How Income Redistribution Could Help Stabilize The Economy

by: Kimball Corson

It is time to put what is unspeakable for many on the table for discussion. Capitalism in America is seriously compromised. It is not working, except for large global, multinational corporations or niche companies which address immediate needs. The rest of the economy is permanently in the doldrums.

This is so for three key reasons. To begin with, our balance of trade leaves our economy permanently depressed. What we spend abroad for oil and such is money we don't spend at home. Next, the huge number of continuing unemployed and underemployed leave labor markets and also the economy permanently depressed. The unemployed and underemployed buy less. Also, the ratio of those employed to the population has collapsed (see the graph, click to enlarge). Worse, this graph does not include the problem of underemployment.

Click to enlarge

Finally, our distribution of income has become so badly skewed that the number of dollars going into the purchase of consumer goods and services, as opposed to secondary financial assets, is permanently depressed and damaged. Middle and lower class American spend a much higher percentage of their income on consumer goods and services than rich Americans do. But relative income has been redistributed from them to the rich.

Income redistribution would largely ameliorate the last two problems which would be a major improvement for our economy. Consider it.

Ours is a consumer driven economy. With most income in the hands of the rich, as a nation, we consume less and too little. The rich spend a much lower percentage of their income on consumer goods and services and more on stocks and bonds than those who are not rich. This problem is serious and it is bound up with the key failing of capitalism that most economists understand, but dare not speak out about. But, first, the numbers on the skewed income distribution and then a discussion on how capitalism has failed us in this regard.

Currently, the top 50% get 85% of all the income and the bottom 50% receive only 15% of all income. The top 1% get 24% of all income. Then the 400 highest families on average receive an income of $345 million per family. There are now over 1000 billionaires -- not millionaires, billionaires -- in the US with combined net worth of over $4 trillion.

Wealth, too, is massively concentrated, but that is a much lesser problem. As to wealth, a different, the top 1% are now estimated to own between 40% and 50% of the nation's wealth, more than the combined wealth of the bottom 95%. This is important primarily because wealth in the form of capital – plant and equipment, primarily – generates income, especially for those at the top end of the income distribution. To be sure, families with incomes up in the many millions rarely get all their income in the form of salary for the head of the household. Most is income from capital.

Consider now the key problem of capitalism, its Achilles heel if you will. Capitalism works well at it front end, that is, in regard to competition and the allocation of most productive resources. Its theories are well developed and extensive. It fails miserably and is hugely atrophied at its back end, on how income gets distributed. All it says is that, if there is perfect competition throughout the economy, each factor or type of input to the production of goods and services, including labor as an input, will be paid the value of what the last unit of that factor is worth to the productive process, that is, the value of its marginal product. That is true for all inputs. The bigger the supply of labor, other things equal, the lower will be the value of its marginal product and, therefore, its pay. But all this assumes that is how income gets distributed. But that is not so.

First, competition for labor is not perfect. Wages are very inflexible and resistive to being lowered. The market mechanism doesn’t work well. Unions also intervene. The owners of capital – plant and equipment -- do all they can to make production processes as capital intensive and free of labor as possible. Our manufacturing sector in America has been made very productive where it can be highly capitalized and machines substituted for labor. Therefore, labor’s participation and so its income generally have fallen, relatively. Government corruption and educational/intelligence differentials have also worked to skew the income distributions.

Second, very few workers are paid the value of their marginal product. Pay tends to equal what an employee can induce the political system within which he works -- be it a firm, corporation or other business -- to pay him. CEO's do well. So do others officers and those tightly tied into the business money flow. Others struggle. Many -- now 25% unemployed (9.2% looking -> 17% including now those who are not -> 25% counting in the under employed, too) lack even the chance to struggle. Worse, pay at marginal value rates can be awful, too. Distributionally, the system simply does not work well, neither in theory or fact. It is politically and financially corrupted beyond repair.

The idea that the factors of production are paid the value of their marginal product -- about all economics has to say on distribution and then in a perfectly competitive economy -- is a joke. It is the Achilles heel of capitalism and the reason so many European and American intellectuals and European countries reject the distributional side of capitalism, that, and the perceived dishonesty involved. American economists also recognize the problem but are too silent about it because big multinational corporations pay millions for research by their universities. Their silence is substantially bought. Harvard and Columbia study and research the inequalities in detail, but there is hardly a word, even from those institutions, on anything remedial.

However, Charles Lindblom, a Sterling Professor Emeritus of Political Science and Economics at Yale University and author of the two wonderful and easily understandable books, The Market System: What It Is, How It Works, and What to Make of It and Politics And Markets, has this to say about the problem at a macro level:

While the Market System is the best mechanism yet devised for creating and fostering wealth and innovation, it is not very efficient at assigning non-economic values and distributing social or economic justice.

That is putting it mildly, as Lindblom does all things.

Classical economists such as Adam Smith, Thomas Malthus and David Ricardo were concerned with the theory of income distribution. How it is supposed to work between the main factors of production, land, labor and capital. They focused on and developed the value of the marginal product concept. Modern economists no longer really believe that and now fully recognize that “income inequality diminishes growth potential through the erosion of social cohesion, increasing social unrest and social conflict causing uncertainty of property rights. Extreme inequality can effectively reduce access to productivity enhancement measures, or cause such measures to be allocated inefficiently toward those who already have, or can no longer absorb such measures.” Wikipedia. But again, they won’t speak up.

