The Weakest Link of Economic Theory

by: Kimball Corson

The truly weakest part of economic theory is the notion that resource inputs to production receive compensation equal to the value of their marginal contributions. The theory is little more developed than that and of course it assumes perfect competition and information. Basically, for a matter of such great importance, it is simply a bad joke and Capitalism’s weakest link. Let me explain why.

First, it simply isn't true. As Karl Marx postulates, capital hogs much more than its share because it can. Those who own businesses control the receipt of money by those businesses in the first instance and they control the distribution of that money in the last instance. Growth in GDP these days derives considerably from increased productivity so that increment in GPD and much more, is being expropriated to capital which is owned mostly by wealthy Americans.

To make matters worse, income distribution within firms is controlled as much by political factors and tensions as by the value of marginal contributions to the firm. Cabals and cliques in firms govern income distribution within them, as well as the distribution between labor compensation and the portion of profits paid to capital and those held as retained earnings.

Unions cannot block that and haven’t. Unless all areas of the economy are unionized, unionized companies are simply at a competitive disadvantage in the larger labor market. In application here then, economic theory fails massively and almost completely. That it should be so for an aspect of economics that is so important to us all is a travesty. This is economics’ dirty little secret.

Second, the standard theory of income distribution or returns to productive inputs, in addition to being wrong, is very immature and slight, being quite underdeveloped. It is economics’ Achilles’ heel. It is Capitalism’s Achilles´ heel. Just try to find a university course of the theory of marginal returns to productive inputs. Courses on aggregate income determination, yes, but not on the theory of income distribution. (I just checked all of MIT’s course offerings to confirm this, at least for that University.)

To the extent income distribution is studied at all, it is only to determine what the distribution is and how to find that out and measure it. Again, for all the developed theory in the rest of economics, for Capitalism to fall down here so miserably is ironic. For most of us, this is what matters most. A good argument can be made here that Marx’s labor theory of value is more serviceable in this quarter, notwithstanding its technical deficiencies, than the economic theory of capitalism.

Third, in the absence of a valid or useful economic theory of income distribution, we are left with too much of a political free for all, both within corporations, other businesses and within and by government. We are left without a standardized measuring rod in regard to what the distribution of income should be among households. Absent a normative standard, there is nothing to tell us how to correct or how far off we are.

A theory of income distribution that I have formulated elsewhere is, not compensation according to the value of marginal contributions, but income distribution corrected by government within a negative income tax system which is designed to maximize aggregate demand or GDP, while not impairing the nationwide stock of capital, adjusted for reasonable growth. That situation would be sustainable, politially and economically. What we have now is not.

When income is maldistributed as it is now, I contend, that lower income households, which spend the highest percentage of their income on consumer goods and services, spend less, therefore reducing aggregate demand because the loss of demand for goods and services is not made up for by the higher income households which spend a lower percentage of their income on goods and services and a higher percentage on purchasing financial instruments, such as stocks and bonds. Aggregate demand and GDP both suffer, as a consequence. Financial markets are inflated by the resulting excess demand.

Net worth and financial wealth distribution in the U.S. in 2007

That income is maldistributed now is beyond doubt. No economic theory can justify the present maldistribution.

That is the top 20% of households, get 61% of all income, and that was in 2006, with less than40% of all income going to the bottom 80% of households. Indications are the situation is significantly worse now. To be in the top 1% now, your income in 2005 dollars has to be well over $1 million a year.

As the graph below shows, the top 1/10 of 1% get 6% of all income generated by the economy.

The rising concentration of income is spelled out in a special New York Times analysis of an Internal Revenue Service report on income in 2004. "Although overall income had grown by 27% since 1979, 33% of the gains went to the top 1%. Meanwhile, the bottom 60% were making less: about 95 cents for each dollar they made in 1979. The next 20% - those between the 60th and 80th rungs of the income ladder -- made $1.02 for each dollar they earned in 1979.

Furthermore, the Times author concludes that only the top 5% made significant gains ($1.53 for each 1979 dollar). Most amazing of all, the top 0.1% -- that's one-tenth of one percent -- had more combined pre-tax income than the poorest 120 million people." This is seriously out of whack, I suggest, by whatever standard is used.

The situation regarding wealth distribution and the income from it is even worse.

Share of capital income flowing to households in various income categories

Adapted from Shapiro & Friedman (2006).

The bottom 80% of all households get only 12.6% of all income from capital, less massively by far than the top 1%.

That the distribution of income is politically determined within corporations may be also seen by the following:

CEOs' pay as a multiple of the average worker's pay

We are falling ever more off the mark under the distribution theory I have argued and aggregate demand is therefore suffering so badly that, along with our continuing trade deficit and hostile policies toward small businesses, we can, I further argue, expect a new “lower normal” level of sustainable GDP at any future time relative to we would otherwise would have had without these problems.

Indeed, income is now so maldistributed that we are slowly but surely moving into the domain of popular heightened hostility toward government and even developing social unrest and some ill-focused grass roots movements. Our leaders are asleep at the wheel here, too busy preening and feathering their own nests. Because it is developing slowly, like a train in the early stages of picking up speed, they don’t even see it coming.

Disclosure: none relevant