 23 developed countries and the 50 states of the US, they found social/health problems lower in countries like Japan and Finland and states like Utah and New Hampshire with high levels of equality, than in countries (US and UK) and states (Mississippi and New York) with large differences in household income.
For most of human history higher material living standards – full stomachs, access to clean water and warmth from fuel – led to better health and longer lives. This pattern of higher incomes-longer lives still holds among poorer countries, where life expectancy increases rapidly as per capita income increases, but in recent decades it has slowed down among middle income countries and plateaued among the richest thirty or so countries in the world. Americans live no longer on average (about 77 years in 2004) than Greeks (78 years) or New Zealanders (78), though the USA has a higher GDP per capita. Life expectancy in Sweden (80 years) and Japan (82) – where income was more equally distributed – was longer.
In recent years the characteristic that has strongly correlated with health in developed countries is income inequality. Creating an index of "Health and Social Problems" from nine factors, authors Richard Wilkinson and Kate Pickett found health and social problems "more common in countries with bigger income inequalities", and more common among states in the US with larger income inequalities. Other studies have confirmed this relationship. The UNICEF index of "child well-being in rich countries", studying 40 indicators in 22 countries, correlates with greater equality but not per capita income.
Pickett and Wilkinson argue that inequality and social stratification lead to higher levels of psychosocial stress and status anxiety which can lead to depression, chemical dependency, less community life, parenting problems and stress-related diseases.
Research has shown an inverse link between income inequality and social cohesion. In more equal societies, people are much more likely to trust each other, measures of social capital (the benefits of goodwill, fellowship, mutual sympathy and social connectedness among groups who make up a social units) suggest greater community involvement, and homicide rates are consistently lower.
Comparing results from the question "would others take advantage of you if they got the chance?" in U.S General Social Survey and statistics on income inequality, Eric Uslaner and Mitchell Brown found there is a high correlation between the amount of trust in society and the amount of income equality. A 2008 article by Andersen and Fetner also found a strong relationship between economic inequality within and across countries and tolerance for 35 democracies.
In two studies Robert Putnam established links between social capital and economic inequality. His most important studies established these links in both the United States and in Italy. His explanation for this relationship is that
Community and equality are mutually reinforcing... Social capital and economic inequality moved in tandem through most of the twentieth century. In terms of the distribution of wealth and income, America in the 1950s and 1960s was more egalitarian than it had been in more than a century... [T]hose same decades were also the high point of social connectedness and civic engagement. Record highs in equality and social capital coincided. Conversely, the last third of the twentieth century was a time of growing inequality and eroding social capital... The timing of the two trends is striking: somewhere around 1965–70 America reversed course and started becoming both less just economically and less well connected socially and politically.
Albrekt Larsen has advanced this explanation by a comparative study of how trust increased in Denmark and Sweden in the latter part of the 20th century while it decreased in the US and UK. It is argued that inequality levels influence how citizens imagine the trustworthiness of fellow citizens. In this model social trust is not about relations to people you meet (as in Putnam's model) but about people you imagine.
Crime rate has also been shown to be correlated with inequality in society. Most studies looking into the relationship have concentrated on homicides – since homicides are almost identically defined across all nations and jurisdictions. There have been over fifty studies showing tendencies for violence to be more common in societies where income differences are larger. Research has been conducted comparing developed countries with undeveloped countries, as well as studying areas within countries. Daly et al. 2001 found that among U.S States and Canadian Provinces there is a tenfold difference in homicide rates related to inequality. They estimated that about half of all variation in homicide rates can be accounted for by differences in the amount of inequality in each province or state. Fajnzylber et al. (2002) found a similar relationship worldwide. Among comments in academic literature on the relationship between homicides and inequality are:
Higher income inequality led to less of all forms of social, cultural, and civic participation among the less wealthy. When inequality is higher the poor do not shift to less expensive forms of participation.
