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The Chairman's Blog
The Roots of Income Inequality
The Chairman's Blog

The Roots of Income Inequality

Gallup Chairman Jim Clifton interviewed Jonathan Rothwell, Gallup's principal economist, about his book on income inequality, A Republic of Equals: A Manifesto for a Just Society, which is being released today.

Jim Clifton: What is your book about?

Jonathan Rothwell: The book has three goals:

  1. Explain where income inequality comes from -- specifically, why 1% of U.S. income earners take home 20% of pay.
  2. Describe what makes a society just.
  3. Advance an argument that a market-based economy with political equality for all offers the best means of achieving a fair and equitable distribution of income and social status.

Clifton: Why should leaders care about this book?

Rothwell: Income inequality is one of the most contentious political issues of our time. The leading Democratic Party candidates talk about it and have proposals to address it. On the political right, there is robust debate among scholars, pundits and politicians about what to do about income inequality, if anything.

What is lost in the debate is a coherent theory for why income inequality exists.

Many Democrats believe mass inequality is a natural consequence of capitalism. The party's left wing believes only income redistribution and public control of healthcare, energy and banking can fix inequality. More scholarly views of inequality attribute it to declining unionization, increasing globalization and automation -- and how these factors interact with skill and education.

One problem with these explanations is that they act as though inequality was invented in 1980 -- a turning point in income inequality -- and never existed prior to that, which isn't true.

A second problem with these explanations is they're not supported by the facts. The highest income earners have never worked in sectors that are highly unionized (e.g., finance, healthcare and professional services), so declining unionization has had almost no effect on them.

Likewise, most top income earners are in domestic sectors that aren't affected by international trade, so globalization isn't part of the story. Moreover, at the macro level, countries that trade more are no less equal.

There is also no reason to think that automation has disproportionately benefitted most top earners. Hedge funds were invented in 1949 long before the widespread use of computers and have basically had the same 2 and 20 pay structure since their inception. Doctors and lawyers and most CEOs do not use automation or robots.

"Income inequality is one of the most contentious political issues of our time."

Clifton: Does it just come down to talent?

Rothwell: I have no doubt that many rich people are highly talented. But it can't explain most of income inequality for several fundamental reasons.

First, what we know from a century of research on employee performance, cognitive ability, and personality is that a diverse constellation of traits predicts success in life, measured as performance, income, or health status. These include IQ, conscientiousness, emotional stability, enthusiasm and integrity. These traits are distributed more equitably than income.

My analysis of data from around the world shows that CEOs, doctors, lawyers and other high-income earning groups tend to score slightly higher on measures of IQ -- but not nearly enough to justify more than moderately high salaries. And plenty of very high-scoring people make rather modest incomes. I calculate that if people were paid solely on IQ, experience, and personality traits, U.S. income inequality would be half of what it is currently.

A second reason to question the idea that talent explains income distribution is to see how occupational status affects income, irrespective of talent. This can be done by looking closely at specific occupations that are massively over-represented in the top 1% of income earners.

Economists have studied these occupations -- in finance, medicine, law, dentistry -- using a variety of methods. One is to see what happens when someone changes careers. Moving into the high-paying occupations and industries inevitably results in a massive income increase, whereas talent has not changed.

"What is lost in the debate is a coherent theory for why income inequality exists."

Clifton: Why do we need a theory of income inequality?

Rothwell: We need to better understand inequality so we don't make mistakes culturally and in public policy.

Culturally, we are most apt to advance when we are confident that education, literacy and work are rewarding. The notion that competence is explained by talent, rather than opportunity and education, cuts against this cultural faith. The most inventive period in U.S. history was just after the Civil War, when we eliminated slavery, improved the Constitution, created land-grant universities and started massive investments in education.

Former slaves and their children flocked to schools with tremendous enthusiasm and literacy rose rapidly for Southern Americans of both races. As a result, Americans largely invented the modern technologies we take for granted, and black Americans who moved to the North were right there with them -- inventing at very high rates, with many becoming successful entrepreneurs.

Unfortunately, this all coincided with Jim Crow ideology, which held that social status was purely a function of group genetics. The policies that followed made it impossible for black Americans to fully participate in markets for goods and services, and I'd add that those policies had many negative unintended consequences that went beyond harming blacks -- like economically segregated and over-priced housing.

Likewise, it would be a terrible mistake to prevent markets from working in the name of reducing inequality, as many on the left would like. Segments of the left largely agree with President Donald Trump on the merits of preventing trade with China and Mexico in order to save American factory jobs. But the negative effects of trade on factory workers are offset by large gains from lower prices and pale in comparison to the negative effects of healthcare inflation. The beneficiaries of healthcare inflation have largely been hospital and pharmaceutical executives and physicians, all of whom enjoy huge regulatory advantages won by decades of lobbying. The losers have been everyone else, who now see 18 cents of every dollar go to healthcare.

Beyond trade, proposals to reduce income inequality include raising the minimum wage, encouraging unionization, forcibly breaking up tech companies just because they are successful, and eliminating the independent contractor business model used in the so-called gig economy. These proposals have the wrong understanding of income inequality, and thus propose the wrong solutions.

"Culturally, we are most apt to advance when we are confident that education, literacy and work are rewarding."

Clifton: So why do you think income inequality is so high in the U.S.?

Rothwell: The overarching reason is that we don't enjoy political equality in this country. That has two consequences:

  1. Unequal access to public goods and services -- security, education, healthcare, infrastructure, etc.
  2. Unequal access to markets for goods and services.

The first is especially bad for children born in poor families and holds back many in the black community. Jim Crow policies created segregated neighborhoods, which in turn dispense unequal schooling, policing services, and exposure to environmental toxins and the like. This explains why black Americans outperformed white immigrant communities in the North at the beginning of the 20th century but fell behind by the end of the 20th century.

The second -- unequal access to markets -- is also special in the United States, despite our reputation for being a highly free-market country relative to Europe. In reality, our state governments -- which are controlled in large part by professional associations -- impose extremely burdensome rules on legal services and health services, which end up benefitting elite professional groups at the expense of everyone else. In many cases, European countries have more free-market rules governing these services.

Likewise, the U.S. has famously profitable financial services. But what is less recognized is that banks and financial firms have driven down profit margins for most consumer-facing financial services. The problem with financial services in the U.S. is that the federal government (via the Securities and Exchange Commission) forbids retail investors from participating in the markets with the highest returns and highest profit margins (hedge funds, venture funds, private equity funds). Only accredited investors and institutions can invest in these assets.

As a result of the arms-length process, these funds charge outrageously high fees to union pension funds and other institutions that pool the investments of ordinary Americans, resulting in massive redistribution of income to the top. This isn't a function of markets, but of political economy and regulations.

"A lesson throughout history is that common people will rise to the occasion when given the chance to use their talents."

Clifton: Should we do away with income inequality altogether?

Rothwell: No. Every democratic country has high-income earners and entrepreneurs who do better than the average laborer. No one objects if Serena Williams is paid more than the average pro tennis player. She earned it.

The problem with extreme inequality is that it is based on political power, not merit. For that reason, it is fundamentally unfair. It is also inefficient.

My ideal society would compensate people proportionately to the value of what they do. It would also take care of the poor and disabled and give them equal access to public goods and economic opportunities.

A lesson throughout history is that common people will rise to the occasion when given the chance to use their talents. That is how we got the Industrial Revolutions in Britain and the United States, and that is how we will solve our greatest challenges as a society.


Jim Clifton is Chairman of Gallup.

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