Sharing the Gains from Economic Growth
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The Fiscal Times
January 28, 2014

President Obama will make reducing inequality a major part of his State of the Union Address according to several reports. But to avoid being accused of waging class warfare, he will talk about creating “ladders of opportunity” instead of focusing directly on the inequality problem.

This shift in emphasis is a mistake because it misses a key part of the inequality problem. It’s true that opportunity is unequal, and creating “ladders of opportunity” should be part of any attempt to address the inequality problem. But it’s also true that the distribution mechanism is broken, the gains from economic growth have not been widely shared, and a focus solely on opportunity does nothing to solve the problem of income being misdirected to the upper end of the income distribution.

Related: The Mobility Myth and Other Income Inequality Surprises

Nevertheless, this represents an important shift in the emphasis of economic policy. For the last thirty years or so, we have focused mainly on production – on enhancing economic growth – based upon the idea that a rising tide lifts all boats. By lowering taxes on businesses and on the so-called job creators at the top of the income distribution, the economy would grow faster and the gains from growth would be widely shared. Sure, those at the top might do relatively better than others, but so long as everyone was gaining from growth that would not be a problem.

But that is not what happened. Tax cuts and other policies favorable to business and the one percent did not produce a growth miracle as promised, and the economic gains that we did realize went mainly to those at the very top of the income distribution. The result was stagnating wages for the masses and staggeringly high gains for the few.

This is not the first time there has been a shift in focus from production to distribution motivated by a desire to understand why the distribution of income is so unequal. When Adam Smith wrote the Wealth of Nations in 1776, the major focus was on production.

He was writing at the beginning of the industrial revolution, a time when most of the population had lived at subsistence for as long as anyone could remember, and the major question was how to provide enough goods and services to lift the average household out of such misery. Thus, Smith wrote about topics like the division of labor as a means of providing the needed boost to economic growth.

Related: 5 Years After the Crisis—Why the Income Gap is Widening

As the industrial revolution took hold and economic growth increased, for the first time in memory there was a large economic surplus over and above what was needed for people to simply survive. But conditions for the masses did not improve as expected. Instead the gains were distributed highly unequally.

This prompted economists like David Ricardo to begin thinking about the distribution of goods and services, and to develop theories about wages, rents and profits. Why did various groups receive unequal shares of income, and was this efficient in terms of creating the right incentives for economic growth? Was the distribution fair and equitable from a moral perspective?

The answer, according to the economics that developed subsequently, was yes. Theoretically, income equaled sacrifice – people were rewarded with precisely their contribution to society at the margin. That was fair – people got exactly what they “deserved” – and, since people were rewarded according to their contributions, it created the right incentives for innovation and economic growth.

But this conclusion relies upon markets to direct income properly. What if the distribution of income suffers from market failure? We are used to thinking about market failure when it comes to production, for example the consequences for prices and output when a firm has considerable monopoly power, but we do not think as much about how market failures in either production or distribution affect the distribution of income. 

Related: Obama’s Risky Strategy on Closing the Income Gap 

Of course, one of the big lessons of capitalism is that production and distribution are related, and we hear no end of complaining about negative effects on growth when income is redistributed away from those at the top through taxation and other means. But we should be just as concerned, perhaps even more so, if a broken income distribution mechanism causes income that should go to workers to be directed to the top instead.

That is what has happened over the last several decades. If you accept that paying people according to their contribution to production is fair, equitable, and efficient in terms of the incentives it creates – paying people the value of their marginal product in more technical terms – then something has clearly gone wrong with the distribution mechanism.

Even though worker productivity has gone up over this time period, wages and income have stagnated. Workers are not getting what they deserve according to economic theory and the societal norms we have adopted that say people should be paid according to their contribution to the productive process.

Related: The Pope’s Views on Inequality Test Obama’s Mettle

We need to understand why the distribution of income is broken, and then figure out how to fix it. My own view is that the decline in unions and the increase in political power among the wealthy have caused a very unequal bargaining position between workers and firms.

The unequal power relationship has allowed wages to stagnate while incomes at the top have soared. But whatever the cause, the mechanism that distributes income to various groups in society is broken, and this important problem needs to be better studied and better understood.

That is why Obama’s shift in emphasis from inequality to opportunity and his fear of being accused of class warfare is a mistake. We need better opportunity, particularly at the lower end of the income distribution, but we also need to be sure that when those opportunities are realized income rises with productivity. 

When it doesn’t, correcting the problem through taxes and transfers or other means is not class warfare. It simply takes income that was undeserved according to societal norms, and sends it where it rightfully belongs.

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University of Oregon macroeconomist Mark Thoma writes primarily about monetary policy its effect on the economy. He has also worked on political business cycle models. Thoma blogs daily at Economist’s View.