The trade-off between equality and efficiency reexamined

After having read and reviewed Stiglitz's book earlier this week, and after having written the following paragraph...

"I too have long considered the relationship between equality and efficiency to be non-linear, instead of just a simple trade-off. Too much equality isn’t good since it reduces incentives, but neither is too much inequality. I would say the relationship is of an inverted-U type where moving to both extremes – too much and too little equality is bad for the economy. The trick is to find an optimal point which reduces the level of inequality where it offers more opportunities for everyone, but also just enough for it to continue to drive incentives. More on that in my next blog post."

...I just had to dig deeper into the whole equality-efficiency trade-off. So I picked up a seminal book from a man who specialized in economic trade-offs, none other than - Arthur Okun! Okun is more famous for his "law" stipulating the linear relationship (read: trade-off) between GDP and unemployment, where every 1% increase in the rate of unemployment corresponds to a 2% decline of GDP. But today I will not be examining this supposed relationship from the 60s, but a more contemporary one (proposed in the 1970s), claiming that there is a similar linear relationship between equality and efficiency, all summarized in the following book:

Okun, Arthur (1975) Equality and Efficiency. The Big Tradeoff. Brookings Institution, Washington, DC. (this would now be vol. 12 of the What I've been reading section)

Okun's book, published in 1975, testifies of this relationship where greater economic equality necessarily to some extent implies lower efficiency of the economy. In other words, lowering inequality comes at a cost of lowering efficiency. He develops a very interesting argument in which he acknowledges this trade-off, but also proposes a set of policy interventions that would increase both efficiency and equality – such as policies aimed at attacking inequality of opportunity, like racial and sexual discrimination in the workplace (which were arguably even greater back in the 1970s than today) and barriers of access to capital. So in a way even though he implies a linear relationship between equality and efficiency, where one is necessarily sacrificed in terms of another, he clearly sees that when inequality is too high, it can also act as an impediment on efficiency. Okun emphasizes on several occasions that he is a stern believer in the market system, but also that some rights (like the right to vote) should not be bought and sold for money. In other words, he believes in the enormous efficiency of the market system (he devotes an entire chapter emphasizing the benefits of the “mixed” economy model vs the socialist economic model), but is also concerned with the moral implications of why some of our basic human rights cannot have a price tag attached to them. The reason why is very eloquently summarized in following sentences: “Everyone but an economist knows without asking why money shouldn’t buy some things. But an economist has to ask that question”. Hence the first chapter.

It is in this book that he also uses his famous “leaky bucket” metaphor to emphasize the inequality-efficiency trade-off. Here’s a brief explanation: say you want to tax the richest families for a certain amount of money (e.g. $4000 per family) and then redistribute this money to the poor so that each poor family gets $1000 (the ratio of poor to rich is assumed to be 4:1). Now imagine you are carrying all this money you took from the rich in a leaky bucket, so that each poor family will necessarily receive less than a $1000. What’s the cutoff value of money the poor would receive for you to consider the transfer efficient? There is basically no wrong answer here – it depends on your preferences for redistribution. Some people would accept 10 or 20%, some 60% (like the author), some almost 99%. The point that the leaky bucket experiment is trying to make is that each redistributive action will necessarily come at some cost in efficiency. But we as a society must accept this in order to lower economic deprivation that not only hurts the economy, but it can also infringe on our principles of democracy.

Okun devotes a considerable amount of attention to the problem of too much power in the hands of certain interest groups and how they might use it to bias the budget (and much more) in their direction. He cites oil producers, farmers, teachers, union workers, gun lobbies, you name it. Specifying the intensity of their preferences through money is a perfectly legitimate manifestation of their democratic right to fight for their interests. However by doing so they necessarily channel public resources to the hands of the few, at the expense of an unorganized majority which lacks enough interest to engage (just as Mancur Olson taught us).

What fascinates me is that this discussion seems so contemporary, yet Okun wrote it back in 1975! Furthermore, he lays out other facts about 1975, where he complains about the “unacceptably” high levels of wealth and income inequality: “The richest 1 percent of American families have about one-third of the wealth, while they receive about 6 percent of after-tax income.” Today that figure is much higher – it is about 18% of total income. In the books on inequality I’ve read so far, the 1970s were the golden age! But according to Okun, it was still too high. Even in the decade when top income tax rates were 75%, America still had the inequality problem.

