The many faces of inequality

Ignacio de la Torre. Professor. IE Business School

31 March 2014

Aggressive policies are not the way to combat inequality. We have to raise the purchasing power of the most disadvantaged, not bring down that of the rest of population.

In President Obama’s recent state of the nation address he kept saying how the increase in inequality is one of the greatest challenges currently facing the country. This increase in inequality is by no means exclusive to the US, and can be observed in a large number of other countries in the Western world. Ironically, in the case of Spain it was precisely under the second mandate of the socialist party that levels of inequality increased most, which only goes to show how ineffective many political programs really are.

Given the fact that the subject of inequality tends to fan anger as well as academic interest, before we do anything else let’s establish the key issues at stake before we open the debate with a series of proposals.

First, although there are many ways in which to gauge levels of inequality, economists tend to use the Gini Coefficient to measure it. This coefficient measures the inequality in terms of income, where zero represents absolute equality, and one represents absolute inequality.  

Second, generally speaking it is gross income that is measured, which means that in when progressive tax systems are in place whereby in theory the more you earn the more you pay, net income would have different Gini coefficients to gross incomes.  Hence the US would show a much lower level of inequality if net incomes were used.

Third, it is possible to measure unequal distribution of wealth rather than unequal incomes. For example, in the 19th century the bourgeoisie kept increasing their incomes while the aristocracy increased their wealth.   In general, countries where there is an enormously unequal distribution of wealth tend to have the most unstable geopolitical situations.  Experts also agree that a country with greater inequality of wealth tends to grow less than a country where it is income that is more unequal.

Fourth, inequality is a relative concept within the same nation. Hence, if a hundred citizens in a given country earn between €100,000 and €200,000, and then there is one citizen who earns €99,000, the latter will appear “poor”. This makes us see inequality in both relative terms and in absolute terms. If, in this same imaginary country, the first twenty-five inhabitants started to earn €500,000, the result would be that levels of inequality would rise, and yet the incomes of the “disadvantaged” would still be the same. They would therefore still have the same level of purchasing power.

Fifth, studies on human happiness show that we are programmed to join the rat race in which people end up preferring to earn a salary of €50,000 if everyone else earns €25,000, to earning €100,000 when the rest earn €200,000.  In other words, a person with a lower salary would be happier if it were higher compared to that of his or her peers. This psychological phenomenon is doubtlessly the greatest cause of unhappiness, given that human beings tend to compare themselves with someone who has more or earns more, and the desire for or comparison with someone that has more or earns more condemns them to a state of perpetual dissatisfaction.

Sixth, the increase in inequality in the West is caused by globalization, which has promoted competition among workers worldwide leading to a drop in the salaries of less skilled workers in Western countries. The economic crisis that has dragged on since 2008 has served to further increase inequality, given that in times of recession levels of inequality tend to rise and vice versa. This process lays the foundation for populist policies.

In light of theses premises, it is interesting to debate possible alternative lines of action.

First, the aim of absolute equality as a political criterion might not make any kind of economic or philosophical sense. Examples like Cuba show how it is possible for everyone to be equally poor, but they are not compatible with an attempt to generate human happiness based on parameters like having enough money to live on and political freedom.

Second, taking for granted that it is essential to generate economic growth, which in turn is what drives per capita income, it is true that among the more affluent countries, those with lower levels of inequality tend to grow more than those with higher levels, with the odd exception. Inequality in terms of material wealth is more detrimental to growth than unequal incomes, because unequal incomes promote social mobility more thanks to the rise of entrepreneurs. In order to generate opportunities to progress based on merit a country has to have strong institutions, as the book Why Nations Fail explains so well. Moreover, in the case of emerging countries, it is a big mistake to only look at GDP growth to evaluate levels of success. In the last few years that  Mubarak was in Power, Egypt grew at rates of over 6%, but instead of leading to the appearance of a middle class, said growth was siphoned off by a kleptocracy.  Hence a supposed bonanza led to greater geopolitical risk. 

Third. The best way to combat inequality does not lie in harsh fiscal regimes or inflammatory policies, but rather in raising the purchasing power of the disadvantaged (by rounding their income levels up, not bringing others down).  This can be achieved through a variety of policies. i) structural reforms that generate economic growth, ii) promoting productivity as playing a major role in raising per capita incomes without jeopardizing the country’s competitiveness, as well as being essential to achieve points one and two, iii) a top-level education in order to ensure a successful future of the youngest generations, given that quality education is closely related to growth and productivity.

In the light of recent history, many western democracies, headed by political organizations of varying persuasions, have failed miserably to implement measures to “balance things upwards”. The destruction of education in many Western countries is probably the most shameful legacy that many of our descendants will hold against us.  The reason for this is no other than a question of incentives: good measures take years to yield results, while the only incentive the political classes have lies in winning the next elections.

In the end, as on many other occasions, it will be history that judges the incompetence of our elected leaders and the complacency of voters. 

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