Following the utilitarian principle of seeking the greatest good for the greatest number – economic inequality is problematic. A house that provides less utility to a millionaire as a summer home than it would to a homeless family of five, is an example of reduced "distributive efficiency" within society, that decreases marginal utility of wealth and thus the sum total of personal utility. An additional dollar spent by a poor person will go to things providing a great deal of utility to that person, such as basic necessities like food, water, and healthcare; while, an additional dollar spent by a much richer person will very likely go to luxury items providing relatively less utility to that person. Thus, the marginal utility of wealth per person ("the additional dollar") decreases as a person becomes richer. From this standpoint, for any given amount of wealth in society, a society with more equality will have higher aggregate utility. Some studies have found evidence for this theory, noting that in societies where inequality is lower, population-wide satisfaction and happiness tend to be higher.
Economist Arthur Cecil Pigou argues that
... it is evident that any transference of income from a relatively rich man to a relatively poor man of similar temperament, since it enables more intense wants, to be satisfied at the expense of less intense wants, must increase the aggregate sum of satisfaction. The old "law of diminishing utility" thus leads securely to the proposition: Any cause which increases the absolute share of real income in the hands of the poor, provided that it does not lead to a contraction in the size of the national dividend from any point of view, will, in general, increase economic welfare.
Philosopher David Schmidtz argues that maximizing the sum of individual utilities will harm incentives to produce.
A society that takes Joe Rich’s second unit [of corn] is taking that unit away from someone who . . . has nothing better to do than plant it and giving it to someone who . . . does have something better to do with it. That sounds good, but in the process, the society takes seed corn out of production and diverts it to food, thereby cannibalizing itself.
However, in addition to the diminishing marginal utility of unequal distribution, Pigou and others point out that a "keeping up with the Joneses" effect among the well off may lead to greater inequality and use of resources for no greater return in utility.
a larger proportion of the satisfaction yielded by the incomes of rich people comes from their relative, rather than from their absolute, amount. This part of it will not be destroyed if the incomes of all rich people are diminished together. The loss of economic welfare suffered by the rich when command over resources is transferred from them to the poor will, therefore, be substantially smaller relatively to the gain of economic welfare to the poor than a consideration of the law of diminishing utility taken by itself suggests.
When the goal is to own the biggest yacht – rather than a boat with certain features – there is no greater benefit from owning 100 metre long boat than a 20 m one as long as it is bigger than your rival. Economist Robert H. Frank compare the situation to that of male elks who use their antlers to spar with other males for mating rights.
The pressure to have bigger ones than your rivals leads to an arms race that consumes resources that could have been used more efficiently for other things, such as fighting off disease. As a result, every male ends up with a cumbersome and expensive pair of antlers, ... and "life is more miserable for bull elk as a group."
Income inequality lowers aggregate demand, leading to increasingly large segments of formerly middle class consumers unable to afford as many luxury and essential goods and services. This pushes production and overall employment down.
Conservative researchers have argued that income inequality is not significant because consumption, rather than income should be the measure of inequality, and inequality of consumption is less extreme than inequality of income in the US. Will Wilkinson of the libertarian Cato Institute states that "the weight of the evidence shows that the run-up in consumption inequality has been considerably less dramatic than the rise in income inequality," and consumption is more important than income. According to Johnson, Smeeding, and Tory, consumption inequality was actually lower in 2001 than it was in 1986. The debate is summarized in "The Hidden Prosperity of the Poor" by journalist Thomas B. Edsall. Other studies have not found consumption inequality less dramatic than household income inequality, and the CBO's study found consumption data not "adequately" capturing "consumption by high-income households" as it does their income, though it did agree that household consumption numbers show more equal distribution than household income.
Others dispute the importance of consumption over income, pointing out that if middle and lower income are consuming more than they earn it is because they are saving less or going deeper into debt. Income inequality has been the driving factor in the growing household debt, as high earners bid up the price of real estate and middle income earners go deeper into debt trying to maintain what once was a middle class lifestyle.
Central Banking economist Raghuram Rajan argues that "systematic economic inequalities, within the United States and around the world, have created deep financial 'fault lines' that have made [financial] crises more likely to happen than in the past" – the Financial crisis of 2007–08 being the most recent example. To compensate for stagnating and declining purchasing power, political pressure has developed to extend easier credit to the lower and middle income earners – particularly to buy homes – and easier credit in general to keep unemployment rates low. This has given the American economy a tendency to go "from bubble to bubble" fueled by unsustainable monetary stimulation.
