A closer look at income inequality

By Jay Prag

[From the Inland Valley Daily Bulletin]

Politicians from Jerry Brown to Barak Obama have waded into the murky waters known as income inequality. The waters here are murky because it’s not easy to know if income inequality comes from a problem with the economy or is the result of market forces and personal choices.

And not knowing that, it’s not easy to be sure that the “cure” for unequally distributed income won’t create more problems than it solves.

What do we want our country, our state or our region to be: wealthy or fair? And can we somehow be both? History shows that economies often struggle with the competing goals of high average annual income and evenly distributed annual income.

Without worrying where the numbers come from for now, consider two possible scenarios for an economy populated by 10 people. Country X has one person whose income is $100,000 per year and nine whose income is $11,111 per year. In Country Y, everyone earns $20,000 per year. Average annual income in both of these economies is $20,000 per year but it is evenly distributed in Country Y and very uneven in Country X. Some would say Country X is unfair.

In fact, without any additional information, we can only say that Country X is uneven. To say that it is unfair requires that we know a lot more about where the income comes from.

If the “rich person” in Country X forces the rest of the population to work for him and he pays only subsistence wages, most observers would call that economy unfair. Perhaps Country X is a farm and the “rich guy” inherited all of the land and legally owns all of the farm’s production.

The poor people are presumably the farm workers. It could be argued that the “poor people” are getting an unfair share of the crop because of birthright. In this case, the poorer people have no choice about their income.

But it’s not hard to make Country X look a lot less unfair. Suppose the landowner is the only one who knows how to farm. In that case, handing the land over to anyone else would make all 10 people starve to death. While the subsistence wage for the workers might be very low, it isn’t necessarily unfair. The farm owner could have produced enough only for himself and not bother with the other nine people.

Pushing back, you might say the source of the knowledge of how to farm is unfairly distributed.

So unfair starts when only the land owner is given that knowledge. Maybe. But perhaps he isn’t given that knowledge. It might be that getting that knowledge is hard and only the “rich person” put in the effort. Having gotten that knowledge, how much of the crop does that person deserve?

There isn’t an unambiguous right answer to this in economics; the imbalanced distribution of income in Country X might be fair.

Strangely enough, the economy in which everyone earns the same $20,000 might actually be unfair. Country Y’s citizens may have agreed to equally split the crop from a collective farm. But knowing that one’s income is thus derived, no one on the farm will work harder than they have to; you’re aware of the fact that only one-tenth of your extra effort’s output comes back to you.

So an economy that’s guaranteed to look fair might never grow! Some would say that economy is inherently unfair to harder working people.

None of these scenarios is right or wrong. None of them accurately describes the US or California. But all of them are plausible. Given that, we have to consider that fairness is a very hard concept to describe and thus, a very hard thing to attain, let alone assure.

Most government policies that attempt to “cure” income inequality simply try to distribute the crop in a more balanced way after it is grown. The assumption in these policies is that the size of the crop is unrelated to its distribution. Clearly, that isn’t always true.

For my money the closest we can get to “fair” without destroying more income than we redistribute is to make sure that everyone has access to the means of success: everyone can get a good education, everyone can start a business and every can keep most of the proceeds from their own hard work. We will still have income inequality but it can be argued that each person gets the share of the crop that they worked to produce.

Jay Prag is a finance professor at the Peter F. Drucker and Masatoshi Ito School of Management at Claremont Graduate University and serves as academic director for the school’s Executive Management Program.