O.K. so the distributional side of capitalism is badly broken. Why and what can we do about it? Those are the questions.

As to why, there is an emerging consensus. The causes of the egregious skew in the income distribution are reasonably well known and understood: they are 1) intelligence and educational differentials, 2) using government for high income self interests, 3) compensational abuse by executives at the expense of others, 4) using the economic system opportunistically, knowing there will be little enforcement of the laws -- probably in about that order. Each and all are used to destroy compensation equal to the value of the marginal product which is the only theory capitalism has for distributing income.

As to how to effectuate income redistribution back in the direction from which it has been skewed, two methods are most suggested.

Years ago, Milton Friedman proposed the negative income tax. Rather than have a sea of social programs to help those short of income, with all the bureaucracy and expense that entails, instead we should simply pick an income level, say, the poverty level; if you are above it, you pay taxes; if you are below it, you receive a check for cash, all with minor adjustments for disincentive effects. A negative income tax system could be used with a highly progressive income tax, especially at the top end to correct annually for the distributional system failure we observe. Instead of tipping at the poverty level, a sliding scale could be used instead of a single point, so checks in various amounts, depending on income, were sent out from the tax revenues obtained, again, with adjustments for work disincentive effects. We could tailor the distribution to what we want as a matter of social policy.

Alternatively to a negative income tax, we could do what many advanced European nations do. They use free markets on the front end to generate income and wealth and then correct a bit for income inequality by partial redistribution of income in the form of free health care, free or subsidized education, subsidized transportation and some other free or subsidized social services which give their citizens a much better overall standard of living than ours, on average, according to multiple measures, e.g., infant mortality, children living in poverty, homelessness, educational achievement on average, number of persons jailed per 1000, percentage of population receiving medical care, etc.

By either of these means we could significantly correct the income distribution problem and improve our economy substantially. Several points should be made regarding proposed income redistribution by either of these means.

First, excessive spending in Europe, over and above tax receipts, especially by the PIIGS, is little different than our own excessive spending in the U.S. over our own tax receipts. Neither our, nor European deficits are a necessary condition of income distribution by either of these proposals. Deficits arise largely from poor government management. They are not necessary under either system. Smart cookies, those Europeans, when they don't mismanage their budgets. When some do, they become PIIGS, looking for bailouts.

Second, there is this criticism. The work disincentives would be excessive. This is not true. Adjustments can be made to the negative income tax proposal, as Friedman did, to ameliorate that problem. As to the European method, the disincentive effects are essentially non-existent because too many day to day needs remain to be provided for.

Third, we are not taxing or taking away the wealth or capital of those owning most of it. It is not expropriated from them and then becoming owned by the state, as in Socialism. So this is not Socialism, as many misunderstand the word. There is only taxation at highly progressive rates the income which is in minor part from personal labor, but mostly from that capital. Any attending problems for the economy, by way of residual disincentive or distortion effects, are certainly less than the distortions and problems we now face.

Finally, no one is proposing full equality of income. In their study for the World Institute for Development Economics Research, Giovanni Andrea Cornia and Julius Court concluded that both very high egalitarianism and very high inequality cause slow growth. According to them, considering the inequalities in economically well developed countries, public policy should target an ‘efficient inequality range’. The authors claim that such efficiency range roughly lies between the inequality observed of a typical Northern European countries ( a Gini coefficient of about 25) and that of countries such as the USA, France, Germany and the UK (Gini coefficient of about 40). The idea here is that for most countries, there is an optimum inequality of income, but surely for us, well below the inequality we have. Ours is a major problem.

The impediments to income redistribution are buried in the sentiments promoted strongly by some in America (1) that every penny a person can finagle out of the economic system is theirs by God given rights, (2) Socialism or anything remotely resembling it is anathema, (3) government and taxes are evils which should be, if not abolished, then at least be chopped to a tenth of their present dimensions. The sentiments have promoted excessive income inequality in America. Indeed, we have already had income redistribution in America, just in the wrong direction! The economic system that it has produced is not only not working; it is unworkable.

If we do not redistribute income as I suggest, we can expect aggregate demand to remain depressed and our economy to stay in the doldrums. Better, but less interesting and profitable investments, in that context, would focus toward large global, multinational companies such as Coca Cola (NYSE:KO), GE (NYSE:GE), Procter & Gamble (NYSE:PG), IBM (NYSE:IBM), Johnson & Johnson (NYSE:JNJ), etc, with better and more profitable opportunities in specialty companies which address specific and immediate problems in the U.S., those which fill a more unique niche and, less interestingly, those which reliably serve the large global, multinationals. General businesses can expect to remain depressed with insufficient consumer spending.

With redistribution, some reforms in Washington and in corporate compensational practices, our economy has every chance to return to its former self and historical approaches to the market and investing again working quite well. The market could then be expected to better reflect truer values and face less volatility.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in FSYS over the next 72 hours.