Harvard Professor Jeffrey Frankel : The Oligarchy Fallacy

Income inequality has received a lot of attention lately, particularly in two arenas where it previously received little: American public debate and the International Monetary Fund. A major reason is concern in the United States that income inequality has returned to Gilded Age extremes; but inequality has increased in many other parts of the world as well, and remains high in Latin America.

What have we learned so far? Perhaps what is most interesting about the current discussion is that much of the focus has been on the consequences of inequality beyond its adverse effect on the welfare of the poor.

One such avenue of debate starts from the hypothesis that inequality is bad for overall economic growth. Another begins with the view that inequality leads to volatility and instability. Did inequality cause, for example, the subprime mortgage crisis of 2007 and hence the global financial crisis of 2008?

A third proposition is that inequality translates into envy and unhappiness: someone who would have been happy at a given income is unhappy if he discovers that others are getting more. A persuasive version of this claim holds that top executives demand and receive outlandish compensation not because they value the money so much, but because they compete with each other for status.

A fourth concern appears to trump even the first three. It is the fear that, because there is so much money in politics,  the rich succeed in persuading governments to adopt policies that favor them as a class. Whereas the first three sources of concern are amenable to self-correction, at least in a democracy, the concentration of economic and political power in an oligarchy is self-reinforcing. In the US, recent Supreme Court decisions regarding campaign contributions suggest that the influence of money in politics will only grow.

But pursuing the anti-oligarchy argument is not the best way to reduce inequality. Rather, we should work from the premise that poverty in particular, and inequality in general, is simply undesirable. Even in the US, most voters care about inequality, and even among the top 1%, approximately two-thirds believe that income differences are too large and support progressive taxation. Most Americans believe in helping the less fortunate, provided that it can be accomplished without undermining economic efficiency through excessive government intervention or distortion of incentives.

The problem is that, despite their economic self-interest, voters often elect, and reelect, politicians who enact laws that are inconsistent with such goals. Ten years ago, for example, America’s elected leaders somehow hoodwinked the median US voter – who is most likely to leave little to his or her heirs – into believing that it was necessary to eliminate taxes on $5 million estates in order to protect small family-owned farms.

In other words, the problem is not that the median voter is unwilling to trade off growth in exchange for more equality. The problem is that the political process produces outcomes that deliver both less growth and less equality.

For the US, the most sensible measures include expansion of the Earned Income Tax Credit (EITC), elimination of payroll taxes for low-income workers, a cut in deductions for high-income taxpayers, and restoration of higher inheritance taxes. These are policies that reduce inequality efficiently, at relatively low cost to aggregate income. Other policies – including universal pre-school education and universal health care – may even promote overall economic growth while reducing inequality, especially if they are financed by efficiency-enhancing measures such as the elimination of fossil-fuel subsidies (and, preferably, their replacement with a tax).

Meanwhile, many government programs that are billed as ways to improve income distribution benefit the poor relatively little and impair economic efficiency. The original rationale for agricultural subsidies was largely to help small farmers, but the main beneficiary has long been agribusiness. Mortgage subsidies contributed to the subprime loan crisis, without even primarily helping lower-income families. And yet many Americans are persuaded to support such policies, not because it is in their interest, but because they do not understand the economics.

Other countries have similar programs that are sold as pro-equality but are inefficient or even undermine their stated goal. In developing countries, distortionary measures that tax, subsidize, or regulate food and energy prices tend to be poor tools for improving income distribution, and frequently have the opposite effect. Of the more than $400 billion that countries spend on fossil fuel subsidies each year, for example, far less than 20% of the benefits go to the poorest 20% of the population. A disproportionately small share of social spending goes to the poorest 40%. Conditional cash transfers, on the other hand, have proven highly effective; they reach the poor while promoting education and health.

The anti-oligarchy argument claim is that the rich have too much money, which they use to elect politicians who will enact laws that favor their interests. But it seems better to argue about the best policies to improve income distribution efficiently, and to point out which politicians support them. “Yes” to the EITC and pre-school education; “no” to subsidies for oil, agriculture, and mortgage debt.

The alternative to such engagement is a very roundabout strategy that would achieve more enlightened policies by weakening the ability of the rich to buy votes. However important that goal may be, attaining it requires reducing the share of income that goes to the rich by addressing inequality, which requires pursuing pro-equality policies, like the EITC and pre-school education. Is complaining about oligarchy really a more effective strategy for achieving these policies than arguing the case for them directly?