Greater income inequality can lead to monopolization of the labor force, resulting in fewer employers requiring fewer workers. Remaining employers can consolidate and take advantage of the relative lack of competition, leading to less consumer choice, market abuses, and relatively higher real prices.
Some modern economic theories, such as the neoclassical school, have suggested that a functioning economy entails a certain level of unemployment. These theories argue that unemployment benefits must be below the wage level to provide an incentive to work, thereby mandating inequality. Such theories state additionally that the unemployment rate cannot reduce to zero.
Many[quantify] economists believe that one of the main reasons that inequality might induce economic incentive is because material well-being and conspicuous consumption relate to status. In this view, high stratification of income (high inequality) creates high amounts of social stratification, leading to greater competition for status.
[W]hat is the end of avarice and ambition, of the pursuit of wealth, of power, and pre-eminence? Is it to supply the necessities of nature? The wages of the meanest labourer can supply them... [W]hy should those who have been educated in the higher ranks of life, regard it as worse than death, to be reduced to live, even without labour, upon the same simple fare with him, to dwell under the same lowly roof, and to be clothed in the same humble attire? From whence, then, arises that emulation which runs through all the different ranks of men, and what are the advantages which we propose by that great purpose of human life which we call bettering our condition? To be observed, to be attended to, to be taken notice of with sympathy, complacency, and approbation, are all the advantages which we can propose to derive from it. It is the vanity, not the ease, or the pleasure, which interests us.
Modern sociologists and economists such as Juliet Schor and Robert H. Frank have studied the extent to which economic activity is fueled by the ability of consumption to represent social status. Schor, in The Overspent American, argues that the increasing inequality during the 1980s and 1990s strongly accounts for increasing aspirations of income, increased consumption, decreased savings, and increased debt.
In the book Luxury Fever, Robert H. Frank argues that satisfaction with levels of income is much more strongly affected by how someone's income compares with others than its absolute level. Frank gives the example of instructions to a yacht architect by a customer – shipping magnate Stavros Niarchos – to make Niarchos' new yacht 50 feet longer than that of rival magnate Aristotle Onassis. Niarchos did not specify or reportedly even know the exact length of Onassis's yacht.
In the 1960s, economist Arthur Melvin Okun argued that there was a "trade-off" between economic growth and equality. Pursuing equality could reduce efficiency (the total output produced with given resources) by reducing incentives to work, save, and invest and through the “leaky bucket” of wasteful government efforts to redistribute (such as a progressive tax code and minimum wages). Some resources “will simply disappear in transit, so the poor will not receive all the money that is taken from the rich”. Along the same lines, earlier writers had argued that wealthier individuals save proportionally more of their incomes, so that more inequality would lead to higher overall savings and thus capital accumulation and growth. On the other side Ozan Hatipoglu argues that is important to reduce the income inequality since “Inequality between rich and poor plays an important role for technological progress, because by determining who are able to aﬀord newer goods, it aﬀects incentives for innovative activity.”
Many authors have empirically examined the relationship between economic growth and income inequality in a large group of countries. Following the broader economic growth literature, the typical approach was to relate countries' real GDP per capita growth over a long period of time (e.g., 1965 through 1990) to the income distribution at the start of the period, simultaneously taking into account other standard determinants such as the initial level of real GDP per capita. A typical conclusion was that more unequal countries tend to grow slower (Alesina and Rodrik, 1994), though the evidence was contested.
Because of general dissatisfaction with the empirical approach, including difficulties in determining causality and capturing country-specific factors, attention turned to the analysis of how changes in the income distribution affected the growth rate in subsequent time period (usually five years) in a large group of countries. Forbes (2000) found that an increase in inequality tends to raise growth during the subsequent period. This literature did not go too far as Banerjee and Duflo (2003) found a complex relationship between inequality and growth, in which changes in inequality in either direction lowered growth subsequently. They interpreted this finding as supporting the notion that redistribution hurts growth, at least over the short- to medium-run, but also cautioned about interpreting income distribution-economic growth analysis of this type.