This can only confirm Okun’s hypothesis that the US has always sacrificed equality for efficiency. Inequality in the US has been and probably always will be higher than in Europe – but that is precisely because of the innovation-driven, trial-and-error, cut-throat capitalism of the US versus the welfare-state, cuddly capitalism of Europe. And that's fine. But the fact is that inequality in neither of these has to be this high. Hence the final chapter where he proposes a set of standard policy measures (some of them quite good, focusing equality of opportunity) designed to combat the “alarmingly” high inequality of the 1970s (sic!), without sacrificing efficiency. 

Building up on Okun: The trade-off reexamined

Following in that direction, I consider the given relationship to be an inverted U-shaped curve, with higher levels of inequality corresponding to lower levels of efficiency (and hence GDP/income per capita growth), and vice versa - too much equality implies a lack of incentives for the people to create wealth. In other words there will (and should) always be some acceptable level of inequality, which in itself is not necessarily bad given that it is combined with high social mobility. However if the levels of inequality are too high they will negatively impact economic growth. The goal is then to find a balance of lower inequality combined with high social mobility, in order to maximize economic efficiency, i.e. to maximize the productive capabilities of the economy. In other words, there is no linear trade-off between equality and efficiency - there is a need to strike a balance between them. I summarize it in the graph below:

We start from the bottom-left corner with the Gini index at its theoretical 0 level, implying perfect equality (each person having the same income). Clearly for that level of equality efficiency (measured as either total factor productivity (TFP) or GDP p/c growth) is also around 0, since no one has any incentives to produce and to innovate given that all rewards are equal. Even at slightly lower levels of equality (after introducing some inequality), efficiency does not increase, assuming that it takes time for agents to pick up the signal that there is now a possibility to work more in order to get more. Then as inequality stats to increase, the level of economic efficiency increases even more as the relationship becomes reinforcing - more people see that their innovation, talent or extra effort will be significantly rewarded so they expand their activities which creates upward pressure on both inequality and efficiency. Until it reaches a point of maximum economic efficiency for a given level of inequality. As I've pointed out in the graph this is not necessarily at the Gini=0.3, it could be either higher or lower than that - this needs to be verified empirically. After that global maximum of the curve, the relationship turns negative - more inequality beyond the efficiency-maximizing level slowly but steadily decreases economic efficiency until society descends into close to perfect inequality (a Gini=1 means one person has all the income), where again there are no incentives to produce, innovate or create new value, given that all of this new wealth will just fall into the hands of the selected few (like in a stationary bandit dictatorship).

The question to ask is why does this relationship between efficiency and inequality suddenly turn from positive to negative? Which are the forces at work that turn inequality not only into a social, but also an economic problem for society, in a sense that greater wealth accumulation into the hands of fewer and fewer individuals undermines productivity and the desire to innovate? The answer is exactly that - as more and more people start realizing that the value they produce is, within a crony system, ending up in the hands of the few, rather than being distributed among the many, their productivity will necessarily decline. It is exactly like living in a communist dictatorship. Most people rationally choose not to innovate because they realize that any wealth they create will be extracted by the state. So a communist dictatorship will always, ironically, resemble a society with high levels of inequality, given that the elite around the dictator will hold not only full political power, but also a vast majority of economic power (if you want examples just take a look at this list to see which kinds of countries score highest in their Gini levels). 

Now, I've deliberately put the US on the right side of the curve suggesting that it is currently beyond the peak of an efficient level of inequality, and that it certainly does have room to lower its current high inequality which would not hurt its economic efficiency. On the contrary - it would most likely improve it. Remember that the total factor productivity in the US has been in a stage of relative stagnation since the 1970s, which I think can be explained by the simultaneous origination of the Third Industrial Revolution and the technological progress that has lowered productivity and kept low and middle-class wages relatively stagnant. Combined with globalization and a host of other factors (read about all of them here) all of them have affected the rise of inequality combined with a decrease of efficiency. An experienced researcher is likely to conclude that perhaps there is an omitted variable bias in this story, meaning that there is one common factor that is affecting both the rise in inequality and the decline of efficiency - technological growth is the perfect example. I agree, the relationship is far from proven to be a causal one. Nevertheless, some levels of income inequality are obviously bad for growth. If the majority of the population is experiencing declining living standards this affects their purchasing power and their consumer choices, which on the other hand puts a lot of businesses in danger of having declining sales. A consumerist society is only efficient if the people can get a decent salary for a decent job. The prosperous cycle is an amazing thing, but it needs to be in motion. If it stops or it slows down (and we can actually measure this by an indicator called the velocity of money, which is dancing at historical lows right now!) then the economy is likely to undergo a period of prolonged stagnation. 

Finally, given that my graph above is a mere theoretical construct, one should really consult the actual data to see whether or not it holds. I intend to do just that in the next few years.