In recent years, the economic growth literature has recognized that growth in most countries does not follow a smooth path, but is characterized by sharp turning points – periods of sustained growth and stagnation. The interesting empirical questions, then, are about the determinants of the turning points (Pritchett, 2000).
Along these lines, Andrew Berg and Jonathan D. Ostry (2011) examined the question of what sustains long periods of strong growth, and found that one of the most robust and important determinants is the level of income inequality. In particular, they found that high 'growth spells' were much more likely to end in countries with less equal income distribution, and that the measured effect was large. For example, they estimate that closing half the inequality gap between Latin America and emerging Asia would more than double the expected duration of a 'growth spell.' Their findings were robust to the inclusion of other variables in the model, and to alternate definitions of growth spells. According to their study, which has featured prominently in the financial press, inequality is of course not the only thing that matters but it clearly belongs in the "pantheon" of well-established growth factors such as the quality of political institutions or trade openness.
Berg and Ostry postulate that high levels of inequality might damage long term growth by amplifying the potential for financial crisis, discouraging investment because of political instability, making it more difficult for governments to make difficult choices (such as raising taxes or cutting public expenditure) in the face of shocks, or by discouraging investment in education and health for the poor.
Economic sociologist Lane Kenworthy has found no correlation between levels of inequality and economic growth among developed countries, among states of the US, or in the US over the years from 1947 to 2005. Nor did Jared Bernstein find a correlation, plotting yearly real GDP growth and the share of income going to the top 1%, 1929–2010
According to economist Branko Milanovic, while traditionally economists thought inequality was good for growth
"The view that income inequality harms growth – or that improved equality can help sustain growth – has become more widely held in recent years. ... The main reason for this shift is the increasing importance of human capital in development. When physical capital mattered most, savings and investments were key. Then it was important to have a large contingent of rich people who could save a greater proportion of their income than the poor and invest it in physical capital. But now that human capital is scarcer than machines, widespread education has become the secret to growth."
"Broadly accessible education" is both difficult to achieve when income distribution is uneven and tends to reduce "income gaps between skilled and unskilled labor."
A study by Perotti (1996) examines of the channels through which inequality may affect economic growth. He shows that in accordance with the credit market imperfection approach, inequality is associated with lower level of human capital formation (education, experience, apprenticeship) and higher level of fertility, while lower level of human capital is associated with lower growth and lower levels of economic growth. In contrast, his examination of the political economy channel refutes the political economy mechanism. He demonstrates that inequality is associated with lower levels of taxation, while lower levels of taxation, contrary to the theories, are associated with lower level of economic growth
The credit market imperfection approach, developed by Galor and Zeira (1993), demonstrates that inequality in the presence of credit market imperfections has a long lasting detrimental effect on human capital formation and economic development.
The political economy approach, developed by Alesian and Rodrik (1994) and Persson and Tabellini (1994), argues that inequality is harmful for economic development because inequality generates a pressure to adopt redistributive policies that have an adverse effect on investment and economic growth.
The sovereign-debt economic problems of the late twenty-oughts do not seem to be correlated to redistribution policies in Europe. With the exception of Ireland, the countries at risk of default in 2011 (Greece, Italy, Spain, Portugal) were notable for their high Gini-measured levels of income inequality compared to other European countries. As measured by the Gini index, Greece as of 2008 had more income inequality than the economically healthy Germany.
A number of researchers (David Rodda, Jacob Vigdor, and Janna Matlack), argue that a shortage of affordable housing – at least in the US – is caused in part by income inequality. David Rodda noted that from 1984 and 1991, the number of quality rental units decreased as the demand for higher quality housing increased (Rhoda 1994:148). Through gentrification of older neighbourhoods, for example, in East New York, rental prices increased rapidly as landlords found new residents willing to pay higher market rate for housing and left lower income families without rental units. The ad valorem property tax policy combined with rising prices made it difficult or impossible for low income residents to keep pace.
Firstly, certain costs are difficult to avoid and are shared by everyone, such as the costs of housing, pensions, education and health care. If the state does not provide these services, then for those on lower incomes, the costs must be borrowed and often those on lower incomes are those who are worse equipped to manage their finances. Secondly, aspirational consumption describes the process of middle income earners aspiring to achieve the standards of living enjoyed by their wealthier counterparts and one method of achieving this aspiration is by taking on debt. The result leads to even greater inequality and potential economic instability.
Neoclassical economics views inequalities in the distribution of income as arising from differences in productivity, and attribute rising inequality to rising differences in the productivity of different groups of workers. In this perspective, wages and profits are determined by the marginal productivity of each individual in the economy. Thus rising inequalities are merely a reflection of the productivity gap between highly-paid professions and lower-paid professions.
Socialists attribute the vast disparities in wealth and income to the private ownership of the means of production by a class of owners, resulting in a situation where a small portion of the population receives unearned income in the form of property income by virtue of ownership titles in capital equipment, financial assets and corporate stock. In contrast, the vast majority of the population is dependent on income in the form of a wage or salary. In order to rectify this situation, socialists argue that the means of production should be publicly owned, so that income differentials would be reflective of individual contribution to the social product.
In Marxist economic analysis and Marxian economics, rising income inequality is structural to capitalism. In this analysis, capitalist firms increasingly substitute workers for capital equipment under competitive pressures to reduce costs and maximize profit. Over the long-term, this trend increases the organic composition of capital, meaning that less labor inputs (workers) are required in proportion to capital inputs, increasing unemployment and increasing the size of the reserve army of labour. This process exerts a downward pressure on wages. The adoption of capital equipment for the substitution of labor (job automation) increases productivity per worker and thus profits for the capitalist class, resulting in a situation of relatively stagnant wages for the working class amidst rising levels of property income for the capitalist class.
Marxists ultimately predict the emergence of a communist society based on the common ownership of the means of production, where each individual citizen would have free access to the articles of consumption (From each according to his ability, to each according to his need). According to Marxist philosophy, equality in this sense is essential for freedom because equal access to the output of the means of production frees individuals from dependent relationships, allowing them to transcend alienation.
Meritocracy favors an eventual society where an individual's success is a direct function of his merit, or contribution. Economic inequality would be a natural consequence of the wide range in individual skill, talent and effort in human population.
Most modern social liberals, including centrist or left-of-center political groups, believe that the capitalist economic system should be fundamentally preserved, but the status quo regarding the income gap must be reformed. Social liberals favor a capitalist system with active Keynesian economics macroeconomic policies, neoliberalism, and progressive taxation (to even out differences in income inequality).
However, contemporary classical liberals and libertarians generally do not take a stance on wealth inequality, but believe in equality under the law regardless of whether it leads to unequal wealth distribution. In 1966 Ludwig von Mises, a prominent figure in the Austrian School of economic thought, explains:
The liberal champions of equality under the law were fully aware of the fact that men are born unequal and that it is precisely their inequality that generates social cooperation and civilization. Equality under the law was in their opinion not designed to correct the inexorable facts of the universe and to make natural inequality disappear. It was, on the contrary, the device to secure for the whole of mankind the maximum of benefits it can derive from it. Henceforth no man-made institutions should prevent a man from attaining that station in which he can best serve his fellow citizens.
Robert Nozick argued that government redistributes wealth by force (usually in the form of taxation), and that the ideal moral society would be one where all individuals are free from force. However, Nozick recognized that some modern economic inequalities were the result of forceful taking of property, and a certain amount of redistribution would be justified to compensate for this force but not because of the inequalities themselves. John Rawls argued in A Theory of Justice that inequalities in the distribution of wealth are only justified when they improve society as a whole, including the poorest members. Rawls does not discuss the full implications of his theory of justice. Some see Rawls's argument as a justification for capitalism since even the poorest members of society theoretically benefit from increased innovations under capitalism; others believe only a strong welfare state can satisfy Rawls's theory of justice.
Classical liberal Milton Friedman believed that if government action is taken in pursuit of economic equality then political freedom would suffer. In a famous quote, he said:
Economist Tyler Cowen has argued that though income inequality has increased within nations, globally it has fallen over the last 20 years. He argues that though income inequality may make individual nations worse off, overall, the world has improved as global inequality has been reduced.
Patrick Diamond and Anthony Giddens (professors of Economics and Sociology, respectively) hold that 'pure meritocracy is incoherent because, without redistribution, one generation's successful individuals would become the next generation's embedded caste, hoarding the wealth they had accumulated'.
They also state that social justice requires redistribution of high incomes and large concentrations of wealth in a way that spreads it more widely, in order to "recognise the contribution made by all sections of the community to building the nation's wealth." (Patrick Diamond and Anthony Giddens, June 27, 2005, New Statesman)
Pope Francis stated in his Evangelii Gaudium, that "as long as the problems of the poor are not radically resolved by rejecting the absolute autonomy of markets and financial speculation and by attacking the structural causes of inequality, no solution will be found for the world’s problems or, for that matter, to any problems." He later declared that "inequality is the root of social evil."
When income inequality is low, aggregate demand will be relatively high, because more people who want ordinary consumer goods and services will be able to afford them, while the labor force will not be as relatively monopolized by the wealthy.
In most western democracies, the desire to eliminate or reduce economic inequality is generally associated with the political left. One practical argument in favor of reduction is the idea that economic inequality reduces social cohesion and increases social unrest, thereby weakening the society.
There is evidence that this is true (see inequity aversion) and it is intuitive, at least for small face-to-face groups of people. Alberto Alesina, Rafael Di Tella, and Robert MacCulloch find that inequality negatively affects happiness in Europe but not in the United States.
It has also been argued that economic inequality invariably translates to political inequality, which further aggravates the problem. Even in cases where an increase in economic inequality makes nobody economically poorer, an increased inequality of resources is disadvantageous, as increased economic inequality can lead to a power shift due to an increased inequality in the ability to participate in democratic processes.
The capabilities approach – sometimes called the human development approach – looks at income inequality and poverty as form of “capability deprivation”. Unlike neoliberalism, which “defines well-being as utility maximization”, economic growth and income are considered a means to an end rather than the end itself. Its goal is to “wid[en] people’s choices and the level of their achieved well-being” through increasing functionings (the things a person values doing), capabilities (the freedom to enjoy functionings) and agency (the ability to pursue valued goals).
When a person’s capabilities are lowered, they are in some way deprived of earning as much income as they would otherwise. An old, ill man cannot earn as much as a healthy young man; gender roles and customs may prevent a woman from receiving an education or working outside the home. There may be an epidemic that causes widespread panic, or there could be rampant violence in the area that prevents people from going to work for fear of their lives. As a result, income and economic inequality increases, and it becomes more difficult to reduce the gap without additional aid. To prevent such inequality, this approach believes it’s important to have political freedom, economic facilities, social opportunities, transparency guarantees, and protective security to ensure that people aren’t denied their functionings, capabilities, and agency and can thus work towards a better relevant income.
Progressive taxation reduces absolute income inequality when the higher rates on higher-income individuals are paid and not evaded, and transfer payments and social safety nets result in progressive government spending. Wage ratio legislation has also been proposed as a means of reducing income inequality. The OECD asserts that public spending is vital in reducing the ever expanding wealth gap.
The economists Emmanuel Saez and Thomas Piketty recommend much higher top marginal tax rates on the wealthy, up to 50 percent, or 70 percent or even 90 percent. Ralph Nader, Jeffrey Sachs, the United Front Against Austerity, among others, call for a financial transactions tax (also known as the Robin Hood tax) to bolster the social safety net and the public sector.
The Economist wrote in December 2013: "A minimum wage, providing it is not set too high, could thus boost pay with no ill effects on jobs....America's federal minimum wage, at 38% of median income, is one of the rich world's lowest. Some studies find no harm to employment from federal of state minimum wages, others see a small one, but none finds any serious damage."
Public policy responses addressing causes and effects of income inequality in the US include: progressive tax incidence adjustments, strengthening social safety net provisions such as Aid to Families with Dependent Children, welfare, the food stamp program, Social Security, Medicare, and Medicaid, increasing and reforming higher education subsidies, increasing infrastructure spending, and placing limits on and taxing rent-seeking.